Look at the outperformance of stocks that were cast away by the index funds. Turns out the indexes made mistakes, as research by Robert Arnott of Research Affiliates points out. Spencer Jakab reports in The Wall Street Journal:
Rebound relationships are best avoided, but maybe not in the stock market.
In a paper that starts out by stating that “no one enjoys getting dumped,” two investing quants reveal some surprising, and potentially lucrative, traits of companies that have really let themselves go. With about half of the money invested in American stocks now sitting in index funds, and many active managers holding portfolios that resemble them—just try beating the market these days without “Magnificent 7” stocks such as Nvidia NVDA 0.80%increase; green up pointing triangle or Microsoft MSFT 0.18%increase; green up pointing triangle—index castoffs have a hard time meeting someone new.
That is when investors should pounce, says Rob Arnott, chairman of advisory firm Research Affiliates, with colleague Forrest Henslee. This week they are unveiling a stock index named NIXT that would have earned investors about 74 times their money since 1991 by buying stocks kicked out of indexes.
The basic idea isn’t revolutionary: Plenty of hedge funds make money, or try to, by buying stocks that are about to enter a widely held index such as the S&P 500 and selling short those about to leave. They know that there will be forced buyers and sellers who don’t care about the price. Instead of a speculative one-night stand with those stocks, though, NIXT includes them after they have been dumped. And, while not being wedded to those losers forever, it dates them for five years—an eternity for fast-money types. The surprising thing is how long the good performance lasts.
A helpful way to see the effect is to think of a nixed stock’s value relative to the S&P 500 as being equal to one on the day it gets booted. Former members of the S&P 500, Russell 1000 and Nasdaq-100 indexes were worth 2.25 as much, on average, a year before deletion—quite a fall. But then they start to do better than the index and keep it up for five years, reaching 1.28. In other words, they beat the market by a chunky 5% a year.
As you can see, there’s still value in some of the misfit toys in the market. It’s even a challenge for indexes to pick the winners and losers. Investing is emotionally challenging, and picking winners and losers is hard. To make it more difficult, add in the priorities of ESG funds that may not put profits first, and it can get more difficult. After severe backlash to ESG funds voting owners’ shares in politically motivated ways, money managers are working to stem the anger by giving back control to investors over their share voting power. Dominic Webb reports at Responsible Investor:
As ESG becomes increasingly politicised in the US, and asset owners in the UK and Europe place their managers under ever more scrutiny, big firms are beginning to offer clients greater levels of customisation over how stewardship and engagement are carried out on their behalf.
State Street Global Advisors, BlackRock and Vanguard have all given clients the ability to direct their own votes in pooled funds, and the latest development in stewardship customisation is offering clients different levels of intensity and objectives for engagements.
BlackRock was the first to launch a service offering clients in select funds the opportunity to have their assets stewarded more intensely on sustainability topics at the start of July, but State Street followed shortly after.
Action Line: At its core, ESG investing is built on emotions. Don’t let emotions ruin your portfolio. There may be some value in those misfit toys. When you want to talk about owning a portfolio of investments with voting rights you control, I’m here. In the meantime, click here to subscribe to my free monthly Survive & Thrive letter.
