In the ever-fluctuating landscape of stock markets, the movement of companies in and out of major indexes like the S&P 500 can have profound implications, not just for the companies involved, but for investors looking for solid opportunities. Recent changes saw American Airlines, Etsy, and Bio Rad Laboratories drop from the S&P 500 due to a period of poor performance, resulting in their transition to smaller-cap indexes. Such transitions often evoke questions about the future performance of these stocks. Rob Arnott, the founder of Research Affiliates, offers an intriguing perspective that suggests the potential for a rally among these so-called ‘deletions’ may be on the horizon.
Arnott has pioneered a strategy that could change how investors view stocks that fall from grace. His newly launched Research Affiliates Deletions ETF (NIXT) is designed specifically to invest in these ‘deleted’ stocks—companies that have dropped out of both the top 500 and top 1000 by market capitalization over the last five years. The underlying philosophy of NIXT hinges on the belief that stocks losing their status in the upper echelon of indexes tend to rebound significantly, offering unparalleled value for discerning investors.
According to Arnott, the stocks that exit these indexes typically trade at lower valuations after prolonged downtrends, making them attractive candidates for a rebound. The ETF consciously selects these stocks while also looking for foundational quality—eliminating those that could be considered “value traps.” With strict criteria surrounding profitability and debt management, NIXT aims to optimize returns while mitigating risks.
The correlation between index membership and stock performance is substantial. Historically, when stocks move from large-cap indexes to smaller ones, it can trigger mechanical trading patterns, leading to a flurry of buying and selling activity that may not reflect the inherent value of the stocks involved. Arnott reflects on how this relationship can often result in downward pressure on the share prices of ‘deleting’ companies, generating an opportunity for investors who remain vigilant.
The phenomenon of rebounds following deletions is not a new revelation. Arnott first observed this behavior in the 1980s and has been advocating this strategy ever since, even incorporating it into his own investments. This long-term perspective allows Arnott to back his approach with historical data while demonstrating its efficacy in various market conditions.
Analyzing the historical performance of deletion stocks versus the Russell 2000 Value Total Return Index yields promising results. Arnott’s research indicates that his strategy would have outperformed the benchmark index across various time horizons—three, five, and ten years. This historical success lends weight to the thesis that value can often be found in companies that have suffered temporary setbacks.
However, data interpretation requires prudence; not every deletion will translate into a compelling investment. Arnott acknowledges this but maintains that the underlying principle of value drives the overall positive returns. The anticipated volatility from stocks that have been removed from major indexes can serve as a fertile ground for discerning investors prepared to navigate the turbulent waters.
A significant aspect of investing in these deletions is the liquidity concerns that often plague them. Arnott notes that many of these stocks are thinly traded, meaning that significant buy or sell orders can dramatically affect their prices. This illiquidity can create opportunities for shrewd investors who recognize that the short-term negative impacts of selling pressure can yield attractive long-term gains.
Moreover, understanding the timeline regarding index changes enhances the investment approach. The gap between the announcement of deletions and their actual execution allows the market to react. Savvy investors who act upon this knowledge can find advantageous positions prior to the mechanical sell-offs.
The narrative surrounding stocks that transition out of significant indexes is complex yet rich with potential. Rob Arnott’s pioneering efforts through Research Affiliates highlight the dynamic relationships between index performance, investment risk, and opportunities for gain amid general assumption and market action. As the cycle of market cap shifts continues, being critical of the trends while aligned with a value-based strategy can yield substantial rewards for the vigilant investor who dares to look beyond conventional wisdom. The current climate ripe with deletions showcases how opportunities might just be a downturn away— if one is prepared to act.