Arnott: 'Buy High and Sell Low With Index Funds!'
An analysis from Research Affiliates reveals that index funds are notorious for this buy-high/sell-low dynamic.
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.”
Arnott and team then looked at these top stocks decade by decade. And they found that the rotation of the top 10 largest market-cap stocks in the world has been “prodigious.”
Of the 10 largest stocks in 1980, just two stocks (IBM and Exxon) were still on the list in 1990. Of the 10 largest in 1990, again just two (Japan’s National Telephone and Telegraph, or NTT, and Exxon) were still on the list in 2000.
Of the 10 largest in 2000, only two (Microsoft and Exxon Mobil) were still on the list in 2010. Of the 10 largest in 2010, again only two (Microsoft and Apple) were still on the list at the start of 2018.
Finally, in the most recent 10-year span, only one of the top 10 market-cap stocks in 2008 (Microsoft) remained on the list at the beginning of 2018.
On average, only three stocks in the top 10 list when ranked by global market cap remain on the list 10 years later.
The seven companies that fall off the list reliably underperform the seven newcomers that take their place, and importantly the seven dropouts have a larger weight at the start of the 10-year period than the seven additions that replace them, according to Arnott and team.
Meanwhile, of the three stocks that remain in the top 10, Arnott and team find that the top company almost always remains somewhere on the list 10 years later — but never in the pole position — and almost never outpaces the ACWI over the same 10 years. The other two survivors may be lower or higher on the list, and may be either an outperformer or an underperformer.
According to the publication’s analysis, it follows that roughly nine of the top 10 largest holdings in a global cap-weighted portfolio will underperform on a 10-year basis.
“Would most rational investors want to own a portfolio in which the largest holding has a 95% likelihood of underperforming over the next 10 years?” the publication states. “Or in which the largest holding in each sector or each country is likely to underperform by 5% a year over the next decade? Or a portfolio in which each of the top 10 stocks has roughly 90% odds of underperforming the rest of the portfolio? No.”
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