In a groundbreaking study, Rob Arnott, chairman of Research Affiliates, and his colleague Forrest Henslee introduce a novel investment strategy that capitalizes on stocks removed from major market indexes. Their analysis, which begins with the straightforward yet impactful notion that “no one enjoys getting dumped,” delves into the lucrative opportunities presented by these often-overlooked stocks. Their findings are detailed in their new stock index, NIXT, which has demonstrated extraordinary returns for those who have invested in such “index castoffs.”
Arnott and Henslee’s paper highlights a key trend: with about half of the money invested in U.S. stocks now residing in index funds and many active managers’ portfolios mirroring these indexes, stocks that are removed from major indexes often struggle to attract new investors. This creates a unique opportunity for those who are willing to explore investments in these discarded stocks.
The NIXT index was developed with the objective of exploiting the financial potential of stocks that have been removed from widely followed indexes like the S&P 500, Russell 1000, and Nasdaq-100. According to their research, investing in these stocks post-exclusion has proven remarkably profitable. Since 1991, a hypothetical investment in stocks removed from these indexes would have grown approximately 74 times, showcasing the significant potential of focusing on these underappreciated assets.
The concept is rooted in a well-established investment principle: stocks added to an index often see a pre-inclusion price surge due to anticipated buying by index funds, while those being removed face selling pressure as funds exit their positions. Arnott’s innovation is to buy these “dumped” stocks after their removal and hold them for an extended period of up to five years. This approach allows investors to benefit from the rebound of these stocks as the initial selling pressure subsides.
The performance of these stocks, relative to the S&P 500, starts at parity (value of one) on the day they are removed from the index. Historically, these stocks were valued at 2.25 times more a year before their removal, reflecting their previous strong performance. However, after removal, these stocks tend to outperform the market, with their relative value increasing to 1.28 compared to the S&P 500 over the next five years. This means that they beat the market by an average of about 5% annually.
This pattern contrasts sharply with stocks that are added to an index. These stocks typically experience a rally leading up to their inclusion but often lag behind the index in performance during the first year after inclusion. The difference is largely attributed to the nature of the stocks being removed: they are usually more thinly traded, and the forced selling by funds creates a temporary price pressure that often leads to a subsequent rebound.
Arnott, a prominent figure in the world of finance, is renowned for his contributions to smart beta investing—a strategy that involves using alternative weighting methods to traditional market capitalization-based indexes. His previous work with Jason Hsu and Philip Moore in 2005 played a significant role in popularizing the smart beta trend, which now manages over one trillion dollars in assets. Research Affiliates, founded by Arnott in 2002, has developed several influential investment strategies, managing approximately $150 billion.
One of Arnott’s earlier innovations was the creation of a fundamental index that focuses on financial metrics such as profitability rather than market value. This fundamental index has outperformed traditional capitalization-weighted indexes by 1.8 percentage points annually from 1992 to 2022, with even greater performance in the small-cap sector.
While Arnott acknowledges the success of index funds, he argues that the NIXT strategy offers a unique and potentially highly rewarding approach for investors willing to venture beyond conventional investment methods. Stocks that are removed from major indexes tend to be smaller and cheaper, often trading at a substantial discount compared to the S&P 500. Between 1991 and 2022, these stocks were priced at a 26% discount relative to the S&P 500 based on their price-to-earnings ratio, whereas stocks added to indexes were priced at an 83% premium.
Arnott anticipates that small-cap value stocks, which include many of the removed stocks, are poised for strong performance after years of underperformance. However, he also notes that there are practical limitations to the amount of capital the NIXT index can handle before the effectiveness of the strategy diminishes. Based on their modeling, the strategy remains effective with investments up to $1 billion.
Despite the promising results of the NIXT index, there are other investment options that have historically delivered even higher returns. For instance, the Nasdaq-100 index, which is heavily weighted with large tech stocks, has produced returns approximately three times greater than the S&P 500 from 1991 to 2023. Investors who are bullish on technology and artificial intelligence may prefer to concentrate their investments in these high-growth areas.
Ultimately, the NIXT index presents an intriguing opportunity for investors willing to explore less conventional investment avenues. While the strategy may offer substantial rewards, it also involves navigating a more speculative investment landscape. For those open to taking a chance on stocks that have been discarded by major indexes, the potential for attractive returns might outweigh the risks.