Rob Arnott on the Upside of Getting Dumped This Valentine's Day

It’s Valentine’s Day, and if Rob Arnott has it his way, we will all be celebrating the upside of getting dumped. The founder of Research Affiliates, one of the great minds in the world of index investing, has a flair for colorful language. Talking to Arnott is always a treat. And this week, he draws an interesting line between a well known human experience and a novel new investment idea.  “Did you know that more people get dumped on Valentine’s Day than at any other day of the year other than New Year’s eve?" Arnott told me in an interview. “Most of us have been dumped at some point. When that happens, we can wallow in self pity or learn a few lessons, pull our socks up and move on.” “Companies get dumped too,” he said. “This is the perfect time of the year for that analogy.” Why are we talking about being dumped? Mid-last year, Arnott debuted an equally-weighted, annually rebalanced Deletions Index and, later, an ETF tracking that index, with ETF Architect — the Research Affiliates Deletions ETF (NIXT) — that captures the investment opportunity tied to rejection.  NIXT invests in companies that have been dumped from a large-cap universe (similar to the S&P 500 and Russell 1000, but built in-house by Research Affiliates). The strategy applies quality screens to avoid the cheap-for-good-reason stocks, also known as the value traps. The end result is a basket of about 150 value and small-cap stocks that have, potentially, significant upside potential.  According to Arnott, traditional market-cap-weighted large-cap indexing has a major flaw, and that is buying high, selling low. Companies are often added to these indexes when they are “high flying growth stocks,” coming off hot recent performance, but deletions typically happen on the heels of a year of “dreadful” performance.  Consider the math. Stocks being added to the index have typically outperformed the market by about 50% in the previous year before addition, according to Research Affiliates data. Stocks deleted from the S&P 500 universe have typically underperformed the index by about ⅓ in the previous year before deletion. Buy high. Sell low.  “They get kicked out when they are deep value stocks, unloved, and expected to do badly,” he said. “The advantage of that is that if you are dirt cheap, and you get your act together, you are priced against bleak expectations.”  In other words, the hurdle for outperformance is very, very low. The other side of being nixed from an index is perhaps more interesting. In the year following a deletion, dumped stocks (those that aren’t value traps, but were successful businesses that have hit a snag) go on to outperform the index by about 20% on average. Additions, on the other hand, underperform by about 2% in their first year post inclusion. If we put these results to words, this is what “pulling your socks up and moving on” looks like in investment results. NIXT captures that opportunity.   There’s plenty of literature on the index methodology and on the ETF itself. Research Affiliates is no stranger to investor education efforts and neither is ETF Architect. “The Upside of Getting Dumped” is an excellent paper to start your due diligence with — you can find it here. There’s also a recent ETF Prime podcast where Arnott details the strategy. Arnott will be a keynote speaker at the upcoming Exchange conference, exploring value investing and the opportunity in deletions. (Have you signed up yet?)  When talking to him this week about the pain of being dumped on Valentine’s day and the beauty of capturing value in rejection, I was especially curious about the spark.  Arnott is a long-term value investor with some 40 years of experience dedicated to the effort. When he founded Research Affiliates and developed a line of fundamental benchmarks in the early 2000s, he was considered a pioneer in fundamental indexing and smart beta investing. So, what was the lightbulb moment for such an experienced investors that led to the creation of the deletions index just last summer?  Here’s what he had to say: “It was a series of lightbulb moments.”  Back in 2018, he identified that, because traditional market cap indexes buy high and sell low, the average deleted stock went on to outperform the index by 20% in the following year. The mere fact that indexes had to sell the stock for deletion pushed down the value of that stock further, benefiting the performance thereafter. The “snap back” effect was further compounded by the fact that deleted stocks are almost always small-cap and value by definition, he said. Intrigued by his own assessment, Arnott went on to buy S&P 500 deletions on his own account. “It was a very concentrated position, with lots of volatility," he said. "It was great fun.” After about a year of doing that he expanded the universe to include Russell 1000 deletions, because that index deletes twice to three times as many stocks as the S&P 500 does. This was a pursuit of diversification. “It was still a wild ride, and still great fun, but not something I’d want to subject clients to,” he said.  His next move was to understand if, and how long, the deletion effect lasted. What he found was that, when averaged across the S&P 500 and Russell 1000 over a 30-year period, deletions outperformed by an annualized 7% in the first two years, 5% on year three, then 4% and 3%. The effect carried on for five years.  “So I tested deletions held for five years and had beautiful results,” Arnott said. After refining the process to exclude companies that were readmitted to large-cap indexes, and to filter for value traps through quality screens, he found that the outcome of that strategy didn’t really change performance, but it reduced risk. "So, we thought, this is great. Let’s create an index.” And the Research Affiliates Deletions Index was born. The ETF, NIXT, followed a few months later.  “One of the surprises in this process, which has happened again and again in my career, is that moment when I think ‘why didn’t someone think of this before?’," he said. "Deletions have been known for a long time. The effect has legs. It was a real shock that nobody had bothered to create a deletions index or ETF in all of that time. It was really fun to launch.”  For more news, information, and strategy, visit ETFDB.