How a Hidden Quirk Helped Traders Beat the Market

For a long time, traders quietly exploited a market anomaly.

It went mostly undetected for 30 years. Yet with this strategy, folks had a chance to beat the market by almost 100 percentage points over time.

You might think something like that would be impossible to hide... or that it must have required a complex trading technique.

It didn't. In fact, this strategy is so simple, it's shocking that it took so long for academics to uncover it.

That's how this hidden market quirk came to light. It only started getting mainstream attention three years ago. And, while it no longer works on the S&P 500 Index, we're still seeing it in other, more specific areas of the market.

So, let me show you how it works... and what it means for investors today.

Everyone dreams of beating the market. But actually doing it – consistently, with a simple strategy – is harder than most investment pros would care to admit.

An incredible 51% of U.S. large-cap mutual funds underperformed their benchmark last year. And that was a good year for active managers... The 10-year average shows that they underperform 67% of the time.

Still, some tricks out there consistently lead to outperformance. One of them is only holding stocks overnight...

If you had simply bought and held the market from 1993 to 2020, you would have made 627%. That's a great return. But you could have made 720% by only holding it overnight. We can see this by looking at the SPDR S&P 500 Fund (SPY)...

In the quant world, we call this overnight drift. It's a quirk of the market where most of a stock's returns occur overnight rather than during normal market hours.

Now, the effect of overnight drift on the S&P 500 has diminished since 2020. That's when the academics finally noticed what was going on and started publishing research on the topic... like the Federal Reserve Bank of New York's paper "The Overnight Drift," which came out in February 2020.

The market finally recognized the inefficiency... And more people tried to exploit the arbitrage.

It got to the point where an exchange-traded fund ("ETF") – the NightShares 500 Fund (NSPY) – launched to allow folks to easily invest in the anomaly. As more folks got in on the idea, most of the inefficiency gap closed.

As a result, since 2020, the overnight drift strategy is no longer a winner for the S&P 500. "Buy and hold" is outperforming once again.

So, if the arbitrage is gone, why should we care?

Well, other funds and stocks still experience overnight drift. The Energy Select Sector SPDR Fund (XLE) is a perfect example. Take a look...

For XLE, the overnight drift strategy has outperformed buy and hold by 30 percentage points since the start of 2020. In other words, even in the "post-COVID era," this phenomenon is still in play... at least in various corners of the market.

Overnight drift is difficult to profit from on its own. But it's a good reminder of an important point... Markets are not efficient.

Understanding this will allow you to look deeper to find anomalies hiding in plain sight. And it will help you to be a better investor.

In the meantime, the next time you go to place a buy order, consider placing it at the closing bell. It won't make or break your investment... But it will give you a leg up over other investors who aren't as well informed.

Good investing,

Matthew Poltorak

Further Reading

"My professors weren't getting rich because at the time, the 'efficient markets theory' was all the rage," Steve Sjuggerud writes. Some folks say it's nearly impossible to beat the market. But successful traders have outperformed for a reason... Learn more in Steve's two-part series here and here.

"Think about why most folks underperform," Dr. David Eifrig says. The problem isn't that investors don't know a secret trick or technique to making money. Instead, most people fail to beat the market because they don't manage their emotions... Read more here.