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Dispatches

Indexers Can Exclude Some Stocks Without Affecting Returns

Excluding a low to moderate number of stocks from a passive portfolio following an index has minimal influence on investor performance.

by Andrew Gomes | March 2024

Excluding a low to moderate number of stocks from a passive portfolio following an index has minimal influence on investor performance.

Researchers performed simulations using a historical investable universe from 1964 to 2021, focusing on the top 1,500 common shares by market capitalization. A market-cap-weighted return index of the defined investable universe was constructed to serve as a passive benchmark. After removing randomly selected stocks from the universe each year, the researchers recalculated the market-cap-weighted portfolio return using the remaining stocks. They then compared the performance of the increasingly restricted market-cap-weighted portfolios to the passive benchmark’s performance.

Terminal Wealth Multiple Percentiles Under Stock Exclusion

The results showed that the returns of passive portfolios with up to 100 excluded stocks remained comparable to the returns of the benchmark portfolios. The analysis was extended to industry-concentrated exclusions, demonstrating similar patterns. Long-only factor portfolios were also found to be minimally affected by a moderate number of exclusions, while more extreme exclusions were shown to negatively impact performance, depending on construction methods.

The researchers also tested custom portfolios, which allow investors to deviate from benchmark indexes. Four customization options were studied: tax-loss harvesting, factor enhancements, socially responsible investing restrictions and single-stock exclusions. The researchers found that a modest approach to these customizations preserves expected performance properties in passive portfolios.

The results suggest that index investors can comfortably exclude a moderate number of stocks without significant deterioration in investment performance.

Source: “Exclude with Impunity: Personalized Indexing and Stock Restrictions,” by Yin Chen and Roni Israelov; Financial Analysts Journal, October 19, 2023.

Discussion

JIM L from MI posted over 2 years ago:

what an odd article. how many personal investors try to replicate an index with individual stocks? and you might not have liked the results for the last decade if you excluded the wrong handful of stocks and expected the rest to have the same results


ROBERT A from NC posted over 2 years ago:

Jim L makes a good point. A lot would depend on WHICH stocks were excluded. But I don't think it's a bad strategy to find a good index ETF and sift it to come up with 10 or 20 stocks for long-term holding.


JOHN L from NJ posted over 2 years ago:

The distribution of individual stock returns is not normal. Most stocks are out performed by treasury bills. A very small group of stocks have insanely high returns. This is one reason why active investors struggle to beat an index. They need to have some of the small number of super performers in their concentrated portfolio to be competitive. Unfortunately for active investors, the soon to be top performers are not easy to find.


ROBERT A from NC posted over 2 years ago:

John L is correct. That may be why my method of holding winners and selling losers has worked. A single super winner held for decades can easily overwhelm losses from many losers.


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