You can beat the S&P 500 with stocks that indexes dumped, market guru says

The best and the brightest on Wall Street don't have a great track record when it comes to beating the S&P 500, but Research Affiliates Chairman Rob Arnott may have found an answer and has launched an alternate index to prove it.

In a report titled "Nixed: The Upside of Getting Dumped" that was co-authored with Forrest Henslee, he said stocks that get booted off indexes eventually outperform them while stocks that are added underperform.

"As it turns out, getting dumped by an index can have an impressive upside, just as a romantic breakup can sow seeds for personal growth," they wrote. "Dumped companies and their shareholders fare surprisingly well on average, better even than the stocks that replaced them."

While stocks added to indexes surge early on, especially between the date a change is announced and the date when the change takes effect, momentum quickly fades, according to the report.

Over the subsequent year following a change, additions to the S&P 500 lagged the market by 1%-2% from 1990 through 2022. By contrast, stocks that were dumped by the S&P 500, Russell 1000 and Nasdaq 100 outperformed the broad market index by more than 5% annually for the next five years.

Because so many funds track widely followed indexes, deleted stocks face massive selling pressure, often resulting in prices that are much lower than where they would've been before the decision.

"This sets the stage for an impressive rebound," the report said.

An investor in a dumped-stocks portfolio optimized for the five years after deletion would have multiplied their wealth by a factor of 74 between the start of 1991 and the end of 2023, it estimated.

Only a Nasdaq-100 investor would have matched that performance but would have endured gut-wrenching downturns in the process. Meanwhile, S&P 500, Russell 1000, and Russell 2000 Value investors would be behind by 55%-65%.

To be sure, dumped stocks haven't beaten the big indexes over the past decade, as the current growth-dominated bull market has crushed value and small-cap stocks, Arnott and Henslee noted.

"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," they added.

To put these findings to the test in today's market, the advisory firm launched the Research Affiliates Deletions Index (NIXT) .

It buys dumped stocks from top 500 and top 1,000 market-cap weighted indexes, holds them for five years, and rebalances them annually to equal weight.

"For the past 30 years, stocks have rebounded well after being dumped by an index," the report said. "We’re looking forward to seeing if they maintain that resilience in the decades ahead."

The NIXT fund builds on earlier findings from Arnott, who predicted in December 2020 that Tesla would lag the S&P 500 in the year after being added to the index.

Just half a year later , the S&P 500 was up 17% while Tesla was flat and the stock that was dumped, Apartment Investment and Management, had soared 44%.