There is a “very avoidable” buy-high/sell-low dynamic of traditional index fund managers, which causes investors to annually lose — on average — tens of basis points in performance, according to Rob Arnott, founder and chairman of Research Affiliates.
A recent publication from Research Affiliates — titled “Buy High and Sell Low With Index Funds!” — looks at how index funds manage their portfolios, including what they buy, when they buy, what they sell and when they sell. Arnott gave a similarly titled presentation during the recent Inside Smart Beta conference in New York City, where he revealed the publication’s findings.
“What’s the character of the stocks being added to an index?” Arnott asked the crowd. “Are these stocks that are unloved [and] out of favor? Or are these stocks that are on-a-roll, popular, beloved — where it’s kind of embarrassing that they weren’t already added? It’s mostly the latter.”
On the other side, Arnott said that when stocks are deleted from an index it’s usually the ones that are considered “bleak, boring and performing lousy.”
As Arnott and team explain in the publication, stocks that are added to capitalization-weighted indexes are routinely priced at a substantial premium to market valuation multiples (i.e., buying high), while discretionary deletions are routinely of deep-discount value stocks (i.e., selling low).
In fact, the publication finds that additions tend to be priced at valuation multiples that average more than three times as expensive as those of deletions.
“This helps explain why from October 1989 through December 2017, the performance of additions lagged discretionary deletions by an average of over 2,200 basis points in the 12 months following the addition or deletion,” the publication states. “Once investors recognize this buy-high/sell-low dynamic, they can avail themselves of some surprisingly simple ways to earn above-market returns.”
In a similar fashion, the publication finds that cap-weighted index funds also “own high and shun low,” which is illustrated by their holding the largest market-cap stocks in the world, which also carry the largest weights in a cap-weighted portfolio.
Arnott and team then analyzed the implications for index fund rebalancing in which cap-weighted index funds buy recent winners and sell recent losers. They looked at the 10 largest market-cap stocks in the world for every year from 2018 through 1998, as well as 1990 and 1980.
“What do we find?” Arnott asked during the conference. “We find an average of about three additions, three deletions and three flip-flops [or stocks that were added that year and deleted at the end of the year] year-by-year. That’s the average. Ouch. That’s a lot of turnover.”