ETFs put to the test of theory that stocks perform better overnight

A few new exchange-traded funds are offering individual investors a chance to capture the so-called nightfall effect, a strategy that academic research suggests could pay off in the long run, but remains largely untested.

AlphaTrAI Funds Inc.’s NightShares 500 ETF, ticker NSPY, and NightShares 2000 ETF, NIWM launched on June 28 to capture after-hours trading. Both funds buy their positions just before 4:00 p.m. EST and sell them back just after 9:00 a.m. in the next trading session, sitting spot during the day session.

Like regular ETFs, however, investors can trade them when the stock markets are open.

“We’re buy-and-hold, but just overnight,” said NightShares chief executive Bruce Lavine. “We use the most liquid parts of the market, namely the open and close, to enter and exit our position.”

ETFs are based on academic research indicating that returns are greater between trading sessions.

In a 2008 paper, authors Michael Cliff of Virginia Tech, Michael J. Cooper of the University of Utah, and Huseyin Gulen of Purdue University found that the premium on US stocks between 1993 and 2006 was “only due to overnight returns”.

“This day and night effect is robust to the day of the week,” they wrote, calling it a “puzzling finding.”

In a 2020 study updated last April, New York Fed researchers Nina Boyarchenko, Lars C. Larsen, and Paul Whelan said the largest positive returns over a 24-hour cycle occur between 2 a.m. and 3 a.m. Eastern Time when European markets open, on average. 3.6%. They attribute “overnight drift returns” to risk-averse market makers adjusting their holdings after the US market close.

They say overnight returns “have been positive in 20 of the 23 years since 1998 and statistically significant in 17 of them.” Specifically, the 2am-3am. the return “is statistically significant every day of the week and 9 out of 12 months of the year”, unlike returns during other times of the day.

But NightShares ETFs are the first to test the strategy, according to investment research firm CFRA.

“It’s an interesting idea, there are no other products like this,” said Aniket Ullal, ETF analyst at CFRA.

Mr. Ullal also said that remains an unproven thesis.

“As to whether it’s a good strategy and whether it works compared to regular trading hours, I’m not sure. The performance hasn’t been good, that’s clear.”

As of July 25, nearly a month since the fund’s inception, NSPY had lost 2.7%, while the S&P 500 had gained 3.5% over the same period. The NIWM also fell while the Russell 2000 rose, both around 4%.

ETFs are relatively small. NSPY has $8 million in assets under management and an expense ratio of 0.55%. The net asset value was $30.76 on July 20. NIWM has $4 million in assets under management and an NAV of $29.42, with an expense ratio of 0.55%.

NightShare’s Lavine believes the strategy will outperform the broader market over the long term.

“One of the reasons we think the overnight effect exists is that institutions reduce risk at the end of the day and take over risk in the morning. So we kind of bring the little guy the opposite of this trade.”

ETFs are offered to long-term investors as well as those with a thesis on how markets react to relevant morning data, such as the consumer price index or employment reports.

“If you think that, for example, the initial reaction to the data is going to be very positive, but everyone is going to panic, then you’re going to see this pop and then you’re going to see this drop after the bell,” Max Gokhman said, AlphaTrAI’s chief investment officer, “you can buy our product and forget about it, and you’ll be out before” day trading deteriorates.

Data from AlphaTrAI shows that during the particularly horrific period between January 2 and June 30 of this year, the small cap iShares Russell 2000 ETF, IWM, lost 17.94% in normal hours and only 6.79% overnight. Given the most common strategy of holding stocks day and night, the total loss over the period was 23.51%.

In the large-cap SPDR S&P 500 ETF, or SPY, the difference was much narrower, with a total negative return of 19.98% broken down into a decline of 11.06% during the day and 10.04% when the markets were closed.

Volatility was much lower in both cases between daily sessions, according to AlphaTrAI.

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