Friday was the last day that American Airlines , Etsy and Bio Rad Laboratories traded as members of the S & P 500 , after a recent bout of underperformance resulted in their falling to smaller cap indexes . But that demotion may be a sign that a rally is coming soon, according to Research Affiliates founder Rob Arnott. Stocks like these are the backbone of the Research Affiliates Deletions ETF (NIXT) , launched earlier this month. The fund buys and holds stocks that have dropped out of the top 500, or top 1000 stocks by market capitalization over the past five years, essentially betting that downward momentum will reverse. "The stocks that are added are at big premium multiples, they've been on a roll, they've outperformed massively," Arnott said. "That's what gets them to a market cap big enough to be of interest. Then those stocks replace deletions that are typically stocks that have been in free-fall for a long time, that are trading dirt cheap, where the market cap has fallen far enough to be of little interest." Index funds are a massive part of the asset management business, and on the whole funds that track large cap indexes like the S & P 500 are more popular than the products that track small- and mid-cap stocks. When stocks move from one index to another, it can trigger billions of dollars of mechanical buying and selling. First observed in 1980s Arnott said that he first noticed the rebound phenomenon for stocks falling to lower valued indexes in the 1980s. He published an article on the subject in 2018 and said he has been using the strategy in his personal account for the past several years. The new fund uses custom indexes based on market caps to identify the "deleted" stocks, but Arnott said the historical performance is similar over time to using the actual changes in the S & P 500 or Russell 1000, which have other considerations besides pure market value of each company. The custom indexes rebalance once a year in the spring, and NIXT already holds Etsy and Bio-Rad, though not American Airlines. As part of its portfolio construction, the fund also filters out the lowest quality stocks to avoid "value traps." Profitability and debt coverage ratios are two of several variables used in the quality screen, Arnott said. The resulting portfolio is effectively a small cap value fund with upside. Data shared by Arnott shows that the index the Deletions ETF is based on would have outperformed the Russell 2000 Value Total Return Index over the past three-, five- and 10 years. Illiquid deletions "Deletions tend to be thinly traded, small cap, illiquid. And if you have to trade 25% of the total market cap of a company, and it's on the sell side and it's a thinly-traded stock, it's going to get hit hard," Arnott said. In the aftermath, the result "is they perform beautifully." Notably, Arnott said that research about the deleted stocks' performance uses returns from the date that an index change becomes effective, not when it was announced. The S & P 500, for example, has a two-week gap between announcement and the actual index change, during which time some traders and fund managers try to get ahead of the shifting demand for individual stocks. To be sure, the strategy doesn't work for every stock that falls out of a large cap index. But the upside from the winners tends to outweigh the downside for the losers, Arnott said. "Picture a portfolio where half the stocks go down 50%, and half the stocks double. That portfolio's going to be up 25%. That's roughly the picture we have for deletions," Arnott said. Research Affiliates is an investment advisory company with roughly $147 billion in assets, according to the firm's website, and it launched the fund alongside ETF Architects.
