What is an index?
To understand rebalancing, we need to understand an index and how investments are allocated based on an index.
You can imagine an index as a shopping list for stocks. This list is published for all the investment brokers and ETF funds that follow the index to access. They will then mirror their funds and the stocks of the companies on the index based on the ratios that are defined on it.
How does this change over time?
Let's say you have a simple index with four companies.
Company A = $100 market cap (10% of the index)
Company B = $200 market cap (20% of the index)
Company C = $300 market cap (30% of the index)
Company D = $400 market cap (40% of the index)
In the example above, if I, as the investor, then buy $1000 worth of an ETF that follows the index above, my money will be allocated to the companies in the same weighting.
Company A = $100
Company B = $200
Company C = $300
Company D = $400
When certain companies experience faster growth in their share prices, they naturally become more heavily weighted in the index. This causes them to make up a larger portion of the index. As investors, this can lead to a reduction in our diversification, which may negate the main reason why we choose to invest in an index rather than in individual stocks.
Weighting rules
There are many requirements for stocks to be included in the Nasdaq 100 index, such as liquidity, market cap size etc. Here you can read the complete NASDAQ methodology rules.
However, to rebalance the index, there are two key considerations:
The current weight of the single largest market capitalization Index Security is greater than 24.0%
The “collective weight” of those Index Securities whose individual current weights are more than 4.5%, when added together, exceed 48.0% of the Index.
Current Nasdaq 100 Weighting
We can observe, based on the current weightings, the top 6 listings (excl. Meta Platforms, which is under the 4.5% threshold) come to a combined total of 51.18% of the index (55.59% with Meta).
This will be reduced so that the top 5 companies combined will not exceed 38.5% of the index (currently, the top 5 companies have a weighting of 46.60%).
Historical Index Rebalancing
December 1998
One way we could look at what could happen in the rebalance is to see what happened in prior rebalances. The first recorded special rebalance that occurred was in Dec of 1998.
During that month, the index actually rose over 13%.
May 2011
During this rebalance, the market actually declined 3.5 per cent during the month following the rebalancing.
In summary
It's difficult to predict the market's behaviour after special rebalancing events. However, we've observed that there tends to be more volatility in the month following due to the rebalancing of large trading in stocks.
Before deciding on your investment strategy, it's important to consider how the upcoming reduction in index weighings may affect your portfolio if you hold any of the top stocks in the Nasdaq. Increased volatility and declines in value due to profit-taking are possible outcomes, particularly for companies like Meta and Nvidia, which have experienced significant rallies this year.
However, if your investment is in the index as a whole, it's not anticipated to have a significant impact on the overall index.
It's always advisable to do your own research, carefully evaluate your options and consult with a financial advisor before making any investment decisions.
Comments