The recent demotion of American Airlines, Etsy, and Bio-Rad Laboratories from the S&P 500 index has sparked discussions among market analysts and investors alike. These companies, once considered staples of the index due to their market capitalization, have now found themselves relegated to smaller-cap indexes, a move that typically signals challenges in their operational performance. However, this shift might not be all bad news. In fact, it could represent a unique investment opportunity, as posited by Rob Arnott, founder of Research Affiliates.
In response to the trend of companies falling out of major indices, Arnott recently launched the Research Affiliates Deletions ETF (NIXT). This fund specifically targets stocks that have dropped out of the S&P 500 or similar large-cap indices within the last five years. The core investment thesis here is straightforward: buy underperforming stocks at depressed prices, anticipating that a rebound is on the horizon. The philosophy rests heavily on the observation that these “deleted” stocks often see a price recovery after their relegation.
Arnott eloquently compares the dynamics of index additions and deletions. Stocks that get added to indices often possess inflated valuations owing to their recent performance spikes, while those being demoted may represent value opportunities trading at significantly lower multiples. The NIXT fund essentially takes a contrarian approach, betting that these discarded stocks will eventually experience a turnaround.
The movement of stocks between indices can trigger significant trading activity, often amounting to billions of dollars. Such a phenomenon was first identified in the 1980s, and it has been characterized by a tendency towards a short-term price drop for the stocks demoted. During this period, trades can create downward pressure on stock prices—particularly for smaller and more illiquid companies. However, after this initial distress period, stocks have shown a propensity to recover dramatically.
Arnott’s experience indicates that this strategy has a sound historical foundation. He notes how deletions often reflect stocks at a low point, which makes it plausible for them to bounce back. The fund utilizes custom indices based on market capitalizations, allowing it to monitor the stocks that have been forcibly removed from major indices.
A distinctive feature of the NIXT fund is its quality assessment filter. Not all stocks that drop out of indices are suitable rebounds; some could be ‘value traps’—companies trading at low prices due to deeper, unresolved issues. To mitigate this risk, the fund employs a rigorous screening process that encompasses various quality metrics, including profitability and debt coverage ratios. By doing so, the fund aims to construct a portfolio that not only holds potential for upside growth but also maintains a level of financial prudence.
The performance data shared by Arnott is compelling—suggesting that the index used for the Deletions ETF could have outperformed the Russell 2000 Value Total Return Index over significant historical timeframes. This reinforces the idea that deleted stocks, when carefully selected, offer better-than-expected performance metrics.
While Arnott remains optimistic about the long-term potential for deleted stocks, it is crucial to exercise caution. Not every stock that slips from a large-cap index will recover; the strategy primarily depends on selective stock picking and the overall market conditions impacting small-cap equities. In scenarios where half the stocks see significant drops while the other half double in value, the overall portfolio can still yield a net gain. This balancing act encapsulates the essence of the strategy: embracing volatility while seeking out transformative change within underperforming companies.
The Research Affiliates perspective provides investors with a blueprint for leveraging index shifts to their advantage. And while the performance of stocks like American Airlines, Etsy, and Bio-Rad may currently indicate struggles, their future could hold potential rewards for those willing to delve deeper and engage in strategic, informed investing.
As investors consider these dynamics, the interplay between risk and chance becomes crucial, prompting an essential analysis: Are you prepared to embrace the risks associated with potential high-reward investments?