Legendary investor Rob Arnott outlines the 2-part strategy that's helped his personal stock portfolio double the S&P 500 over 8 months

• Rob Arnott has used a leveraged long-short strategy to outperform the S&P 500 index since May.
• His approach leverages the differences between holdings in the RAUS ETF and the S&P 500.
• Arnott's method highlights inefficiencies in passive index funds.

Rob Arnott is revered in the investing world for his alternative passive index strategies, but when it comes to his own portfolio, the Research Affiliates founder likes to have a little fun playing the role of hedge-fund manager, too.

In an interview on Thursday, Arnott detailed a leveraged long-short strategy that has allowed him to double the returns of the S&P 500 over the last eight months. He shared with Business Insider screenshots of his personal brokerage account showing this strategy having produced a 36.67% return since mid-May. The S&P 500 has returned about 14% in that time.

The strategy comes from the idea behind the ETF Arnott launched in September: the RACWI US ETF (RAUS). The fund takes a fundamental approach to indexing, identifying companies with attractive qualities and valuations, and then weighting them by market capitalization.

It essentially seeks to correct what Arnott sees as flaws in passive indexes like the S&P 500, which add stocks following periods of outperformance, only to dump them when they've underperformed. RAUS has a 95% overlap with the S&P 500.

Seeking to capitalize on this concept outside the index, Arnott had the idea to take long positions on the stocks that his index includes which the S&P 500 does not, and take short positions on stocks that the S&P 500 includes but his index does not. He then amplified those positions with leverage.

"One really fun strategy, and I wish this had occurred to me back in '21, is what if we go long our non-overlap holdings, strip out the whole 95% that's overlapped, just go long our 5% non overlap and let's short the S&P's 5% non overlap," Arnott said, referencing when Research Affiliates launched its Cap-Weighted Index, on which RAUS is based. "Why stop there? Why not go 200% long and 200% short? I did that in my personal portfolio."

Arnott could not share the names of individual stocks in his portfolio for compliance reasons. However, in September, he listed Palantir (PLTR), DoorDash (DASH), and CrowdStrike (CRWD) as examples of S&P 500 stocks not in RAUS. Examining a list of RAUS's holdings, a few examples of stocks held in RAUS that are not in the S&P 500 include Xerox (XRX), Zoom Communications (ZM), and Rivian Motors (RIVN).

"One of my colleagues likes to say, 'Suppose I come to you and I say I've got this great strategy: I'm going to buy stocks when they've just doubled and when they're trading at twice the market multiple, and I'm going to sell stocks when they've just fallen in half and are trading at half the market multiple. Why don't you invest with me?'" Arnott said. "Most people would listen to that and say that's stupid, but that's the way index funds trade."

In September, Arnott illustrated this inefficiency in passive index funds with Dillard's Department Store, a repeat constituent of the Russell 1000 index.

"In the last quarter century, it has been removed from the index and added back to the index four times," Arnott said at the time. "So buy low, high, low, four times, and every time you're doing enormous damage to your wealth if it's the only stock you're trading."

"How big a difference does it make? It's been a member of the Russell 1000 in 22 of the last 35 years. During those 22 years, it has underperformed the Russell index by 99%," he continued. "In the 13 years that it wasn't a member, it gave you 67 times the wealth of the Russell 1000."