U Disappeared: Indexing and the Shift of Diurnal Patterns

Abstract

We find that the well-documented U-shaped diurnal pattern of stock liquidity does not hold in recent years: stocks' bid-ask spread appears to decrease, not increase, towards the closing of the trading day. This pattern shift is driven by the rise of index-tracking investors, who need to trade at the closing price to minimize tracking errors. The sharply increased trading from passive indexers improves stock liquidity at the close of trading. We find that stocks with high index fund ownership tend to have a higher trading volume, smaller bid-ask spreads, and lower price volatility over the last 5-minute trading window relative to its intraday average, compared to stocks held less by index funds. Causal evidence is established by exploiting the switches between Russell 1000/2000 stock indexes. Last, we discuss the implications to market efficiency and the cost of indexing.

Keywords: diurnal patterns, indexing, intraday liquidity, price efficiency

JEL Classification: G10, G14