Investors are missing gains by passing on the market's least-loved stocks, investing legend Rob Arnott says

• Stocks kicked off the top indexes tend to outperform, Research Affiliates wrote.
• A portfolio of stocks booted from indexes would make an investor 74 times wealthier between 1991 and 2023, the research said.

Stocks kicked off top indexes could offer surprisingly lucrative returns for investors willing to bet on them, according to new from Research Affiliates.

The firm's founder and investing legend Rob Arnott and vice president Forrest Henslee wrote that stocks dropped by an index outperform for at least five years with remarkable persistence. After being deleted from an index, nixed stocks can outdo the market by an average of 5% a year.

"Absent fees, taxes, spending, and other charges, an investor in a broad deletions portfolio for the five post-deletion years would be 74-times wealthier at year-end 2023 than in January 1991," the authors wrote. "Only a Nasdaq-100 investor would fare as well, albeit with higher volatility and the harrowing drawdown of the dot-com crash."

To test this thesis in the decades ahead, Research Affiliates announced the release of the NIXT index. The fund will buy rejected stocks and hold them through the five-year timeframe.

So what is it about these unloved stocks that generates such consistent outperformance?

When an index decides to remove an asset, it's essentially creating excessive selling momentum, Arnott wrote.

"Deletions experience massive selling pressure since index fund investors must unload their shares; as a result, the market clearing prices of dumped stocks are often much lower than what they would have attracted before the deletion decision," the note said. "This sets the stage for an impressive rebound."

Meanwhile, the authors found that firms that replace nixed companies on an index have much less to brag about.

Replacements will often underperform modestly in the subsequent year on average, the research said. For instance, S&P 500 additions lagged the market by 1%-2% from 1990 to 2020.

Now is also an opportune time to consider a deletions portfolio, as these names could achieve further outperformance in the coming decade, Arnott said. That's as the current growth-dominated bull market will eventually peter out, he argued, allowing small caps and value stocks to climb higher.