Investors often view changes in stock index composition as signs to reevaluate their portfolios. With American Airlines, Etsy, and Bio-Rad Laboratories recently exiting the S&P 500 index due to declining performance, there’s a plethora of strategic implications worth examining. Surprisingly, their demotion could point towards potential recovery and growth, according to investment strategist Rob Arnott, founder of Research Affiliates.
The world of stock indexing is complex and multifaceted. Within this ecosystem, larger cap indices like the S&P 500 tend to capture the lion’s share of investor attention, often overshadowing the performance of smaller cap stocks. American Airlines, Etsy, and Bio-Rad’s relegation signifies not merely a loss in stature but a shift that can trigger massive buying and selling activities in response to reallocation of investments across different indices.
When these companies drop from prestigious positions, it leads to both mechanical selling by index funds and potential buying opportunities for astute investors. Rob Arnott’s observations indicate that stocks falling into smaller cap segments have previously been able to turn around their downward trajectory. This phenomenon isn’t new; Arnott has documented such behavior since the 1980s, revealing a consistent trend in how these stocks often rebound once they are overlooked.
In response to this compelling data, the Research Affiliates Deletions ETF (NIXT) was launched recently, focusing on stocks that fall out of major indices based on market capitalization. The intent is to capitalize on the rebound potential of stocks that have been disregarded by major index trackers. Beyond simply holding these “deleted” stocks, the fund integrates rigorous filtering processes to enhance its portfolio quality.
Arnott states that the ETF selectively removes the least efficient performers, thereby avoiding “value traps” which can drag down overall performance. By concentrating on profitability and evaluating debt coverage ratios, NIXT aims to assemble a portfolio that not only highlights stocks with low initial valuations but also those with tangible performance prospects.
Data supporting the ETF’s strategy suggests that deleted stocks have historically outperformed alternative small-cap indices, like the Russell 2000 Value Total Return Index, over multiple time frames—including three, five, and ten years. This underlines a crucial element of Arnott’s thesis: while some stocks may experience temporary setbacks, the long-term growth potential often outweighs immediate losses.
The custom indexes developed for NIXT facilitate annual rebalancing, ensuring that the portfolio remains aligned with performance metrics that matter. Stocks like Etsy and Bio-Rad, despite their recent dip, stand to benefit from a fresh pool of investors attracted by the low buying prices and the belief in future appreciation.
Another significant aspect of this strategy involves the nature of these deletions. Many stocks that fall out of larger indices tend to be less actively traded, which can result in pronounced price fluctuations. According to Arnott, when substantial amounts of these stocks are sold, the declines can be severe due to their illiquidity. Interestingly, this often creates an opportunity for savvy investors, who can swoop in when prices are deflated.
Arnott emphasizes that the actual performance metrics should be analyzed from the date when investors can trade the assets post-index change—not merely from when the deletion is announced. This gap allows for speculative behaviors, but also reinforces the eventual recovery potential as initial panic subsides.
While Arnott does acknowledge that the dynamics do not guarantee victory for every stock that falls out of major indices, the statistics generally suggest that the blend of winners tends to outweigh the losers in net gains. He illustrates this with a simple analogy: if half of the stocks in a portfolio drop by 50% while the other half doubles in value, the portfolio shows an overall positive return.
This encapsulates the delicate balance of risk and reward that defines stock market investment, especially concerning deletions. As the mechanisms of the market continue to evolve, the narrative surrounding illiquid stocks and their potential for recovery remains a compelling consideration for both institutional and retail investors.
In the ever-changing landscape of stock trading and investing, understanding the implications of index changes may serve as a key to uncovering future performance — especially for those willing to embrace the unconventional potential behind deletions.