Abstract
Traditional capitalization-weighted indices generally add stocks with high valuation multiples after persistent outperformance and sell stocks at low valuation multiples after persistent underperformance. It is well known that the price impact of these changes can be large once a change is announced. The subsequent reversal is less well known. For example, in the year after a change in the S&P 500 Index, discretionary deletions beat additions by 22%, on average. Simple rules, such as trading ahead of index funds or delaying reconstitution trades by 3 to 12 months, can add up to 23 basis points a year. This benefit roughly doubles when we cap-weight a portfolio selected based on the fundamental size of a company’s business or on its multi-year average market-cap.
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