How Index Funds Reshape Intraday Market Dynamics

Abstract

The rise of index funds reshapes stock market trading dynamics: to minimize tracking errors, they tend to execute trades near the market close. As index fund ownership increases, the clustered trading by uninformed indexers enhances underlying stock liquidity preceding the close, exhibiting higher volume and narrower spreads relative to the daytime average. While informed trades (e.g., short sales) as a result migrate toward the close, we find price informativeness deteriorates. We provide causal evidence by exploiting reconstitutions of the S&P500 and Russell 1000/2000 indexes. Evidence suggests that better liquidity but noisier prices before the close encourage long-term information acquisition.

Keywords: index fund, intraday stock liquidity, price informativeness, informed traders, information acquisition

JEL Classification: G10, G14