[THE VIEW]Long-Term Investment Strategies Targeting Stocks Removed from Indices

Rising Popularity of Investing in Stocks Excluded from Major Indices
Long-Term Approach Gains Attention
Careful Selection Can Lead to Significant Success

One of the long-term investment strategies gaining attention recently is investing in stocks that are excluded from indices. For example, the S&P 500 index tracks the performance of the largest 500 stocks listed in the United States, but some stocks are occasionally added to or removed from this index. Naturally, stocks added to the index have recently performed well, as they move into the top 500 by market capitalization due to price increases. Conversely, stocks removed from the index have relatively poor recent performance. So why is investing in stocks that are removed from the index becoming popular?

First, stocks added to the index often experience short-term price increases for various reasons. This price rise is driven more by increased liquidity and demand from various funds tracking the index than by fundamental value growth. This also aligns with momentum trading (trend-following) strategies, which suggest that stocks with good performance over the past 3 to 6 months tend to outperform stocks with poor performance during the same period in the short term. This investment strategy was very popular in the 1990s and is still considered a valid short-term investment approach.

Stocks removed from the index must have had poor recent performance. Therefore, buying these stocks and holding them long-term corresponds to a reversal trading strategy, which contrasts with momentum strategies. Reversal trading is based on the idea that stocks with poor performance over the past approximately three years tend to outperform stocks with good performance over the next 3 to 5 years.

However, unlike traditional reversal strategies that simply buy stocks with poor past performance and hold them long-term, stocks removed from indices experience even larger price declines. Because funds tracking the index sell these stocks, downward price pressure increases, making these stocks relatively cheaper. It is argued that selecting stocks removed from indices, which are both reversal candidates and excessively undervalued, can yield greater benefits.

Recently, these strategies have succeeded and generated significant returns, leading to the emergence of ETFs based on them. However, before blindly following these strategies, there are important details to consider. First, these strategies are not applied to just one or two stocks but use portfolios containing multiple stocks to minimize risk. Also, careful selection is necessary among stocks removed from the index. Stocks facing major crises or rapid value declines are likely to continue losing value, so the key to success is investing in stocks removed due to relative and temporary value declines, especially those with strong financial health.

Finally, this is a long-term investment strategy and is not suitable for investors seeking short-term gains.

Seongkyu Park, Professor at Willamette University, USA

This content was produced with the assistance of AI translation services.