Here’s A Simple Trade That Could Earn You A 20% Return On Average

Here’s A Simple Trade That Could Earn You A 20% Return On Average
Reda Farran, CFA

over 2 years ago3 mins

  • Stock market indexes routinely add and drop stocks, usually when they’re hot or out of favor respectively.

  • Additions and deletions to the S&P 500 follow a predictable pattern: additions underperform the deletions over the next 12 months.

  • That makes the S&P 500 rebalance a great opportunity to do the opposite of what the index does: buy the deleted stock and short the added one.

Stock market indexes routinely add and drop stocks, usually when they’re hot or out of favor respectively.

Additions and deletions to the S&P 500 follow a predictable pattern: additions underperform the deletions over the next 12 months.

That makes the S&P 500 rebalance a great opportunity to do the opposite of what the index does: buy the deleted stock and short the added one.

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There’s a cardinal rule in investing: buy low, sell high. But stock market indexes often actually do the complete reverse of that, and the moments they do provide you a prime opportunity to roll out one particular strategy and earn yourself some tidy profits.

Why do indexes buy high and sell low?

Stock market indexes, it’s important to remember, are regularly rebalanced. And when they are, they tend to add and drop stocks when they’re hot and out of favor respectively.

See, many of the most widely used indexes measure the performance of a specific country’s stock market by including the biggest “X” number of stocks: the S&P 500, for example, comprises the US’s 500 biggest public companies by value. But since company fortunes can turn on a dime, these indexes are regularly updated to include stocks whose total market values have risen and remove those whose have dropped.

Notably, the stocks they add tend to have high valuation multiples and look expensive, while those whose values have dropped – known as “discretionary deletions” – are often of cheap-looking value stocks. According to investment firm Research Affiliates, new additions tend to be priced at valuation multiples that average over three times as expensive as those of discretionary deletions, using a blend of price-to-earnings (P/E), price-to-cash-flow (P/CF), price-to-book (P/B), price-to-sales (P/S), and (if available) price-to-dividends (P/D) ratios.

Put simply, stock market indexes often end up buying expensive stocks and removing inexpensive ones – or buying high, selling low.

What impact does this have on the stocks themselves?

Here’s where things get interesting: the answer to that entirely depends on when you look.

Providers usually rebalance their indexes once a quarter, first announcing the changes to the index and then rolling them out soon after. And leading up to the changes, the newly added stocks tend to outperform those being removed – not unexpected considering the trillions held with passive funds that are forced to buy the newly added stocks and sell the newly removed ones.

But following the index rebalance, the newly added stocks start to underperform the newly removed stocks. Research Affiliates tested this using changes to the S&P 500 over the past 20 years, and it found that, on average, discretionary deletions outperformed new additions by 14% in the first six months and by 20% after a year.

Average performance of additions (dashed blue line) vs. average performance of deletions (dashed yellow line) after the effective date of the S&P 500 reshuffle. Source: Research Affiliates
Average performance of additions (dashed blue line) vs. average performance of deletions (dashed yellow line) after the effective date of the S&P 500 reshuffle. Source: Research Affiliates

Notice the example of Tesla (TSLA) and Apartment Investment and Management Company (AIV) in the graph above. On December 21st 2020, TSLA entered the S&P 500, while AIV was dropped in a reshuffle that drew a lot of investor interest (mainly because of TSLA’s promotion to the S&P 500). Six months later, AIV had outperformed TSLA by almost 80%. And even since then, the gap has only narrowed to 40% – just look at the graph of the latest performance gap between the two stocks:

AIV has outperformed TSLA by almost 40% since the S&P 500 reshuffle involving the two stocks. Graph source: Koyfin
AIV has outperformed TSLA by almost 40% since the S&P 500 reshuffle involving the two stocks. Graph source: Koyfin

What’s the opportunity here?

Just do the opposite of what the index does: buy the deleted stock and short the added one.

If you’d used this strategy on the S&P 500 over the past 20 years, it would’ve generated 20% on average over the following 12 months. And the beauty of it is that you don’t have to spend time trying to guess which stocks will be added or removed: let the index provider announce the actual changes, and all you have to do is buy and short the stocks on the day the changes become effective.

Of course the usual disclaimers have to be inserted here. First, just because the trade generated a 20% return on average in the past, there’s no guaranteeing it’ll generate similarly impressive returns in the future. Second, this trade works well on average, but that naturally means that in some instances it’ll generate a loss. Last but not least, you should view this as just one of many trades you can add to your arsenal – not a strategy to invest your entire portfolio in. As always, experiment with small amounts and don’t be overly concentrated in a single trade idea or strategy.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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