Do Concentrated Trading Equilibria Exist? The Migration of Informed Trading Following Index Addition

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Abstract
In this paper, we use index addition to gain insights into the trading behavior of informed traders. When a stock is added to the S&P 500 index, it attracts permanent interest from index funds, which are, by definition, liquidity traders. Consequently, this event is associated with an exogenous increase in the volume of liquidity trading, which is likely to be concentrated at the end of the day and in large-sized trades. These aspects of fund trading, in turn, change the optimal strategies of informed traders. We can characterize the resulting equilibrium by comparing 'steady state' trading patterns before and after index addition. Our key findings are as follows. First, while both daily and intraday volume increase substantially after index addition, the largest increase occurs in the last half-hour of the day. There is a permanent increase in daily and intraday return volatility after addition; once again, the largest increase occurs at the end of the day. The increase in return volatility throughout the day suggests that increased information production follows index addition. However, the larger increase in end-of-day volatility also suggests that informed traders change the timing of their trades to coincide with liquidity trades. Second, consistent with the increased presence of index funds, the distribution of trade sizes shifts rightwards after addition and this shift is most marked at the end of the day. The price impact of individual large trades declines, though the magnitude of the decline is similar through the trading day. The increased frequency of large liquidity trades at the end of the day creates incentives for informed traders to make large trades, since they are now able to 'hide' these trades more easily. Consequently, the proportion of total end-of-day price change occurring on large trades increases significantly after addition. Additional tests reject temporary price pressure from large trades as an alternative explanation for our results. Our results support the conclusion that informed traders alter their trading strategies to optimally match both the timing, and the size, of liquidity trades in the market.

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