Nocturnal enigma targeted by ETF launches
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The first exchange traded funds aiming to cash in on the puzzle of the “night effect” launched in the US on Tuesday.
Academic research has shown that most of the gains chalked up by Wall Street actually happen overnight while the market is officially closed, amid the sparse after-hours trading that occurs on some electronic exchanges.
The same mysterious phenomenon has been noted in a range of other countries, from Japan to Norway.
NightShares, a new ETF provider based in California, is launching funds designed to give investors a straightforward way to tap into this nocturnal trend.
“Though the outperformance of overnight markets has been identified and documented by a large body of research for some time, until now there has not been a simple way for ETF investors to capture the value of this phenomenon,” said Bruce Lavine, chief executive of NightShares and a former iShares and WisdomTree executive. “This is some of the most compelling research I have ever seen.”
Data compiled by AlphaTrAI, a sister company of NightShares, suggest the impact of the night effect is most compelling for smaller companies. As of the end of March, the iShares Russell 2000 ETF (IWM) had returned a cumulative 262 per cent during the night time since 2012, but had lost 26 per cent during official US trading hours.
The large-cap iShares Russell 1000 ETF (IWB) delivered cumulative night-time returns of 200 per cent over the same period while its daytime returns were just 19 per cent, according to AlphaTrAI.
Moreover, the larger overnight returns have not been accompanied by increased risk, as volatility has tended to be slightly higher during the day.
The causes of the night effect anomaly remain a mystery, with little agreement on an explanation among academics and analysts.
Max Gokhman, chief investment officer of AlphaTrAI Funds, believed the release of corporate news after the market close was a factor as earnings statements and mergers and acquisitions activity announced in the evening tended to be positive for stock prices more often than negative.
Gohkman also suggested there was “a big structural desire among institutions to de-risk overnight and re-risk in the day”, artificially pushing prices down at the close and raising them at the open.
This may be driven by “the illusion of control”, with traders confident that they can trade their way out of a problem if the market is open, but not when it is closed.
“They think it’s better to have their hand on the throttle than let the autopilot take over, even though the autopilot is safer,” he added.
Traders may also have to pay interest and capital charges overnight, whereas “if you are out by the end of the day you don’t have to deal with any of that”, said Gokhman.
Moreover, higher volatility during official opening hours may be driven in part by the “large community of day traders that add a lot of noise in the day and go home at night flat”, after squaring their positions.
Lavine claimed most of the “really nasty downturns” have occurred during official market opening hours, even though these last for just 6.5 hours a day.
Exiting the market at the opening bell every day and buying back in at the close inevitably drives up trading costs, however.
NightShares is aiming to minimise trading costs by using index futures contracts. The ETFs will hold their assets in cash and Treasury bills rather than the underlying equities. Lavine said the income generated from this approach would offset the “great majority” of ETFs’ trading costs.
Its first two ETFs, the NightShares 500 ETF (NSPY) and the NightShares 2000 ETF (NIWM), will target the night performance of portfolios of 500 US large-caps and 2,000 US small-caps respectively, analogous to the S&P 500 and Russell 2000 indices. Both have an expense ratio of 0.55 per cent.
NightShares has also filed to launch 1.5 times leveraged versions of NSPY and a similar product based on the tech-heavy Nasdaq 100 index.
Todd Rosenbluth, head of research at VettaFi, a data provider, said NSPY could have a role as a long-term buy and hold complement to SPY, or as a short-term tactical trading tool.
“There are [already] investors trying to trade after hours, which is a relatively illiquid market, so this provides an opportunity for them,” Rosenbluth said.
“This could be used tactically by an investor who saw the market sell off at the close but who believed it would recover the next day.”
However, Kenneth Lamont, senior fund analyst for passive strategies at Morningstar, sounded a note of caution about the ETFs’ potential to generate alpha, or outperform the wider market.
“If it was a bankable alpha-generating opportunity then you would presumably see it disappear really quickly,” Lamont argued, with the likes of hedge funds stepping in to arbitrage it away.
“I would hazard a guess that the after-fees performance of these funds will be less impressive than the backtested data,” he added.
“Many of these niche alpha-generating products, when they are let loose into the wild of real markets, tend to be somewhat underwhelming.”