Market Return Around the Clock: A Puzzle
- Oleg Bondarenko and Dmitriy Muravyev
- Working Paper
- A version of this paper can be found here
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What are the research questions?Get your popcorn ready, the quants are about to do battle… As with all good questions in academic research, there are two sides to the story. We recently published Matthew Bartolini’s blog post explaining the impacts of trading costs on the “Overnight Return Anomaly.” This paper, takes the opposing view, providing evidence that equity market returns are positive overnight and close to zero during regular trading hours. To explain this puzzling fact, the authors study how the excess market return depends on the time of the day using E-mini S&P 500 futures with tick-level data from 2004 to 2018. These futures are actively traded for almost 24 hours: the bid-ask spread is almost always one tick, and trading volume is $2.4 billion per hour during the Asian session.
What are the Academic Insights?The authors document several stylized facts about high-frequency returns:
- The four hours around the Asian markets’ close and the European open account for 100% of average market return: a 7.6% annualized return with a Sharpe ratio of 1.67 and a t-statistic of 6.4. The authors call this period between 11:30 pm and 3:30 am ET – “EU-open.” The average return for the rest of the day is slightly negative: -0.8%.
- EU-open returns are extremely robust:
- They are positive in every year, every calendar month and weekday.
- Returns computed with trade prices and quote midpoints are nearly identical.
- If the sample is split in half, a trajectory for cumulative returns during EU-open and the rest of the overnight session are almost identical.
- The Bonferroni procedure and other statistical tests rule out data mining.
- The Sharpe ratio around the European open is several times higher than during any other one-hour period.
- The authors suggest a simple trading strategy to earn market returns: buy futures right before EU-open and close position after its end. This trading strategy:
- is profitable net of conservative estimates of trading costs.
- has enough capacity to earn $50 million per year.
- can be greatly improved if one only trades after VIX and Asian volatility increases.
- this timing strategy has a high out-of-sample R2 and a Sharpe ratio of 1.2 after costs.
- The authors also consider VIX futures and find that their returns are positive during the Asian session, highly negative around European open, and mildly negative during the rest of the day. VIX changes are often used as a proxy for price uncertainty; thus, the uncertainty decreases during EU-open.
- The authors attribute high returns around European open to the uncertainty resolution: European investors help process information accumulated during Asian trading hours. They also rule out several alternative explanations: news arrival, data mining, price pressure/inventory risk, carrying costs, and investor sentiment.
Why does it matter?
- These results help us better understand when and why equity returns are positive.
- The disappearing alpha in conventional anomalies pushes investors to look for new strategies that often involve frequent trading. The authors suggest a promising trading strategy to exploit positive EU-open returns.
- Long term investors can also benefit from positive EU-open returns by timing their purchases before EU-open (and sales after its end).
- The overnight session is becoming increasingly important. The average daily volume for E-mini S&P 500 futures doubled in 2020!!
The most important charts from the paper.
We study how the excess market return depends on the time of the day using E-mini S&P 500 futures that are actively traded for almost 24 hours. Strikingly, four hours around Asian markets’ close and European open account for the entire average market return. This period’s Sharpe ratio is extra-high as overnight volatility is low. Its returns are positive in every year and survive transaction costs. Remarkably, average returns are zero during the remaining 20 hours and almost all sub-intervals. We attribute high returns around European open to the uncertainty resolution as European investors help process information accumulated during Asian trading hours. Consistent with this hypothesis, VIX future returns are positive during the Asian session and highly negative around European open.