Rob Arnott Is Launching an ETF Made Up of Stock-Index Rejects

Out with the new, in with the old.

At least that's the idea behind Rob Arnott's first exchange-traded fund — the Research Affiliates Deletions ETF — which, upon debut, will look to buy companies that were recently deleted from major indexes. The fund, which Arnott says is slated to launch next week, will trade under the ticker NIXT and hold companies for about five years — or until they reenter a benchmark again.

"What could be better than buying the rejects?" Arnott, who is the founder of Research Affiliates, said on Bloomberg TV's ETF IQ. "We've been playing this in our own portfolios for a while now and we decided, 'Why don't we make this available?'"

Arnott, an architect of the so-called smart-beta system of rewiring traditional indexes in ways that limit the influence of giant companies, says that stocks that are added to major gauges tend to be "frothy, beloved companies, on a surge, performing brilliantly, trading at lofty multiples."

Those that are kicked out are "deeply out of favor" and are typically down over 50% in the year before their ouster. But his past research, encompassing data over the last three decades, shows that such stocks outperform the market by about 5% annually on a compounded basis.

The topic of index inclusion or exclusion isn't new to Arnott. He has in the past researched how firms that were getting added or subtracted from the S&P 500 behaved in the months and years that followed. In one stark example, he called out Tesla Inc. in 2020, saying that it would be a drag on the S&P 500 after it became the biggest company ever added to the benchmark. The stock is flat since his warning, though the benchmark gauge has risen 50%.

NIXT will track an index that is based on proprietary methodology, but that consists of U.S. stocks of micro-, small- and mid-cap firms believed to be value stocks. The index is based on a mean-reversion strategy that will include companies whose stock prices have fallen below a predetermined benchmark, among other criteria, according to a filing with the Securities and Exchange Commission.

Not all members of his ETF will be hits, Arnott concedes. Some may go on to "achieve great failure," he said on ETF IQ. "But all they have to do is exceed bleak expectations to rebound handily."

He sees investors being attracted to the strategy in and of itself, or the ETF completing a portfolio by offering exposure to firms that index funds might not hold. He also sees some potentially using it as a replacement to small-cap value holdings "in a fashion that leaves out most of the likely value traps, and has a chance to participate in outsize returns."

A number of money managers and strategists with high name recognition have launched — or are looking to launch — their own ETFs, including economist Nouriel Roubini, Fundstrat's Tom Lee, Fairlead's Katie Stockton and others.

Most ETFs target a popular theme or topic, Arnott says. He's looking to take a different tack.

"If you launch an ETF in an area that is deeply out of favor, unloved and dirt cheap, it may not catch attention, but the possibility of it having a stupendous first 10 years is tremendous," Arnott said. "As a lifelong contrarian, I love the idea of introducing a strategy when it's at near-record cheapness."

And he may not be done yet, he said. His firm could launch more ETFs in the coming months.

"We're always working on interesting ideas," he said.