Does the Special Rebalance of Nasdaq 100 Amount to Market Timing?

Ruth Saldanha: The Nasdaq-100 index underwent a special rebalance recently. No stocks were added or removed, but the weighting of many of the mega-cap names, especially the Magnificent Seven, which are Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla, were reduced, while some others increased. So, what does this mean for this fan favorite index? Has its appeal dipped somewhat? Ryan Jackson is a Manager Research Analyst with Morningstar Research Services, and he looks closely at the index. He's here today to tell us what he thinks.

Ryan, thank you so much for being here today.

Ryan Jackson: Yeah, of course. Thanks for having me on.

Boo-hoo-hoo: Nasdaq Meddles with the QQQ

Saldanha: So, the first thing I wanted to ask you is that no stocks were added or removed in this rebalance. It was just the weights that were changed. Could you walk us through some of the changes, please?

Jackson: For sure. Yeah, and I think it makes sense to start with what the Nasdaq-100 actually is doing. So, the approach of this index is they're taking the 100 largest non-financial stocks that trade on the Nasdaq exchange, they're sweeping them into the portfolio, and they're weighting them by market capitalization. So, what that market cap weighting approach means is that as a company's stock price, and by virtue of that, its market cap grows, so too does its share of the portfolio overall.

So, now, take even one more step back and think about market performance this year.

We've had a handful of stocks, dubbed the Magnificent Seven for their tremendous performance so far this year, that have really led the market, and as a result of that, have seen their market cap skyrocket and their share of the Nasdaq-100 really start to balloon. So, that's all well and good. And all while the Nasdaq-100 is market cap weighted, it does have some stipulations in place that are designed to keep this portfolio from really growing too top heavy. So, sure enough, after these stocks' tremendous first half, they were really constituting a large portion of the Nasdaq-100 at the top, and on July 3rd, they actually crossed a threshold to trigger what is called a special rebalance.

So, again, the special rebalance, the goal is to prevent too much top heaviness in the portfolio. So, what the Nasdaq does is they actually go in, they intervene, take some of that portfolio weight from those top-heavy stocks, and redistribute it to the rest of the constituents in the index. So, after the special rebalance, after all the dust had settled, we saw the Magnificent Seven go from about 55% of the Nasdaq-100 on July 3rd, down to about 43% of the portfolio after that. So, you've got some of those (weighters), companies like Pepsi, Costco, Broadcom are just outside that top seven, they got a little bit of a boost, but really top to bottom among those other 93 constituents, you saw their weight increase a little bit, just commensurate to how big their position was beforehand.

Will this Rebalance Mean Lesser Returns for the Index?

Saldanha: Right. I want to talk about this a little bit more. Now, you said that the Magnificent Seven accounted for most of the stock market gains, of course, which led to their increased market cap. But the question here is that if these weightages have reduced, doesn't it also mean that the returns that you get is going to proportionally reduce in the index as well?

Jackson: Yeah, it's an interesting question. Had this special rebalance gone off, say, at the start of this year, then there's no doubt, right? Because you would have less exposure to these Magnificent Seven stocks, wouldn't have reached quite the same rewards that came out of their great performance. But on a go-forward basis, it's really difficult to say. I think there are two schools of thought when you think about the rebalance and its effect on performance. I think on one hand, you could have folks say, you know, these have clearly been the best stocks on the market. Why are we starting to reduce our exposure to them as they're clearly roaring with these great returns? I think that's an argument for momentum, the idea that you want to let your winners ride. And it's an argument for market cap weighting too, the idea that the market is going to determine what these companies are worth, there's no need for us to go in and really intervene and make our own call.

On the other hand, I think there's this school of thought that would say, look, it's been a really unique market where we've had just a handful of stocks turn in this reasonably strong performance, and it's been a little bit of an imbalanced bull market. So, why not just take our gains now and create a more diversified portfolio? I think that has a lot of merit. I think that's an argument for diversification and it's an argument for value too, right, moving away from some of those recent winners into stocks that might carry a little bit better value. So, I think, there's a lot of different ways to look at it. But ultimately, when you think about the impact on returns going forward, that's just entirely dependent on how the Magnificent Seven continue to do and whether they can keep up their strong year so far.

Is the Nasdaq Timing the Market With this Rebalance in the Nasdaq 100 Index?

Saldanha: Right. One thing that we always say at Morningstar that it's not timing the market that matters, but time in the market. In this particular instance, it kind of seems a little bit that the Nasdaq is trying to time the market. Is it at all? How should investors read that?

Jackson: It kind of feels like it. I hesitate to call it any market timing on the part of Nasdaq, just because these are rules that were codified into the index methodology for years. It's just it happens to be a really rare instance that we actually see these special rebalances kick in. So, I don't know if I would really call it market timing. But I think what it is when you zoom out a little bit is a reminder that even the strategies that we tend to conceive of as truly passive will have some of these active elements around the fringes. So, we've got the special rebalances kick in here. One could argue that's sort of an active step. Even something like the S&P 500 we think of as a very passive index. But at the end of the day, it's still maintained by a committee who is deciding which stocks meet their criteria or not. So, on a macro level, I think while I wouldn't call it market timing, I think it's a reminder that even the strategies that we tend to call passive funds aren't always a perfectly objective representation of the market they represent.

The Magnificent Seven’s Loss is Everyone Else’s Gain

Saldanha: Right. We've talked a fair bit about the stocks, the Magnificent Seven specifically, that had their weightage reduced in the Nasdaq. Can you give us a sense of which stocks actually increased their weightage the most?

Jackson: Yeah. I mean, so not to oversimplify, but it would really be like every other of the 93 companies that make up the Nasdaq-100. And I touched on it briefly earlier, but it's all going to be commensurate to how big their weight was prior to this special rebalance. So, the companies that land just outside the top seven, I think 8 through 10 you've Broadcom, Pepsi and Costco, were those that fell right out. Since they were the largest stocks that aren't being reduced, they're going to get the largest boost. But at the same time, towards the bottom of the portfolio, too, you're going to see even those, 96, 97, 98 stocks get a little bit of a jump up as well. So, I think of it almost like if you've ever filled up an ice tray under the faucet before, you've got those first few cubes that overflow first, that's your Magnificent Seven. But then the next ones get quite a nice boost but all the while trickling out to the edges. That's kind of how I think about the redistribution of this weight that we've seen leave the Magnificent Seven and go to the rest of the portfolio.

The Nasdaq 100 Index – and QQQ – Are Still Not Great Investments

Saldanha: Right. The last thing I wanted to ask you is that you've said in the past that the Nasdaq as an index is flawed. Now, after this rebalance, has your view changed? Is it the same? Has it gotten better? What do you think now?

Jackson: Sure. So, the fund that we rate that tracks the Nasdaq-100 index is called Invesco QQQ trust. Ticker is QQQ. And I currently have a neutral Morningstar Medalist Rating on that strategy, which means we don't have a ton of conviction that this is going to outperform its category index on a risk-adjusted basis over a full market cycle. Ultimately, this special rebalance does not change that view, still affirming its neutral rating, because at the end of the day, while this feels like a big change going from 55% to 43% in the Magnificent Seven, it's not a huge impact on the portfolio. The key components that drove that neutral rating remain intact. You used the word flawed, which I think is perfect, because one of the big flaws that drove that neutral rating was the fact that it's only selecting stocks that trade on the Nasdaq exchange, we look at that as an arbitrary stock selection process creates some head scratching omissions when you actually look at the final portfolio. So, the special rebalance doesn't change that.

That all said, I do think if anything, it's a net positive for QQQ and its investors. I talked a little bit earlier about the pros and the cons of moving out of these top positions. I think given that this was a pretty top-heavy index and remains a fairly top-heavy index, the stronger diversification is definitely a net benefit moving out of those heaviest positions. We'll see if it pays off for Nasdaq-100 and those to invest in QQQ. But for the time being, I see it as a marginal advantage for those that invest in it.

Saldanha: Great. Thank you so much for joining us today.

Jackson: Yeah. Thank you, Ruth.

Saldanha: For Morningstar, I'm Ruth Saldanha.