The Implications of Nasdaq 100 Rebalancing

24 de jul. de 2023

CME: Micro Nasdaq 100 Futures ( MNQ1!), E-Mini S&P Technology Select Sector Futures ( XAK1!)
The Nasdaq 100 index tracks the 100 largest non-financial stocks listed on the Nasdaq stock exchange. Since its inception over 38 years ago, it has become the world’s preeminent large-cap growth index.

So far in 2023, Nasdaq 100 has surged 42%, far outpacing the 18.7% gain from the S&P 500 and the 6.4% return by the Dow Jones Industrial Average. This big rally has prompted the Nasdaq to implement an index "Special Rebalance". What’s going on here?


Nasdaq-100: Market-cap weighted Index with a Twist
In the world of stock market indices, the two most common construction methodologies are equal-weighted and market-cap-weighted. The Nasdaq 100 is market-cap weighted, meaning the weight of each component is based on its market cap as a percentage of the aggregate market cap of the index. The higher the market cap, the bigger the weight.

Nasdaq performs regular quarterly weight adjustments in March, June, September, and December. To prevent the index from becoming too top-heavy and unbalanced, Nasdaq imposes weight limits in its Nasdaq Index Weight Adjustment Guidelines.
• No security weight may exceed 14% of the index.
• If the aggregate weight of the five largest market capitalizations is more than 40%, they will be adjusted to 38.5%.
• No security outside the largest five market cap companies may have a final index weight exceeding 4.4%.

The list below shows index weight as of June 30th, the last quarterly adjustment, and the most recent market cap as of July 21st, for the top ten companies in Nasdaq 100:
• No. 1, Microsoft (MSFT): market cap $2,556bn, index weight 12.92%
• No. 2, Apple (AAPL): $3,019bn (12.57%)
• No. 3, Nvidia (NVDA): $1,094bn (6.94%)
• No. 4, Amazon (AMZN): $1,334bn (6.85%)
• No. 5, Tesla (TSLA): 830bn (4.25%)
• No. 6, Meta (META): 756bn (4.22%)
• No. 7, Alphabet Class A (GOOGL): $1,560bn (3.71%)
• No. 8, Alphabet Class C (GOOGL): $1,599bn (3.64%)
• No. 9, Broadcom (AVGO): 373bn (2.40%)
• No. 10, PepsiCo (PEP): 263bn (1.70%)
• Top-5: market cap $8,833bn, index weight: 43.53%
• Top-10: market cap $13,384bn, index weight: 59.20%
• Nasdaq 100 (^NDX): aggregate market cap $25,990bn



The Top-5 has already breached the 40% mark and will be brought down to 38.5% in the “Special Rebalance” to address the concerns of over-concentration:
“A Special Rebalance may be conducted at any time based on the weighting restrictions described in the Index Rebalance Procedure if it is determined to be necessary to maintain the integrity of the Index.”

How will this Rebalancing Impact Investors?
According to the Nasdaq, over $500 billion in exchange traded funds (ETF) are tied to the Nasdaq-100, including Invesco QQQ ETF, iShares Nasdaq-100 UCITS ETF and ProShares UltraPro QQQ, just to name a few. If each fund tracks the Nasdaq 100 closely and responds to the rebalancing immediately, the Top-5 stocks in the portfolio will be reduced by 5% (from 43.5% to 38.5%). This would create short-term selling pressure in tens of billions of dollars.

To put the figures in context: although the Top-5 companies have an aggregate market cap of nearly $9 trillion, they have a modest daily float. Based on my calculation, the average daily transaction value over the past three months was only $77 billion, less than 1% of their market valuation, with 337 million shares changing hands.

Leading up to the rebalancing, we are seeing larger trade volume and higher volatility:
• On July 21st, Microsoft had a trade volume of 69.3 million shares, vs. its 3-month average volume of 29.3 million shares;
• Nvidia: trade volume 96.2m vs. 3-mo average 49.3m
• Alphabet: trade volume 55.5m vs. 3-mo average 26.4m
• Amazon: trade volume 69.5m vs. 3-mo average 63.6m

Since peaking at 15,932 on July 19th, Nasdaq 100 has trended down in the last three trading sessions, currently trading at 15,455 on the morning of July 24th.

Arbitrage Opportunity between Technology Indexes
The Nasdaq 100 rebalancing is a unique issue with the Nasdaq 100 index. It has nothing to do with the fundamentals of these companies and has no impact on other Tech sector stock indexes which also include the same component companies.

The S&P Technology Select Sector (XAK) has over 90% correlation with Nasdaq 100 (MNQ) historically. The former includes Apple, Microsoft and Nvidia, but not Alphabet or Amazon.
In the past five years, XAK outperformed MNQ by 40%. In the past five trading days, MNQ underperformed XAK by 1%, likely due to the impact of the Nasdaq-100 rebalancing.


In the long run, Nasdaq 100 rebalance will dilute the impact of the largest stocks in the index. Strong growth in Big Tech will be fully represented in XAK but capped in MNQ. This, in my opinion, would result in a widening spread between XAK and MNQ.

XAK futures contract is based on $100 x S&P Select Sector Technology Index. At 1,786.6, each XAK contract has a notional value of $178,660 on July 21st. CME requires an initial margin of $9,500.

MNQ contract is based on $2 x Nasdaq 100 Index. At 15,555, each MNQ has a notional value of $31,110. CME requires an initial margin of $1,680.

Based on the relative notional values, someone bullish on the spread could establish a trade with 1 long XAK and 6 short MNQ.

Using the last five days as an example:
• If XAK increases by 1%, the long end of the trade would show a gain of $1,787 (17.9 x 100). If, during the same period, MNQ is flat, the short end would have no gain or loss. This spread combination would have a net gain of $1,787.
• Using initial margins of $19,580 as a cost base, this equates to a one-week return of +9.1%.

For comparison, if a trader invests in a Nasdaq 100 ETF and the index gains 1%, the return would also be 1%. Trading in futures comes with a leverage that would supercharge the gain if you were on the right direction.

The spread trade would loss money if MNQ has a stronger performance than XAK.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/