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By JT

Tesla (NASDAQ:TSLA), an American automobile manufacturer, will join the NASDAQ 100 Index (NASDAQ:QQQ). It will replace Oracle (NYSE:ORCL), which is moving to the NYSE. Becoming part of an index is a relatively normal happening for an up and coming company, but for ETF investors, it puts market cap weighting back in focus.

Market cap weighting

Funds and indexes are weighted by market cap select stocks based on their equity value. The largest stocks are accepted into the index. The largest stocks in the index (by market value) receive the largest allocation of funds. The NASDAQ 100 naturally holds 100 different securities, but their weights span from 11.59% for Apple (NASDAQ:AAPL) to .09% for Randgold Resources (NASDAQ:GOLD). Thus, a 1% change in the price of Apple would have a larger impact on the NASDAQ 100 movements than a 100% change in the market value of Rangold Resources.

Market cap weighting has other weaknesses:

  • It doubles down on winners – Tesla is one of this year's hottest stocks, rising more than 280% year-to-date as the market chases the hottest automaker on the block. Now that Tesla has a market value of over $15 billion, the company is large enough to warrant a place in the NASDAQ 100. Should its value grow over the next few years, the NASDAQ 100 ETF will only allocate more to the position, effectively buying more of a quickly-rising stock. Likewise, if Tesla, or any other component, were to plunge, the ETFs that track the index would sell shares at a lower per-share price. Market cap weighted funds buy high and sell low by design.
  • It penalizes levered companies – Some firms are financed by high levels of debt, some are financed entirely with equity. When an index weights based on the equity value of a company, it ignores entirely the debt-financed portion of the company. As such, market cap weighted funds hold bigger positions in less levered companies and smaller positions in levered firms. This may help to explain why market cap weighted funds tend to underperform equal weighted funds.

Adjusting for tech exposure

In few industries do companies rise and fall as quickly as technology. Just one year ago, Apple was the growth stock to end all growth stocks, a company trading at $700 per share, 15 times earnings (in line with the market) that nearly doubled free cash flow in one year to 2011. Free cash flow growth came in at just under 40% to 2012. Now that's a growth stock!

But then the investment thesis fell out. Apple became too big. How much longer could it grow at double-digit rates? What more could it possibly sell? Apple then plunged from a peak at $700 to under $400 per share. The incredible rise and fall of technology is why I think it pays to seek an equal-weighted NASDAQ 100 variant, rather than the plain-vanilla index.

Equal weighted NASDAQ 100 funds

The NASDAQ 100 Index is rebalanced and re-ranked annually. The NASDAQ 100 Equal Weighted Index ETF (NASDAQ:QQEW) is equal weighted, and rebalanced quarterly. The result is a fund that is less hinged on the performance of only a few top tech names, and a fund that cuts temporary winners and buys temporary winners each quarter.

Investors do have to make sacrifices with an equal weighted fund. It's costlier at .60% per year vs. .20%. However, long-term returns have not varied substantially.

Equal weighted NASDAQ 100 ETF - QQEW
YTD Return: 21.73%
1-Year Return: 33.47%
3-Year Return: 67.71%
5-Year Return: 74.95%

Market cap weighted NASDAQ 100 ETF - QQQ
YTD Return: 15.88%
1-Year Return: 21.91%
3-Year Return: 73.60%
5-Year Return: 75.72%

The differences in returns come as a result of the performance of the stocks at the top of the market cap weighted index. Apple's terrible 2013 weighs substantially on the market cap weighted fund, but has little effect on the equal weighted fund, for example, as we predicted earlier this year when focusing in more depth on the outperformance of equal weight indexing.

One can make the case that equal weighted funds carry a higher beta, lower alpha, and/or higher fees. They're right in this case. Consider it the price of insurance, however. Market cap weighted funds are much too exposed to the stocks with the most disproportionate weights. An equal weighted strategy that rebalances quarterly is more diversified, which results in a better index. Indexing is supposed to offer diversified access to a market for "set it and forget it" investing styles. The equal weight fund is better suited for this group of investors.

Source: Market Cap Weighting Weakness: Tesla Joins QQQ