Episode Summary
Executive Summary: The episode explores Rob Arnott’s new Research Affiliates Deletions ETF (NEXT), a smart-beta strategy built to buy stocks after they are removed from major indexes. Arnott argues index deletions are often oversold and can rebound strongly because passive index funds must sell them regardless of fundamentals. The discussion covers the strategy’s rules, quality filters, weighting, performance rationale, and how this fits into the broader evolution of smart beta.
Main Topics: Why deletions can outperform (Priority: 5/5): Arnott explains that stocks deleted from major indexes are often already depressed, attracting forced selling from index funds and potentially creating rebound opportunities. Index mechanics and market distortions (Priority: 5/5): The hosts and Arnott discuss how additions and deletions by S&P, MSCI, and Russell can push prices away from fundamentals, especially when passive funds must rebalance. Design of the NEXT ETF (Priority: 5/5): NEXT holds stocks removed from the S&P 500 or Russell 1000 within the last five years, excludes the weakest 20% by quality, and equal-weights the remainder. Smart beta versus active management (Priority: 4/5): The conversation contrasts rule-based smart beta with discretionary active management, emphasizing that removing emotion and human judgment can improve outcomes. Comparison with other strategies (Priority: 4/5): Arnott compares deletions investing with fallen-angel bonds and contrasts NEXT with small-cap value ETFs, arguing the deleted names are former winners now out of favor, not merely small cheap stocks. Research Affiliates’ ETF philosophy (Priority: 3/5): Arnott discusses why this is his first self-initiated ETF launch, the role of turnkey ETF platforms, and his preference for free-market experimentation in product design.
Key Arguments: Index inclusions and exclusions are not purely passive; they create active trading that can distort prices. Stocks added to indexes often come in after strong run-ups and may underperform afterward because they were bought at frothy valuations. Deleted stocks often have already been beaten down, so they face a lower bar for positive surprise and can rebound sharply. Equal weighting and a quality screen help avoid concentrating in the least attractive names or obvious value traps. Smart beta works best when it systematically breaks the link between price and portfolio weight. Emotionless, rule-based rebalancing can force buying when assets are hated and selling when they are expensive, capturing mean reversion. NEXT is a completion strategy for investors already owning broad market exposure, offering access to names excluded from standard index portfolios.
Data Points: Smart beta AUM: $2 trillion - Arnott says smart beta assets crossed the threshold this year. Smart beta share of ETF assets: 22%–23% - Eric notes smart beta is now roughly a quarter of ETF assets. Additions valuation premium: About 2x the valuation multiples - Arnott says added stocks trade at roughly twice the P/E or P/S multiples of the broad market. Tesla index inclusion price move: Over 40% - Arnott cites Tesla rising between announcement and effective index inclusion. First-year deletion outperformance: About 20% - Arnott says deletions outperform by about 20% in the first year after removal. Five-year deletion outperformance: 28% - Average deletion outperformance over the next five years. Annualized five-year return advantage: About 5% compounded per year - Arnott translates the 28% five-year edge into annualized terms. Quality screen removal: Bottom 20% of candidate stocks - NEXT excludes the weakest quality names each rebalance. Candidate universe size: About 150 to 200 stocks - Stocks deleted from top 500 or top 1000 indices over the last five years. Current holdings count: 147 names - Arnott says the ETF currently holds around this number of stocks. Index fund ownership impact: 25% of outstanding shares - Arnott says S&P index funds effectively must trade about a quarter of each constituent’s market value. Fundamental Index outperformance in 2008: 1,500 basis points - Arnott cites the 2008-2009 rebalance as a major success for RAFI/fundamental index methodology. Dillard’s rebound: Up about 550% since 2017 - Used as an example of a repeated deletion that later rebounded strongly. Bank allocation at rebalance: 50% - Eric references the “immaculate rebalance” where the portfolio became heavily tilted to banks.
Pivotal Quotes: "Emotions are our enemy in investing." — Rob Arnott: Arnott explains why rule-based strategies can outperform human discretion over long horizons. "buy high and sell low with index funds" — Rob Arnott: The title of his 2018 paper and the core critique of standard index inclusion/deletion mechanics. "Out with the new, in with the old." — Bloomberg/episode framing: Headline used to describe the ETF’s contrarian approach of buying deleted stocks.
Implications: The episode suggests that passive index rules can create exploitable mispricings. For investors, NEXT offers a systematic way to buy neglected names, while for the industry it underscores how far smart beta has evolved beyond simple market tracking.
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