Traditional portfolio management often emphasizes mirroring major market indexes. However, recent data and analysis from Research Affiliates, a Newport Beach, California-based investment firm, suggest that stocks removed from indexes may offer compelling investment opportunities. This challenges conventional wisdom and presents a unique perspective on capitalizing on market inefficiencies.
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The Potential of Index Deletions
In a recent webinar, Rob Arnott, founder and chairman of Research Affiliates, highlighted a compelling trend. Data indicates that stocks deleted from indexes often underperform the market significantly in the year leading up to their removal. However, these same stocks historically outperform the market for at least five years after being dropped. This presents a contrarian investment thesis with the potential for significant returns.
This observation led to the launch of the Research Affiliates Deletions ETF (NIXT) in September. This ETF strategically acquires companies recently removed from major indexes, holding them for approximately five years or until they are re-included in a benchmark. This strategy directly capitalizes on the long-term mean reversion potential of these overlooked securities.
Challenging Conventional Indexing
Arnott argues that traditional market-cap weighted indexing suffers from two inherent weaknesses: over weighting overvalued companies and underweighting undervalued ones. This occurs because cap-weighted indexes inherently allocate more capital to companies with higher market capitalizations, regardless of their intrinsic value. Consequently, high-flying growth stocks are often added after periods of outperformance, while undervalued stocks are dropped after periods of underperformance. This creates a cycle of buying high and selling low, potentially hindering long-term returns. The deletion and addition cycle epitomizes performance chasing, exacerbating market inefficiencies.
Research Affiliates’ analysis of S&P 500 additions and deletions from October 1989 to June 2021 further supports this argument. Stocks added to the index often outperform deletions by a significant margin before the change. However, this trend reverses after the trade date, with deletions outperforming additions.
The Three Stages of Deletion: Decline, Removal, and Rebound
The lifecycle of a deleted stock typically unfolds in three stages: decline, deletion, and rebound. The decline phase involves substantial underperformance relative to the market. The deletion phase marks the stock’s removal from the index. Finally, the rebound phase witnesses long-term mean reversion, with the stock potentially outperforming the market for an extended period. This pattern suggests a compelling opportunity for long-term investors. Essentially, index deletions allow investors to capitalize on the market’s tendency to overreact to negative news, potentially acquiring undervalued assets poised for recovery.
Conclusion: A Contrarian Approach to Value Investing
The strategy of investing in index deletions offers a contrarian approach to value investing. By focusing on out-of-favor companies with strong underlying fundamentals, investors can potentially capitalize on market inefficiencies and generate significant long-term returns. Research Affiliates’ data suggests that these discarded stocks, often overlooked by traditional index investors, may represent a hidden source of alpha. The key takeaway is that while conventional wisdom dictates following the market, exploring unconventional strategies like investing in index deletions can unlock compelling investment opportunities.
