Rob Arnott Doesn’t Like ‘Getting Dumped,’ But These Stocks Do

We need to talk. 

Famed investor Rob Arnott’s latest muse is turning underperforming stocks, that were literally dumped by other indexes, into profitable investments. The founder of Research Affiliates and early pioneer in smart beta investing is launching a new index called NIXT that swoons over small-cap value companies that were kicked to the curb by other managers. While “no one enjoys getting dumped,” Arnott and fellow author Forrest Henslee found investors were generally 74 times wealthier in a specific portfolio of deleted stocks dating back to 1991, according to a new research paper.

It’s the latest value strategy that may help money managers fall in love with out-of-favor stocks in an occasionally overvalued and unattractive equity market that is largely driven by a handful of names.

It’s Not You, It’s Me

Sometimes, one man’s trash is another man’s value index. The research found that nixed equities have actually beaten the Russell 2000 Value Index in “spectacular fashion,” and could add “abnormal upside,” especially if the current “growth-dominated bubble” begins to deflate. One of the causes is that when stocks enter or exit an index during a rebalance, they are often left with wide valuation gaps relative to their fundamentals. That’s where Arnott’s team swoops in:

• Added stocks, that generally are more sought-after and have higher valuations, tended to underperform their index over the subsequent year on average. 
• Case in point: Newcomers to the S&P 500 lagged the market one year after joining by as much as 2% from 1990 through 2022. 
• However, removed stocks — which can be underperforming and undervalued — actually beat benchmarks by more than 5% annually over the following five years, according to the research.

“Once dropped by the index, there is a silver lining for these stocks, they, on average, outperform the market over the next several years, creating a compelling opportunity for investors,” Arnott said in a release. 

There’s Someone Else. While there are caveats in the research, the general principle of buying or selling stocks that are entering or exiting indexes (especially really big ones) is not novel. Hedge funds have long cashed in on stocks that are about to enter a widely-held index and shorted those about to leave, according to reporting from The Wall Street Journal.

The NIXT is not the only outperforming index on the block, either. The tech-heavy Nasdaq-100 took in about three times as much as the S&P 500 between 1991 and 2023, according to the report. Maybe we should just be friends.