Quantitative investment specialist, Research Affiliates (RAFI), has found benchmark-binned stocks tend to deliver outsized returns post eviction.
Conversely, the study, which spawned a new RAFI strategy, shows freshly promoted stocks typically underperform after promotion to an index.
“Additions modestly underperform their index over the subsequent year on average, with S&P 500 additions lagging the market by 1% to 2% from 1990 through 2022,” the paper says. “Deletions, by contrast, outperform by more than 5% per year for the next five years.”
The RAFI analysis found additions typically outperform by more than double compared to benchmark-demoted firms in the year or two before index “reconstitutions”.
However, after index providers “all drop the fading older companies to make way for the Teslas and Nvidias, the exciting and frothy new additions”, the momentum quickly evaporates.
New benchmark arrivals tend to sustain outperformance for about three months on average following inclusion, the report says, but turn negative relative to index-demoted stocks within one to two years.
And given index additions are usually flagged well in advance, the high-performance inertia fades almost immediately post actual entry to the benchmark.
“The substantial outperformance of additions relative to deletions, between the date a change is announced and the date when the change takes effect, front-loads that entire momentum effect,” the RAFI study says. “Empirically, there’s nothing left beyond a day or two following index reconstitution.”
Authored by RAFI founder, Rob Arnott, and quantitative equity researcher, Forrest Henslee, the paper also argues the broad-spectrum Russell 2000 index serves as the most appropriate performance benchmark for a deletion portfolio in contrast to similar recent studies carried out separately by S&P and Dimensional Fund Advisors (DFA).
“Since deletions are generally small- and mid-cap, and are almost always deep value stocks, the Russell 2000 Value is much more relevant, and deletions fared well compared to it during much of this difficult span,” the study says. “We can only imagine how they will perform should small-cap and value stocks stage a significant recovery, as we think is likely in the coming decade.”
While the recent DFA and S&P research papers backed the RAFI findings, Arnott took some offence his firm’s earlier studies were ignored in a Financial Times article this July.
“To the uninitiated, this data and analysis may sound interesting and compelling, perhaps even novel. But to us at Research Affiliates, it sounded awfully familiar,” he says in a note. “In fact, from our perspective, Dimensional Fund Advisors and the FT were a little late to the party. Arguably up to 38 years late.”
According to the latest RAFI research, a notional portfolio of deleted stocks has outperformed all other standard US share indices bar the Nasdaq 100 over the 33 years to the end of 2023.
“Deletions haven’t beaten the Nasdaq-100, S&P 500, or Russell 1000 over the last decade. This raises the question: Why bother? It all comes down to value and value’s recent travails,” the report says. “The current growth-dominated bull market has left value and small-cap stocks in the dust. In this climate, nothing beats the S&P 500 or Nasdaq-100. But growth’s dominance will likely come to an end, and when it does, almost anything should beat the S&P 500 and Nasdaq-100.
“… Deletions may well add abnormal upside to a portfolio when the current growth-dominated bubble (and, yes, it is a bubble) starts to deflate.”
The historical numbers might stack up but RAFI will test the theory in practice via its newly launched Deletions Index.
“For the past 30 years, stocks have rebounded well after being dumped by an index,” the paper says. “We’re looking forward to seeing if they maintain that resilience in the decades ahead.”