There’s something that happens between 4pm Eastern time, when the New York Stock Exchange closes for the night and 9:30am when it opens the next morning, and whatever it is, it tends to nudge stocks higher. In the market, it’s often referred to as the “night effect.” And now a new exchange-traded fund is seeking to capitalize on those after-hour gains.
What exactly is the “night effect”?
It’s a strange, but persisting, market phenomenon in which stocks have tended to perform better overnight than they do during the daytime trading hours – and it’s been observed for years by traders and academic researchers. This chart, which measures returns on the y-axis and volatility, or risk, on the x-axis, shows how much better a night investor’s returns were over the past ten years, compared to a daytime trader, for both the large-cap S&P 500 ETF and small-cap Russell 2000 ETF.
Risk return metrics for night, day, and hold strategies for an ETF that consists of large-cap companies in the S&P 500, and for an ETF that consists of small-cap companies in the Russell 2000. Source: NightShares.
This is nirvana for investors: higher returns with lower risk – i.e. a better “Sharpe ratio”. And the night effect phenomenon has been shown to exist during different market conditions (bearish and bullish) as well as across single stocks, sectors, and in at least 23 countries. This is not some flash-in-the-pan coincidence, specific to only one market.
What causes it? Well, there’s no simple answer to this. But generally, there are a few concrete, or “structural”, factors that play a role.
1. The news cycle. I mean, hey, if you’re a company and you’ve got some stock-sensitive news, you’re likely to release it just after the close or just before the open. This is when big mergers and acquisitions tend to be announced, and when 85% of companies publish their corporate earnings reports – 60% in the morning, and 25% after the close. It’s also when the biggest macroeconomic data gets posted. Being invested overnight allows you to capture the market reaction to those big events.
2. The big, wide world. Markets don’t exist in a vacuum. And when something happens during Asia or Europe’s trading session it ripples across oceans. A New York Federal Reserve study showed that some of the biggest stock gains happen between 2am and 3am Eastern time – i.e. when Europe’s markets open.
3. Drowsy markets. When Wall Street is asleep, there’s much lower market liquidity – in other words, a lot less trading going on. That makes it more difficult to sell an asset or buy an asset, and, as a result, you tend to see more exaggerated price moves.
4. Whispers. Ok, maybe not whispers exactly. In the market, we call this “asymmetric information”. Because it’s late at night, the information isn’t distributed to all market participants evenly.
5. Fearful selling habits. There are some people who close out their positions at the end of every trading day, worried that they will lose “control” by leaving their positions open overnight. This leaves a wake of discarded assets at the end of the trading day, for night traders to scoop up.
6. Big bad things. Really big, negative price moves, or left tail events, as they’re known, typically happen during the trading day. Night traders tend to avoid those.
What’s the opportunity here? As savvy investors trying to maximize our returns and minimize our losses, we always need to keep our ears to the ground.
If you believe the overnight trend will continue, you could consider the exhausting task of buying all 2,000 shares in the Russell index at the end of every trading day, and selling them the next morning. Or, you could consider a less costly and more efficient method: by buying the NightShares 2000 ETF (ticker, NIWM; expense ratio, 0.55%), which combines liquid futures and swaps to replicate the overnight performance of the Russell 2000. The chart below shows the performance of three strategies: investing overnight, investing for the trading day, and using a simple buy-and-hold over all sessions.
Past five-year returns of Small Cap ETF across three strategies: night, day, and buy-and-hold. Source: NightShares
As you can see, over time, the night session strategy dramatically outperformed the others. The research also reveals that overnight investors were more insulated when the sell button was hit and stocks fell in price. In other words, it’s not always the early bird who catches the worm, it’s the night owl too.
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