The best and brightest minds on Wall Street do not have a great track record when it comes to beating the S&P 500, but Research Affiliates Chairman Rob Arnott may have found an answer and launched an alternative index to prove it.
In a Report titled “Rejected: The Benefits of Termination” In an article co-authored with Forrest Henslee, he said that stocks removed from indexes ultimately outperform, while newly added stocks underperform.
“As it turns out, getting dumped from an index can have impressive benefits, just as a relationship breakup can sow seeds for personal growth,” they wrote. “Dumped companies and their shareholders perform surprisingly well on average, even better than the stocks they replaced.”
While the number of stocks included in the index initially increases sharply, especially between the date a change is announced and the date it takes effect, the momentum quickly fades, according to the report.
In the year following a change, new additions to the S&P 500 lagged the market by 1% to 2% from 1990 to 2022. In contrast, stocks included in the S&P 500, Russell 1000 and Nasdaq 100 outperformed the broad market index by more than 5% annually over the next five years.
Because so many funds are based on widely followed indices, the deleted stocks are subject to massive selling pressure, which often leads to significantly lower prices than before the decision.
“This sets the stage for an impressive recovery,” the report says.
An investor who holds a portfolio of shares of sold securities and has optimized it for the five years after the cancellation would have multiplied his assets by a factor of 74 between the beginning of 1991 and the end of 2023, the institute estimated.
Only a Nasdaq 100 investor could have achieved this performance, but he would have had to endure heartbreaking downturns. Meanwhile, value investors in the S&P 500, Russell 1000 and Russell 2000 would be behind by 55 to 65 percent.
To be sure, the dumped stocks have not beaten the major indexes over the past decade, as the current growth-dominated bull market has put severe pressure on value and small-cap stocks, Arnott and Henslee noted.
“But the dominance of growth is likely to end, and when that happens, almost anything should beat the S&P 500 and Nasdaq-100,” they added.
To test these findings on today’s market, the consulting firm launched the Index of Research Partner Deletion (NIXT).
The company buys sold stocks from the market capitalization-weighted top 500 and top 1,000 indices, holds them for five years and rebalances them annually to achieve equal weight.
“Over the past 30 years, stocks have recovered well after an index crash,” the report says. “We are curious to see whether they maintain this resilience in the decades to come.”
The NIXT fund builds on previous findings by Arnott, who expected in December 2020 The Tesla would lag behind the S&P 500 in the year following inclusion in the index.
Only half a year laterThe S&P 500 rose 17%, while Tesla was flat and shares of divested Apartment Investment and Management rose 44%.