Welcome to chains.
I'm Joel Webber and I'm Eric Balchunis Eric.
We get to see a lot of ETFs. We talk about a lot of new ones, we talk about a lot of old ones.
We talk about the market as a whole.
I think that when we're going to talk about today is pretty cool.
I haven't ever actually considered this idea before.
Yeah, it's really interesting. It stuck out to me for a few reasons. You know, there's five hundred ETFs that launch, and only a couple stick out right off the bat, and this one does. It's called the Research Affiliates Deletions ETF. The ticker is next, which is pretty apropos and it's for research Affiliates. Who is Rob ar Nott's company and Rob are not is known as the grandfather of smart beta, So the godfather of grandfather one of those two, but
he's he's he kind of really pioneered that space. And for those who don't know, smart beta effect effectively is taking an index and tweaking it and designing it with some activeness so that it does different things than basically just track market beta. Anyway, that's a big category with two trillion now and so here's another ETF that is
sort of from his brain. And this one is also interesting because Athanasios on my team just covered the same thing, so that they independently found the sort of same data that when a stock gets into an index, you think that's the time to buy it, but actually when it gets kicked out, data shows that has a better performance after getting kicked out, which we thought was interesting. And obviously this index and ETF is trying to capitalize on so just an interesting product, and the fees low has
a probably a good shot of success. So I just think it's also interesting because people do really look at how the indexes are impacting stocks and stock prices, and here's somebody saying, okay, let's stop talking about it, let's try to make some money about it.
So joining us on this episode, Rob are not the founder of research, this time on trillions. Out with the New and with the Old, Rob Wilko A trillions, thank you so much so. Our colleagues in Bloomberg News wrote that lead that headline right there, Out with the new, end with the old. That was our colleague of Vildanna hi Rich, so fitting, I think, But where where did
this idea come from? How did you see that there was this opportunity and sort of companies that had fallen out of the indexes that you know, if you pick them all up, might actually be, you know, we're worthy of a portfolio of their own.
Well, we were at a paper back in twenty eighteen entitled by High and Sell Low with index funds, and the point of the paper was that index funds are most people think of them as passive, as representing and spanning the whole market, and they approximate do that they're passive, except that they do add new stocks and they do drop old stocks, hence in with the new and out
with the old. But that's an active decision. In the case of S and P and MSCI, the indexes are additions and deletions are sorted through by a committee, and in the case of Russell, it's done in a somewhat formulaic way. But either way, stocks that get added to the index tend to be stocks that have swored, where their market value has risen to a point where they're big enough to grab a lot of interest and lo and behold. Those stocks tend to be trading at frothy multiples.
On average, about twice the valuation multiples, price earnings or price to sales ratios of the broad market, and once they're added, the process of adding them pushes them higher. Still. In the case of Tesla, just as one example, between the announcement date and the effective date of it coming into the index, it rose I think over forty percent, if memory serves correctly. Now, are the index funds traumatized by buying forty percent higher than they could have just
a few weeks earlier, No, they're not. They're focused on tracking here. They want to track perfectly with the index, and so they want to buy at exactly the price at which the index adds the stock. Now, for every stock that's added, something has to go out, and in the case sometimes it's a merger or an acquisition or a bankruptcy, so there's no decision involved. But if they have to make a decision, it's what we would call a discretionary deletion. They have to choose a company to
take out. Well, that's going to be a company that's been in free fall for a very long time, a company that's trading at a deep discount relative to the market, and the process of deleting it pushes it down even further. So what did we find. We found that once you add a stock on average underperforms for its first couple of years by a percent or two a year. The stocks that are dropped outperformed by about twenty percent in
the first year. Now, averaged over time, a lot of that's clustered in the aftermath of the dot com bubble, in the aftermath of the global financial crisis, but averaged over time, the average deletion outperforms by twenty eight percent over the next five years. That's a heck of a margin, a heck of an incremental return.
It reminds me of the Fallen Angels bond etf When a bond gets kicked out of investment grade and goes into high yield, a lot of times it gets over sold because so much institutional money tracks that index.
Is this trying to.
Exploit a quirk in the fact that indexes have gotten so big that when they kick a member out, it gets over sold beyond the sentiment. And that's important because if a stock gets kicked out of an index, it means that active has been selling it and it's in free fall. As you say, so, I guess it just seems like it could be a tricky business to try to capture the over sold part and yet not get burned by the fact that the company has been deemed to be not worthy by active managers.
You know, you put your finger on a very very interesting and very important point. If active managers don't want it, then it falls in price. It's active managers, not the index funds that do the price discovery, that set the value of a stock. And if it's been in freefall for a long time so that it's now worth so little that they want to kick it out of the index, then who's going to buy it? The index indexes s and p indexes span about twenty five percent of the
market value of every single stock they own. So when Tesla came in, twenty five percent of the stock outstanding had to be bought by the index funds. And when AIV went out, twenty five percent of its outstanding market value had to be sold. And it was now a small, ill liquid, rather thinly traded stock, So the impact on the price is huge. The beauty of a deletion strategy is that on average, you get a big rebound. Now if you want to time it just perfectly forget it
active managers don't want it. You're absolutely right. But the fact that it's so depressed means that it has to only exceed a very low hurdle. It has to exceed bleak expectations in order to perform well. Well over half of all deletions go on to underperform, continue to underperform, but the ones that exceed those bleak expectations rebound in some cases so sharply that the overall average is improved to a twenty eight percent gain over the market over the next five years.
So Rob, one of the things that's so interesting about the strategy is there's this smart beta that we've talked about, and it's actually one of the reasons Eric and I found each other all those years ago, because I was like, this is really interesting. It's like it's sort of got a part of passive and a part of active, and you come together because the strategy is basically rules, right, so it's not just active picking kind of whatever they
feel like is could have outperformance. It's like you look at passive, you take some of the rules of passive and you and some rules of the active, and you kind of find a place, a heartless place in the middle. And I'm curious when you think about this, how how heartless is it?
Right?
Because I'm just drawn to like wanting to know what the companies are that sort of exemplify the strategy. And yet you, on the other hand, it's like you don't really care about the companies so much as the strategy.
That's exactly the rules.
Yeah, Well, the whole essence of smart beta originally was strategies that break the link between the price of a stock and its weight in the portfolio. With conventional indexes, the higher the price, the higher the valuation multiples, the bigger your weight in that portfolio, and so you're assuredly overweighting the overvalued and underweighting the undervalued. Well, deletions kind of tick that to a new level. There they fall in value so much that the index kicks them out
and gives them zero weight altogether. So one way to think about this is it's a completion strategy. If you want to own the market and you own an index fund, you don't own the stocks that aren't in the index. Well, that includes tiny companies that may or may not make it, and size past successes that have fallen deeply out of favor and I think that's why you get the snap back. Your starting point is deep discount valuations, long term under performance.
That sort of thing can lay a foundation for long horizon mean reversion for the bounce back that we're seeking to catch.
Let's talk about this lack of you called it heartless, lack of emotion, because a lot of ETFs coming on hour active like active. I think last time I checked about it, three quarters of all the launches are active, and that's because the ETF rule has made it easier to do active and I won't get in details, but also active having a little bit of a renaissance anyway. Smart Beta is active but using an index. So once you set the index, you the human who manage the fund,
you can't do a thing about it. And that lack of emotion, you know, is interesting because when you have an active ETF at the end of the day, a human can do a thing about it. And so I guess, can you talk a little bit about how the lack of emotion is you know, one of one of the features, not bugs, I guess, of the smart Beta ETFs, which by the way, now have two trillion in assets, that's about twenty two twenty three percent of all etfsts.
Yeah, that's we crossed the two trillion threshold just this year. That's kind of an exciting transition. Emotions are our enemy, and investing emotions condition us to well, think about it this way. Whatever has caused us has given us profit and joy. We want more of that, even though past profits don't mean future profits. Whatever has given us pain and losses. Human nature says, get me out of here,
even though past disappointment doesn't mean future disappointment. In fact, there's a market anomaly called long horizon meaner version, where assets that have performed badly for a very long time tend to outperform. That's one of the key drivers here. Well, human emotion will tell us not to buy those stocks. And so I love stripping emotion out of the decision process because emotion steers us to do the wrong thing at the wrong time all the time in investing.
You know, this idea of no emotion. One of the best examples, and I cite it in my first book. Droll was something that a CTF nerds you included called the immaculate rebalance, And it was a time when one of Rob's indexes, which was linked to the ETF called PRF. It's a fundamentally weighted index. It had to do a rebalance in two thousand and eight, two thousand and nine, and because it had a certain program in it to look for deeply you know, troubled deep value and whatnot,
it went and did a bout. It bought so many bank stocks that the financial allocation went up to fifty percent because no human on earth, no human manager, could stomach buying those banks. After what happened in two thousand and eight, I think I think you just got it to me once. Like it was like a portfolio manager running into a burning building and like.
I'll buy it, I'll buy it all. Yeah.
Yeah, it's like literally running into fire. But the index doesn't care. It's like a terminator. It runs into the fire. It doesn't it doesn't do anything.
Right? Is that?
And tell us about the index, the ETF versus the separate account you have with that index.
Sure, well, the ETF you're referring to PRF is Investigo Power Shares RAFFI one thousand, RAFI being Research affiliates Fundamental Index. Fundamental index basically has a premise that we don't want to weight stocks according to how expensive they are. We want to wait them according to how big their business is. So when you had a situation where very large businesses autos, banks, and so forth were priced for oblivion, then Fundamental Index said, okay,
it's time to rebalance. Let's find out how big these businesses are. Oh, they're still just as big as they were a year ago. Okay, so let's top them up to the weight that they had a year ago. And the result was massive buying of deeply out of favor financial services companies and autos and other consumer durables. One of the autos, GM went bankrupt sixty days later, so you bought into it and it went to zero. But on the other hand, you bought into City and b
of A and other banks. City and b of A were two percent of the US economy each, so you bought back to two percent weight, and they went on to triple in the next six months. So those stocks were bought because waiting companies according to their economic footprint means if the price tumbles and the underlying fundamentals don't, you're going to top it up. And if the price soars and the fundamentals don't, you're going to trim it,
so you wind up contratrating against the market's most extravagant bets. Well, those were big bets in the global financial crisis. And yeah, the best of my recollection, that particular index beat the S and P by fifteen hundred basis points that year. Well, let's bring this back was with a broadly diversified thousand stock portfolio.
So let's bring this back to next because I'm curious about you know a thing that we haven't talked about yet, waitings. How do you decide what to what waitings to give the holdings in the portfolio.
Well, firstly, we're not going to capitalization weight it because that just puts all of your money in the least unloved names on the list. And so we equally wait the stocks. Basically, any stock that falls out of the top five hundred or out of the top thousand in the US stock market, roughly corresponding to S and P five hundred and Russell one thousand. But stocks that fall out of those top tier lists and have done so anytime in the last five years become members of the
next index. And so this consists of all of the stocks that have been deleted from top five hundred to top one thousand anytime in the last five years. Now, how big is that? Un that's a lot of stocks. That turns out to be about one hundred and fifty to two hundred stocks. We then take out the twenty percent worst quality of these stocks, the ones that have debt equity ratios or debt coverage ratios that are terrible, the ones that don't have any profits at all. So
the bottom twenty percent are dropped for quality reasons. We don't we want cheap stocks, we don't want value traps. And the result is that that takes the total list down to on average, one hundred and twenty two hundred eighty names. Right now, it's got I think one hundred and forty seven names equally weight them and no disaster stock is going to hurt you too badly. And if you have a half dozen or a dozen of them that triple, well, that boosts your aggregate return rather nicely.
Okay, let me ask you a question, why not just buy a small cap value ETF. There's a couple ones that have taken off recently in that category. What's the difference here?
Well, a couple of things though, small cap value The biggest name in small cap value I think is IWN, which is the Russell two thousand value ETF by I Shares. Firstly, that's capitalization weighted, so most of your money will be in the least inexpensive of the small cap value names, so the capitalization waiting reduces your opportunity. Secondly, it includes all of the Russell two thousand value stocks, including all the value traps. We try to filter those out with
a quality filter. Thirdly, it includes a lot of little companies that may or may not turn out to be successful. The NIXT index owns companies that were successful that fell out of favor. Fallen angels is a perfectly legitimate label for it. So these fallen angels, some of them regain their footing, and you don't need a lot of them to regain their footing for the average return to be brilliant.
Rob, I'm curious, you've been doing this for a while.
Research affiliates been around creating indexes and whatnot, But this is actually the first time you had an ETF to your name, and I'm curious why this one, and what have you learned about the industry that you didn't know before.
Well, a few things. Firstly, we've been associated with lots of ETFs. PRF that we were just talking about was launched based on our fundamental index concept. PRF was launched with power Shares before. It was part of Invesco reaching out to us and saying, we love your concept, can we launch an ETF. This was a little bit the other way around. ETF Architects is a one stop shop for turnkey launch of ETFs. We reached out to them
to say would you like to launch this? And of course the difference is with a turnkey platform for launching an et most of the revenues come to us, where with power Shares most of the revenues would go to them. So it's just a different business model. What made it our first case where we initiated the launch of an ETF strategy was firstly, this is a niche strategy. It's a really cool, interesting strategy, but it's not a big market strategy that an organization like Invesco or I Shares
is likely to want to launch. Secondly, the one stop shop, the turnkey system for launching ets didn't exist until the last few years and so it wasn't an option for us. We don't have ETF infrastructure. We don't have a trading desk. We specialize in product innovation, which is why our business model is to partner with others for distribution.
Let me ask you something. You're a veteran of the ETF space. When I bumped into a couple veterans over the past year, and they are getting a little old man on launish about all of the new launches, you know, the single stock leverage ETFs, the buffer ETFs. It's sort of like what happened to my beloved ETF industry. It's gone crazy. Are you Are you part of that kind of mindset or are you a little more libertarian?
You know, go crazy?
You know, I am a libertarian with both in my politics and in my approach to business. I love exploring new ideas, and if somebody wants to launch a three x leveraged in Vidia single stock ETF, more power to them. I'm not going to be a buyer, but the marketplace sort out the good ideas from the bad. I'm a huge proponent of free market.
Well, I guess that's a pretty interesting way to bring it back to next. So when do you decide that it's your any of these holdings are no longer worthy.
Of being in your in your team. It's the exit strategy.
The exit strategy is very simple. If it's been readded to the top five hundred to the top thousand, then it's no longer a reject, so it comes out of our portfolio. So it's as you said in the opening tagline, out with the new and in with the old. So the second way you get kicked out of our index is after five years, because there's this window of time of five years in which you get twenty eight percent average incremental return over the next five years. That's five
percent compounded per annum. It dissipates after the first five years. It's still positive, but it's not as interesting.
On the five years. Is that because once it gets kicked out, you need active managers to have some time to sort of sort through and go, wait a second, this is undervalue. But if it lasts five years as a dog, it's just bad.
I think there's truth in that. Although a beautiful counter example. Dillard's is a small department store that I believe has been in the Russell one thousand, four separate times in the last thirty years. It's been kicked out four times the last time it was kicked out was two thousand and seven.
That is a great We do trivia shows on here. That is a killer Jeopardy one thousand level question right there.
Four times.
Huh yeah, And the last time was twenty seventeen, and it's up something like five hundred and fifty percent since then. Most of that was in the first five years that I'm guessing that next year they'll probably be readmitted for a fifth time. So if index funds buy high and sell low, buy high multiple stocks when they're added, sell low multiple stocks when they're kicked out. We try to buy low and sell high by buying deeply out of
favor and selling when they come back into favor. Now some of them, roughly half of them never do come back into favor. But if the ones that underperform underperform modestly, and the ones that outperform underperformed by a big margin, you've got a winning strategy. So I think it's a lot of fun. I think it's a cool idea. I think it's also a way to complete your market portfolio.
If you own.
Russell one thousand or s and P five hundred, you don't own the stocks that aren't in the index. This is a way of cherry picking out of that roster companies that were once successful, that are dirt cheap and that have in many cases better chances than the market thinks of bouncing back. And that creates a completion strategy that can fill out your portfolio nicely.
Now I'm actually I am curious about that bottom twenty percent that you that you mentioned earlier, that screening mechanism. Is that just a one time thing or is it every single time that the that the index rebalances.
Just every rebalance, so it's.
In constant constant flux. Basically what's in the portfolio?
Right? So that that gets back to the earlier question, what gets you kicked out of this index? If your quality tumbles below that threshold, you're out. If you've been in for five years, you're out. If you are readmitted to the top five hundred or the top thousand, y're out. So the goal is to have rejects that have a good chance of a rebound.
Rob real quick.
I have to squeez in this sort of ETF NERD question. Earlier on you said, well, smart beta is you know indexes or ETFs that look for value basically. Now, smart beta has morphed into many categories qualities side sure is you could you consider growth or momentum to be a smart beta ETF.
I don't, but keep in mind fundamental index was the strategy that prompted Towers Watson to coin the expression smart beta in the first place, and they coined it based on this is an idea for how to capture beta exposure to the market that's smart, that has a rebalancing component for that beautiful two thousand and nine rebalance. So they then went and looked for other strategies that do the same thing, that break the link with price equal weighting.
As simple as it is, is smart beta. Well, the term got taken over by the industry and attached to everything under the sun, including ideas that were really smart and ideas that were really stupid. And so there's some very stupid smart beta strategies out there. I'd put a momentum in the not smart beta category. I wouldn't call it stupid, but it certainly doesn't contratrate against stocks that are falling out of favor. It gets you out of them, and so it winds up doing the opposite of what
the original term smart beta meant growth. Likewise, quality always trades at a premium, so quality could be smart beta depending how it's implemented. Most of the time it's implemented cap weighted, which by definition isn't smart beta. So I'm just describing the much narrower definition of smart beta that used to exist. The term as it exists now doesn't mean anything.
Yeah, it's a big tent at this point. But Joel Quick anecdote, I remember when smart beta was all the debate at all the conferences. It must have been like ten years ago, twelve years ago. Is at a conference and this advisor was like smart beta. So let me get this straight. If I buy a smart beta ETF and then short beta, am I long smart?
Oh? I love it. That's great.
I think, I think crowd think you are okay, rob final question, what is your favorite ETF ticker other than your own or any that you're affiliated with.
Oh gosh. Perth Toll is one of my favorite people in the ETF world. She came up with an idea of investing in emerging markets waited by how free their economy is, how free their society is, and zeroing out autocracies. And I love the ideas. So I was actually a seed investor UH when she launched the fund. UH ticker FRDM Freedom. It's great, well, very cool ticker.
We should check back in with. It's been a while since we spoke with her, Robert or not. Thanks so much for joining us on Trillions.
Thanks for the invitation. This has been great fun as always.
Thanks for listening to Trillions until next time. You can find us on the Bloomberg Terminal, Bloomberg dot com, Apple Podcasts, Spotify, or wherever else you'd like to listen. We'd love to hear from you. We're on Twitter, I'm at Joel Webbers Show. He's at Eric Balchunis. This episode of Trillions was produced by Magnus Hendrickson.
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