HAVE INVESTORS BEEN

setting their alarm clocks for 3 p.m. lately?

In the past few years, the markets have grown increasingly erratic during the last 60 minutes of the trading day. But this year, they've been positively spastic, often radically reversing the day's course or dramatically intensifying it. During the last hour of trading, investors have learned to expect the unexpected.

The most extreme recent example of a wild final hour was on April 24, when the Nasdaq Composite Index's plunge of 299 points, or 8%, bottomed out at 3:30 p.m. Within the next 30 minutes the index soared 137 points, erasing nearly half the loss, to close down 161.40, or 4.43%, to 3482.48. The Dow Jones Industrial Average's rebound was equally striking. Just after 3 p.m. it was down 54 to 10790. It then surged 115 points to close up 62.05 at 10906.01.

And that's only the most pronounced example of the phenomenon. In 25 of the 41 trading days in April and May, the Dow, the Nasdaq or both made moves in the last hour that either reversed or extended the day's trend by 50% or more. On May 22, for example, the Dow Jones Industrial Average and the Nasdaq Composite dramatically reversed their downward course, rocketing up 105 points and 124 points, respectively, to finish the day off 84.30 on the Dow and a mere 26.19 points on the Nasdaq. On May 23, the last hour saw the day's trend intensified: The Dow's losses increased by almost 50%, to 120.28 from 78.82 points, while the Nasdaq more than doubled its losses, to 199.66 from 99.20 points.

What gives?

For starters, late-afternoon trading volumes have increased dramatically in the past decade. Wall Street has always considered the first half hour of trading (9:30 a.m. to 10 a.m. ET) and the last half hour (3:30 p.m. to 4 p.m. ET) to be the busiest times of the day. The first half hour is crazy because investors are acting on all the news that was reported after the exchanges closed the previous day, with the orders backlogged overnight being filled as early as possible in the day. The last half hour is busy because investors have little time left to play and want to finalize positions before the trading day ends.

But since the beginning of this year, the stock market has become more active at the very end of the day than any time in recent memory. If you divide a trading day into 13 half hours, all things being equal, each half hour should see 7.7% of the day's volume. Yet, according to The Wall Street Journal Market Data Group, the last half hour of trading on the New York Stock Exchange year-to-date has averaged 12.53% of the day's volume 63% greater than the average of 7.7%. Compared with 1990, when the last half hour saw 10.37% of the day's volume, this is a 21% increase.

The trend over the last 60 minutes is almost as dramatic. This year, the last hour's percentage of daily trading volume is 16.13% greater than it was in 1990.

Why the stunning increases? Sure, the knee-jerk reaction is to blame the market players everybody's vaguely suspicious of: It's those crazy day traders, those evil short sellers or those mysterious hedge funds.

But evidence suggests that it's the index funds the mild-mannered, predictable, vanilla-flavored investment vehicles adored by the masses that are the main culprits behind the stomach-churning late-day price swings.

Aren't index funds merely supposed to replicate the market index in question? Yes, but they can do that only by being fully invested that is, by not carrying cash. "Index funds aren't paid to carry cash," says Arthur Cashin, PaineWebber's director of floor operations on the New York Stock Exchange. "They're not supposed to have [cash] reserves."

So, if investors want to take money out of the index fund, the fund manager is in a quandary. He doesn't want to sell shares to raise that money that would incur trading costs and capital gains. Instead, he waits to see if another investor sends him money that he can turn around and give to the seller. But he can't get a good read on how inflows and outflows will net out until late in the day, at which time he needs to take swift action.

The same problem occurs when new money flows into index funds. Index funds don't receive total cash balances until the latter part of the day, and that cash must immediately be put to work. According to the Vanguard Group, a basic tenet of index funds is that the portfolio is fully invested day in and day out. "We are either a net buyer or a net seller," says Jim Stetler, a principle for Vanguard's quantitative equity group, which runs all the firm's equity index funds.

Now, it's true that all mutual funds are carrying record low levels of cash these days (3.8% in March, from a recent high of 6.1% in January 1998, according to the ICI). But whereas index funds are compelled to eliminate all cash from their portfolios by day's end, actively managed mutual funds always carry some reserves for redemptions and have no obligation to invest their cash inflows immediately. Fund managers are paid to use their discretion to find low prices. "We don't manage cash on a daily basis by buying and selling stocks," says Eric Wetlaufer, co-manager of Putnam's Vista Fund, a midcap growth equities fund. "A seasoned fund buys opportunistically."

With the astonishing growth in index funds in recent years, their potential impact on trading activity late in the day is no small matter. A decade ago, there were only 22 domestic equity index funds, with total fund assets of $4.27 billion, according to investment research firm Morningstar Inc. At the end of 1996, just as the index fund craze was starting, there were 105 funds with $78.39 billion in total assets. By the end of April 2000, total index funds had nearly doubled, to 209, while total assets had increased almost fivefold, to $346.42 billion. In 1990, index funds comprised 1.93% of the entire U.S. stock market; by the end of April that number had ballooned to 10.26%. Vanguard, meanwhile, says that in 1996, 11% of all the cash flowing into domestic equity funds went into index funds. By 1999, 35% of all the cash flowing into equity funds went into index funds.

Besides feeling the weight of index-fund money, late-day trading may be influenced by other players seeking to maneuver around the highly visible activities of the index funds. Since index funds price their shares according the closing prices of the underlying stocks, they place orders to either buy or sell at the 4 p.m. price a "market-on-close" order. But these orders must be placed 40 minutes before the close in order to guarantee execution in the last five to seven minutes of trading, says Cashin. Obviously, mutual fund managers, like others in the market, never want to telegraph whether they're buying or selling. But the passive nature of index funds leaves them little choice.

By putting these orders out so early, the index funds have no choice but to alert the trading firms to their late-day trading strategy. Cashin says there is a possibility that brokers and traders are getting a sense of what the large institutions are doing before they do it and are using that information to take advantage of prices before the end of the day, a practice known as "front-running." The trading firms holding the market-on-close orders know they have a buyer or seller for a large group of stocks 40 minutes in the future. It's possible that traders buy these stocks ahead of the market-on-close orders and then sell the stock to the funds from their own portfolio at a higher price. "You are entering an area of Wall Street you are not supposed to enter," says Philip Dina, compliance director at Mercer Partners, a small brokerage house. "You are not supposed to know how the pros make their money. It's magical and now you are lifting the veil."

While index funds may be an increasingly powerful force on the markets, they're not the sole cause of late-day volatility. Other institutional investors clearly play a part in the late-afternoon madness. So do the momentum-playing day traders who piggyback on top of the pros. In addition, short sellers, who sell borrowed shares now with the intention of repurchasing them later at a lower price and pocketing the difference, can create a minor rally late in a down day as they rush to lock in profits.

Compounding the situation, a few mutual fund companies have combined the last-minute cash flow demands of index funds with the momentum-playing frenzy of day trading. Padco Advisors and ProFunds Advisors allow investors to day trade their index funds. ProFunds, for example, allows investors to trade until 3:55 p.m. forcing it to do large amounts of buying and selling in a short period of time. According to research firm Carson Group, Padco's Rydex funds do most of their trading after 3:30 p.m., and ProFunds begins trading at 3:45 p.m.

Mike Byrum, vice president of investments at Rydex, says his company doesn't concentrate all its trades at the end of the day, but admits it is quite active after 3 p.m. Louis Mayberg, ProFunds' president, says his firm isn't responsible for moving the market one way or the other in the last hour because it makes decisions only at the very end of the day. "We're not in it except for the end of the last hour," he says. But while ProFunds may not start the trend, that large amount of trades in the last 15 minutes adds fuel to an already raging fire.

So what does all this mean for individual investors?

"I think it depends on the individual and the approach they take," says Stephen Barnes, portfolio manager at Barnes Investment Advisory. "For someone with a long-term orientation, these wiggles are white noise, because in the grand scheme of things, a stock wiggling at the end of the day won't have a big effect on your portfolio."

We agree to a point. While our stance has always been that investors should study the companies they plan to invest in thoroughly and make decisions based on the long term, being aware of the market's capacity for wild late-day swings can't hurt and a little patience in pulling the trigger could pay off.