How To Profit From The Nasdaq 100’s “Special Rebalance”

How To Profit From The Nasdaq 100’s “Special Rebalance”
Reda Farran, CFA

8 months ago5 mins

  • After a rollicking AI-driven rally this year, the six biggest tech stocks (Microsoft, Apple, Alphabet, Nvidia, Amazon, and Tesla) now comprise more than 50% of the Nasdaq 100 – way too high for the liking of the index’s overseer.

  • Consequently, the index will undergo a special rebalance with changes taking effect on Monday, July 24th. The index’s methodology suggests that the collective weight of the six mega-cap tech stocks will be cut to 40% from 50%.

  • To profit from this, you could buy the stocks set to see their weights grow and short the six mega-cap tech stocks set to see their influence shrink. But remember, this is just a short-term investment opportunity that should probably be exited soon after July 24.

After a rollicking AI-driven rally this year, the six biggest tech stocks (Microsoft, Apple, Alphabet, Nvidia, Amazon, and Tesla) now comprise more than 50% of the Nasdaq 100 – way too high for the liking of the index’s overseer.

Consequently, the index will undergo a special rebalance with changes taking effect on Monday, July 24th. The index’s methodology suggests that the collective weight of the six mega-cap tech stocks will be cut to 40% from 50%.

To profit from this, you could buy the stocks set to see their weights grow and short the six mega-cap tech stocks set to see their influence shrink. But remember, this is just a short-term investment opportunity that should probably be exited soon after July 24.

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The Nasdaq 100’s been having a boisterous year: the index just posted its best first half-year ever, beating even the dotcom bubble of the late 1990s. That comes down to the market frenzy for all things AI, which has led to an unstoppable rally in Big Tech and left the benchmark overly concentrated in just a handful of stocks. Now, the index’s overseer is taking action that will mellow their influence, with a special rebalancing that could present you with a savvy short-term investment opportunity. Let’s take a look…

What’s this rebalancing all about?

Late last week, financial services firm Nasdaq announced that its flagship stock market index, the tech-heavy Nasdaq 100, will undergo a “special rebalance” with changes taking effect at the opening bell on Monday, July 24th. According to the index’s complicated rules, a special rebalance may be conducted to address overconcentration, essentially by redistributing the stocks’ weights. So it doesn’t remove stocks from the index or add new ones – it just rejigs the underlying weights of the ones it’s already got.

Why has Nasdaq decided to do this?

A rebalance is generally viewed as a way to address overconcentration and maintain the integrity of the index. And this one comes after a vigorous rally in the six biggest tech firms (Microsoft, Apple, Alphabet, Nvidia, Amazon, and Tesla) that’s mostly been fueled by growing optimism over AI. Their shares have risen 62% on average so far this year, almost three times as much as the average stock in the Nasdaq 100. As a result, those six stocks now comprise more than 50% of the total index – way too high for Nasdaq’s (and investors’) liking.

Big Tech’s robust rally has accounted for almost all of the broader market’s gains this year. Source: Bloomberg.
Big Tech’s robust rally has accounted for almost all of the broader market’s gains this year. Source: Bloomberg.

But it’s not just about smoothing out the index: the rebalance will also make life easier for the fund managers who are linked or benchmarked to the Nasdaq 100, helping them stay in compliance with a Securities and Exchange Commission (SEC) diversification rule. Specifically, it’s the one that limits the aggregate weight of the biggest stock holdings – i.e. those with a 5% representation or greater – to just 50%.

How will this impact the Nasdaq 100’s stocks?

The index’s methodology suggests that the collective weight of the six mega-cap tech stocks will be cut to 40% from 50% – dropping their weight by a fifth. That means portfolios benchmarked to the Nasdaq 100 and funds that track the index, including the $200 billion Invesco QQQ ETF, will be forced to sell the names that are having their weights reduced and buy the ones whose weights are set to increase.

Nasdaq announced the rebalancing late Friday, July 7th, and when markets opened the following Monday, all six of the mega-cap tech stocks fell, with shares of Alphabet and Amazon dropping more than 2%. And while the overall Nasdaq 100 was flat, an equal-weighted version, which treats all 100 stocks as though they have the same market cap, climbed 1.8%. It’s a stunning reversal from the previous six months, when the equal-weighted index trailed by 18 percentage points.

All in all, the special rebalance could dent the rally in this year’s winners, including Nvidia and Tesla, according to strategists at Wells Fargo. They expect to see some selling pressure ahead, noting that when a rebalancing happened in 2011, stocks that were downsized lagged 2% to 3% during a similar period. And as the saying goes, history doesn’t repeat itself, but it often rhymes.

So, what’s the opportunity then?

Portfolios benchmarked to the Nasdaq 100 and funds that track the index will be forced to adjust their holdings to reflect the new weights once they’re announced, leading to downward price pressure on the stocks whose weights are being reduced while pushing up the prices of the stocks whose weights are being boosted. That could present you with a short-term investment opportunity, despite traders having already started seizing the anticipated reshuffling (as evidenced by Monday’s price action). See, most professional portfolios and funds that are tied to the Nasdaq 100 won’t be able to adjust their holdings until the new weights are announced in detail on July 14th or until the special rebalance is actually completed on July 24th.

To turn this into an investment opportunity, you could buy the stocks set to see their weights grow and short the six mega-cap tech stocks set to see their influence shrink. Wells Fargo strategists estimate that Starbucks, Mondelez, Booking Holdings, Gilead Sciences, Intuitive Surgical, Analog Devices, and Automatic Data Processing will see their weights rise the most. Since there are seven names here, you could add Meta, which could also potentially see its weight cut a bit, to the previous list of tech stocks. That way you have seven names on the long side and short side of the trade, making it easier to allocate an equal dollar amount to each position. Alternatively, for a potentially easier way to profit from this short-term investment opportunity, you could consider buying the First Trust Nasdaq-100 Equal Weighted Index Fund (ticker: QQEW; expense ratio: 0.58%) and shorting the Invesco QQQ ETF (QQQ; 0.20%).

But remember, this is just a short-term investment opportunity that should probably be exited soon after July 24. After all, if Big Tech continues that relentless rally for the rest of the year, you could end up getting seriously hurt shorting these names.

Finally, while the rebalancing might be a small short-term headwind for the six mega-cap tech stocks, it doesn’t change the companies’ underlying fundamentals or alter their long-run trajectories. What’s more, the stocks are still expected to have commanding presences in the index – even after the special rebalancing. And maybe that’s OK: you could argue that the index domination by a few tech firms isn’t so unhealthy because each of these giants is actually many companies in one. Amazon, for example, is an ecommerce giant as well as the biggest cloud computing provider in the world...

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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