Nasdaq 100 Rebalancing: This Fix May Provide Opportunity

Apr. 06, 2011 9:27 AM ETAAPL, MSFT, QQQ5 Comments
John Tobey, CFA profile picture
John Tobey, CFA
1.25K Followers

Nasdaq committed an error and now has to pay the price. The penalty? Having to publicly announce a dramatic “rebalancing” of its noteworthy Nasdaq-100 (QQQ) stock index.

No, there is no admission of guilt. In fact, after the rebalancing, the same flaws will still be in place. Ironically, all this is taking place in index-land – a place where fractions of a decimal number are viewed as important information.

The Nasdaq-100’s “unique” weighting scheme

Most stock indexes (excluding the Dow Jones Industrial Average) weight each security by market capitalization. But not the Nasdaq-100. Starting with market capitalization in 1998 (its prior “rebalancing”), a complex and erroneous set of “adjustments” over the past 12 years has led to company weights that are far from reality.

Different factors produce the changes, but the key culprit is stock performance. Better = more weighting; worse = less. Apple (AAPL) and Microsoft (MSFT) are the companies most out of alignment representative of their radically different returns: AAPL = +3,735%; MSFT = (29)%.

Even though Nasdaq says the approach is “precise,” it is confusing, non-intuitive and, worst of all, produces skewed results. How bad is it? Well, bad enough that Nasdaq has to make unheard of reallocations to fix it.
Before looking at the returns, let’s examine the basic problem.

Examples of Nasdaq-100’s flawed weightings

The Nasdaq system now has Apple’s outstanding shares up to 2.4 billion shares - 2.6 times the company’s actual 0.9 billion. Meanwhile, Nasdaq-100 has Microsoft’s shares at only 5.4 billion, two-thirds of the actual 8.4 billon.

Based on current prices, Nasdaq-100 has Apple’s valuation at $820 billion, almost six times Microsoft’s valuation of $140 billion. The actual numbers: $310 billion for Apple, about 1.4 times Microsoft’s $220 billion.
Note: Nasdaq omitted the first four years following the initial rebalancing: 1999-2002. Why? Not for lack of data. We can only presume it's because the miserable years of 2000-2002 (see below) would reveal something distasteful. The performance for PowerShares (QQQ), the ETF based on the Nasdaq-100, is shown for reference.

Now let’s look at the returns over time
Nasdaq has issued explanatory pieces on its website. The “NDX Special Rebalance Presentation” (pdf) provides some returns for both a market capitalization-weighted Nasdaq-100 as well as the actual Nasdaq-weighted index.
Nasdaq-100 annual returns
Nasdaq-100 cumulative returns
(Click charts to expand)
Index funds are between a rock and a hard place. Investors expect to see an index fund match its index. The flawed Nasdaq-100 index is no exception. Therefore, index funds can do little but wait until the rebalancing day that Nasdaq has picked: May 2. This fact means investors can take advantage of any price moves ahead of (or following) that day.

So… As investors, we can be annoyed at Nasdaq’s poor weighting scheme. More important, though, we can then think about how to take advantage of the upcoming rebalancing.

Disclosure: I am long AAPL.

This article was written by

John Tobey, CFA profile picture
1.25K Followers
I am the founder and editor of Investment Directions. My career has been managing and consulting to multi-billion dollar funds. Using the widely accepted “multi-manager” approach, I have worked with top investment managers throughout the country, gaining a high level of expertise. My career has spanned many market environments, and I have hands-on experience searching out opportunities and avoiding risks in all of them. I now devote my time to Investment Directions, with the goal of helping investors further their understanding and improve their investing skills. I am currently serving on: The AAUW Investment Advisers Committee and The City of Vista Investment Advisory Committee.
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