Rob Arnott on The Upside of Getting Dumped: Investing in Index Deletions | #549

Episode Summary

Executive Summary: Rob Arnott explains why index deletions are often better opportunities than additions, introducing NIXT—a strategy that buys stocks dropped from the 500 and 1,000 largest U.S. companies and holds them for five years or until reentry. He argues the approach captures value, small-cap, mean reversion, and liquidity effects, while also discussing inflation, weak macro conditions, election seasonality, and AI/growth concentration risks.

Main Topics: Index deletions vs additions (Priority: 5/5): Arnott argues that cap-weighted indexes systematically buy expensive additions and sell cheap deletions, creating a persistent performance edge for patient buyers of deletions. NIXT strategy launch (Priority: 5/5): Research Affiliates’ new index buys stocks that fall out of the top 500 or 1,000 U.S. market caps and holds a diversified basket for five years, aiming to monetize the deletion effect. Value, small-cap, and mean reversion (Priority: 5/5): The deletions strategy is framed as a way to harvest small-cap value returns plus a premium from mean reversion, especially when value and small caps are out of favor. Market concentration and AI bubbles (Priority: 4/5): Arnott warns that AI enthusiasm and Mag 7 concentration may echo past narrative-driven bubbles: the story can be true while still being fully priced. Macro and inflation outlook (Priority: 4/5): He sees asymmetric risk toward higher inflation and slower growth, citing weak PMI, high inventories, inverted yield curves, and rising debt stress. Election effects on markets (Priority: 3/5): Arnott previewed research suggesting contentious elections create temporary pre-election risk-off selling followed by a post-election rebound regardless of who wins. Index design innovation (Priority: 3/5): He also discussed RACWI, a cap-weighted index built from economic footprint rather than popularity, as another attempt to improve benchmark construction.

Key Arguments: Cap-weighted indexing tends to add stocks after they have become expensive and delete them after they have become cheap, creating a built-in buy-high/sell-low pattern. Stocks deleted from major indexes often rebound because forced selling pushes them below intrinsic value and liquidity is temporarily impaired. A patient approach—waiting a year after index changes—would have added roughly 20+ bps annually to S&P returns in his analysis. NIXT generalizes the deletion effect across the 500 and 1,000 largest U.S. companies and, over five years, can outperform the source indexes by about 5% annually. The strategy is effectively a small-cap value portfolio with an unloved/out-of-favor tilt and low overlap with the benchmark only where mispricings are most acute. Market narratives like AI can be directionally true but still become bubbles if expectations are too fast or too optimistic. Growth and mega-cap concentration may mask underlying value leadership, especially outside the U.S. The macro backdrop looks fragile: weak PMI, high inventories, inverted curves, and higher funding costs historically foreshadow slower growth. Inflation risk remains asymmetric to the upside; higher-for-longer tends to be the norm after inflation shocks. Elections mainly affect risk appetite rather than long-term fundamental returns; the market often rebounds after uncertainty clears.

Data Points: Addition vs deletion valuation multiple: ~4x - Arnott says S&P additions trade at about four times the valuation multiples of deletions on average. Additions’ next-year underperformance: 1% to 2% - After being added and pushed up, additions tend to underperform over the next year by a modest amount. Deletion rebound: ~20% - Deletions bounce back by about 20% in the next year after forced selling. S&P index ownership of constituents: ~25% of market cap - He notes S&P indexing owns roughly a quarter of the market cap of each constituent, causing large one-day sales on deletions. S&P turnover rate: ~4% per year - Used to estimate the drag/edge from index rebalancing. One-year delayed trading alpha: 20+ bps annually - If an investor waited one year to trade deletions/additions, S&P returns would improve by over 20 basis points per year compounded. Five-year deletion outperformance: >5% per annum - SP and Russell deletions outperform over five years on average. NIXT index size: 142 stocks - Arnott says the live NIXT basket currently has about 142 holdings. Growth vs value valuation spread: 8x-9x - Fama-French growth has traded at about 8x to 9x the price-to-book of value at extremes. S&P/Russell 10-year return forecast: ~3.5% per year - Asset Allocation Interactive forecast cited for the broad U.S. market. Small-cap value 10-year forecast: ~10% per year - Arnott says small-cap value is priced for about 10% annualized returns over the next decade. Inflation breakeven: 2.1% - 10-year TIPS breakeven inflation cited as the market’s expectation. Economic slowdown probability: 75% - Arnott says their models imply a 75% likelihood of slower-than-trend growth over the next 12 months. Election-market move: ~3% pre-election drop / ~4% rebound - He cited research showing markets tend to fall before contentious elections and rebound afterward. RACWI long-run outperformance: +0.5% per year - Research Affiliates’ cap-weighted methodology beats conventional cap-weighted indexes globally by about half a percent annually over 30 years. RACWI live outperformance: +2% per year - RACWI Global has beaten MSCI ACWI by 2% annually since launch in September 2021. RACWI tracking error: ~1% - Arnott notes this level is comparable to accepted differences among standard indexes. NIXT and index overlap: ~75% overlap with deletion portfolios / ~95% overlap for RACWI Global vs ACWI - Used to show the strategies are closely related while still extracting mispricing. NVIDIA valuation: 70x earnings / 40x sales - Arnott uses these figures to argue that high expectations are the vulnerability, not growth itself. Qualcomm growth example: 60-fold profit growth - Despite huge profit growth since 1999, the stock lagged the S&P 500, illustrating narrative-overpricing risk.

Pivotal Quotes: "Indexing is the gift that keeps on giving." — Rob Arnott: He opens his explanation of why index construction creates recurring opportunities in deletions. "Membership has its privileges." — Rob Arnott: Arnott summarizes the valuation premium and future-return penalty of being included in major cap-weighted indexes. "Disruptors get disrupted." — Rob Arnott: He uses this to caution that today’s AI leaders may not remain dominant even if the technology transforms the economy.

Implications: Investors may find better long-term value in neglected, recently deleted, or smaller stocks than in crowded index leaders. The episode argues for contrarian, valuation-aware allocation, especially if inflation and growth slow while mega-cap expectations remain elevated.