It is a rare delight for ETF nerds when something academic makes it out of the lab. Thanks to the team of quant figurehead Rob Arnott, just such a moment has arrived in the form of a debut ETF focussing on depressed index rejects.
Sadly not yet in UCITS format, Research Affiliates’ indexing arm RAFI has partnered with ETF Architect to launch the Research Affiliates Deletions ETF (NIXT).
The ETF, which goes live on 10 September, tracks the NIXT index and captures deletions from the top 500 and top 1,000 US companies by market cap and holds them for five years, rebalancing annually to equal weight.
Why do I want S&P 500 rejects?
A fair question to ask is why anyone would undergo the blunt-edged ‘buy-the-dip’ exercise of targeting companies being canned by the darlings of US indexing. The answer is simple: it works and for good reason.
Gladly, Research Affiliates provides a less glib twofold explanation, long horizon mean reversion and a liquidity effect.
Essentially, prospective index rejects underperform considerably in the year ahead of their deletion. New additions, meanwhile, surge between the date their arrival to an index is announced and the date this is actually enacted.
The result is a dynamic whereby the momentum afforded to new joiners is all but spent by the time they are anointed as one of the chosen ones of the S&P 500 or Russell 1000. In fact, new joiners have historically tended to underperform the large cap index by 1-2% over the following year.
Index deletions, meanwhile, become ‘deep value’ plays in the lead-up to their eviction. Given total assets indexed to the S&P 500 are equivalent to around 20% of the index’s market cap, the lead to and eventual offloading of a company’s free float at rebalance has a mechanical downward effect on valuations.
However, the long road to recovery from this painful process appears to herald an underappreciated comeback story, with S&P 500, Russell 1000 and Nasdaq 100 deletions having outperformed by more than 5% per annum for the five years following their ejection, over the period from 1990 to 2022.
“As it turns out, getting dumped by an index can have an impressive upside, just as a romantic breakup can sow seeds for personal growth,” said Arnott (pictured), co-founder and chairman of Research Affiliates.
“Dumped companies and their shareholders fare surprisingly well on average, better even than the stocks that replaced them.”
Tesla a prime proof of concept
Illustrating the dynamic outlined above, a 2021 report title by Research Affiliates examined Tesla’s eventual admission to the S&P 500 by S&P Dow Jones Indices’ index committee, alongside the deletion of lesser-known Apartment Investment and Management (AIV).
At the time of Tesla’s arrival, S&P 500 trackers were compelled to buy $94bn of the company’s equity after its price had surged 57% in just the four weeks prior to the rebalance. During the same four weeks, AIV stock fell 17%.
What is even more damning – and a vindication for the new NIXT ETF – is the fact Tesla shares fell 10% over the next six months to Jun 2021, when the report was published. AIV surged 60% over the same period.
When does buying losers work?
Now we have thoroughly elucidated the use case for such an ETF, it is worth adding a caveat. Yes, a backtest of its index outperformed the S&P 500, Russell 1000 and Russell 2000 Value indices over the 1990 to 2022 sample period – and almost matched the Nasdaq-100, with lower volatility.
However, as discussed in a recent report by Dimensional Fund Advisors and SPDJI on index deletions, these candidates lagged the S&P 500 over the past decade.
In sum, asset allocators looking at such a strategy should view it for what it is: an academic and merit worthy way to capture value names among US small and mid-caps. Given the current interest rate context and large cap tech valuations, the timing of NIXT’s arrival could be inspired.
