Night Moves: Is the Overnight Drift the Grandmother of All Market Anomalies
12 Pages Posted: 30 Jun 2022
Date Written: June 17, 2022
The bedrock of financial economics is that there should be a tradeoff between risk and reward: an investment with low risk should have a low expected return, while one that could make you rich should also be one which could lose you a lot of money. A lot of research in finance is focused on finding deviations to this risk-reward tradeoff, which are called “market anomalies” in deference to the idea that they are exceptions to this fundamental law of finance. Discovery of an anomaly is usually followed by frenzied debate and research that tries to explain it away as: 1) a statistical fluke, 2) compensation for some hitherto overlooked risk, or 3) some friction in the market which when fixed will make the anomaly go away.
The “overnight effect" is one such anomaly, which has been uncovered recently enough that its causes are still being hotly debated among researchers and practitioners. The overnight effect refers to the fact that, over at least the past three decades, investors have earned 100% or more of the return on a wide range of risky assets when the markets are closed, and, as sure as day follows night, have earned zero or negative returns for bearing the risk of owning those assets during the daytime, when markets are open. The effect is seen over a wide range of assets, including the broad stock market, individual stocks (particularly those popular with retail investors, and Meme stocks most of all), many ETFs, and cryptocurrencies.
In this article we briefly review the dozen or so papers which have explored this phenomenon to date, which have mostly focused on returns at the level of the broad stock market. We then take a closer look at the behavior of individual US stocks for clues about aggregate stock market behavior. We found that not only did the effect exist at the index level as previously reported, but it also shows up in a suggestively clustered pattern in individual stocks returns, and is particularly strong in “Meme” stocks. We find that a simple long-short portfolio that only takes exposure when the market is closed would have earned a return of 38% per annum (importantly, ignoring transactions costs) with an annualized Sharpe Ratio of about 3.
There are good reasons to care about this market anomaly, namely, 1) retail traders are potentially
missing out on billions of dollars of returns due to mistimed trades, which should concern investors and market regulators alike, 2) there is speculation that the overnight effect might have implications for the long-term valuation of the entire equity market, and, 3) a better understanding of this phenomenon can contribute to our understanding of the limits of market efficiency.
Keywords: Market Anomalies, Valuation and Momentum, Asset Allocation, Global Finance, Market Microstructure
JEL Classification: B12, B16, B20, C00, C10, C11, C50, C57, C73, D03, D81, D83, E00, G00, G02, G11, G12, G14, G17, G23
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