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Companies kicked out of a major index, whether for poor performance or lacklustre growth, rarely tout their exclusion. But for smart beta pioneer Rob Arnott, a deletion is far from a disaster — it is an opportunity.
Arnott and his Research Affiliates firm are making their first foray into the world of exchange traded funds with an ETF that will invest in companies dropped from big indices such as the S&P 500 and the Russell 1000.
The Deletions ETF, which will bear the ticker NIXT, is essentially a bet on long-term reversion to the mean, based on research that shows deleted companies can turn around performance and generate dividends in the years to come, with performance exceeding their erstwhile indices. Because index deletions are typically followed by sell-offs, Arnott hopes to find value in unusually depressed stock prices.
Arnott is the latest big-name investor attached to an ETF and is launching his first such fund after BlackRock, T Rowe Price, Pimco and Franklin Templeton debuted active ETFs run by star managers in recent years. These new offerings come as asset managers are losing out on billions of dollars in fees as mutual funds steadily lose market share to lower-cost ETFs.
“Everybody likes underdogs. Why not buy the rejects?” Arnott told the Financial Times. “Especially given historical evidence that they win by 5 per cent a year for the next five years, at least.”
Arnott is known in finance circles as the “godfather of smart beta”, a blend of active and passive investing that aims to beat traditional broad-based benchmarks. Research Affiliates, which was founded in 2002, has about $147bn in assets under management through partnerships with other asset managers but does not usually manage funds itself.
He and his team have found consistent outperformance from stocks that are dropped from big indices such as Dillard’s, the department store chain, which was ejected from the Russell 1000 in 2017, only to return about 535 per cent over the next five years.
Companies that are added to main indices, meanwhile, may find it tougher to deliver on expectations once they hit the big time, Arnott said.
“Some become the Nvidia or the Tesla or the whatever of a new era,” he said. “For every one of those, there’s 10 other frothy little companies that turn out not to deliver the goods.”
Arnott’s venture is launching into a world where ETFs continue to gain ground on mutual funds. Investors pulled more than $173bn from mutual funds while putting more than $518bn into ETFs from January through July this year, according to data from Morningstar Direct.
While Research Affiliates typically licenses out an index to a third-party manager, Arnott and his firm stand to profit more by launching the Deletions ETF themselves. The fund is set to charge 0.09 per cent in its first year of operation, rising to 0.39 per cent after that, according to a regulatory filing.
“This was our fun, quirky idea, and we’d like to receive the majority of the revenues,” Arnott said. “Launching it ourselves allows us to do that.”