A recent article in Barron’s outlines recent research by “modern-day Socrates” Rob Arnott, founder of Research Affiliates, which suggests “index-fund managers are willfully ignoring low-hanging alpha—the ability to beat the market—in order to slavishly hew as closely as they can to the capitalization-weighted indexes they track.”

Arnott’s analysis of S&P 500 index data from 1989 to 2017 shows that the stocks added to the index underperformed those that were “kicked out” by an average of 23 percentage points over the next 12 months.

In an interview with Barron’s, Arnott explained how index-fund managers can do a better job corralling alpha. Here are some highlights:

• Index investing, says Arnott, can often lead to a “buy high, sell low” scenario since indexes move prices when they add or remove a stock. “Stocks added are almost always trading at high multiples,” he asserts, while deletions are “almost always trading at bargain-bin prices.”
• The point of his research, says Arnott, is not that indexing is “bad, just that you can index better. It is an exploration of micro strategies, to lightly enhance returns. I’m challenging the premise that tracking error [the difference between the price of the index and that of its components] is so important that if you ignore it, you miss the easiest little bits of alpha to pick up.”
• Arnott says his findings hold true for the Russell 1000 index as well.
• On the market’s biggest names, Arnott says, “The most popular and beloved stocks are always justified by the argument ‘it’s different this time.’ ” Seven of the eight largest companies in the world (as of March 31) are tech giants, he says, adding, “History tells us that of the top 10 stocks in the world, eight will disappear over the next decade—if history is any guide Apple might be in the Top 10, but won’t be No. 1.” If an investor’s horizon is 10 years, then, Arnott argues that those top stocks stand a 90% chance of underperforming–“Why would you want that?”