We have observed that additions and deletions to the S&P 500 Index follow a dependable pattern: additions underperform and deletions overperform over the subsequent 12-month period.
In late 2020, a new kid emerged on the bargain-of-the-decade block. UK stocks, and notably UK value, reached very cheap levels relative to value stocks in other developed economies. Today, UK value remains at remarkably low valuations relative to most of its fundamentals.
On December 21, Tesla will be the largest company ever to enter the S&P 500 Index. Tesla’s skyhigh valuation, which meets our real-time definition of a bubble, conforms to the observation that market-cap-weighted indices buy high and sell low—the antithesis of prudent investing.
Traditional index funds match market performance and have negligible trading costs with low tracking error—or do they? Not actually—they routinely buy after high price appreciation and sell after high price depreciation. They also have significant trading costs from adding and deleting stocks. We show how index providers can construct better-performing indices that are less prone to performance chasing and have lower turnover.
In 2016, Research Affiliates published a series of articles challenging the “smart beta” revolution. We pointed out that, while there is merit in many factor tilt and smart beta strategies, performance chasing in these strategies—buying the popular outperforming strategies whose relative valuations are at extremely high levels—can be just as dangerous as performance chasing in other realms of asset management.