Closing Auction, Passive Investing, and Stock Prices

Abstract

Over the last decade, the volume of market-on-close orders has increased to more than 10% of the entire day's trading volume. This paper investigates this rise and documents four stylized facts: (i) passive investing leads to greater usage of market-on-close orders, consistent with passive fund’s motivation for minimizing tracking error; (ii) the price impact from large market-on-close order imbalances is economically large and transitory, leading to short-term price reversal; (iii) a long/short trading strategy exploiting this reversal results in a significant risk-adjusted return of 13.2 basis points per day, consistent with the hypothesis that investors are compensated by providing liquidity to passive funds; and (iv) informed traders also use market-on-close orders, consistent with Admati and Pfleiderer's (1988) prediction that liquidity trades attract informed trades. Overall, the set of findings demonstrates market-on-close order as an important trading channel through which passive investing affects underlying stocks.

Keywords: Closing Auction, Passive Investing, Exchange Traded Funds, Return Predictability

JEL Classification: G11, G12