Keep A Steady Hand On The Tiller

April 08, 2011

Nasdaq’s contortions over stock weightings remind us to choose our indices carefully.


[This blog previously appeared on our sister site,]


As my colleague Dave Nadig pointed out in his blog a couple of days ago, the compilers of the Nasdaq 100 index have got themselves in a muddle over stock concentration limits.

When the owners of the US stock exchange’s popular benchmark wanted to license it for use by exchange-traded fund providers back in the late 1990s — and, as Dave argues, which provider wouldn’t want to make money from his index in this way? — they faced a problem.

In order to keep an index-tracking ETF compliant with the US Internal Revenue Service’s diversification rules, which set a 25 percent upper limit for a single fund constituent, Nasdaq had to rejig its index rules, which until then had set stock weights according to company capitalisation. The reason? One stock — Microsoft — exceeded 25 percent of the benchmark back in 1998, and until they got its weighting down there was no way of launching an ETF on the Nasdaq 100 that wouldn’t be tax-disadvantaged.

The exchange/index compiler got around the problem by imposing “adjustment factors”. These cut Microsoft’s weighting to below 20 percent, reduced the weighting of other large-caps (defined as those representing more than 1 percent of the index at the time) by the same proportion, and also boosted the weighting of the smaller companies in the benchmark.

Now, thirteen years later, Nasdaq’s index committee faces a new problem. As a result of the stock’s underperformance, Microsoft’s index weighting has happily shrunk over the years, so the company no longer threatens to break the 25 percent limit. But a new tech stock darling, Apple, has reached over 20 percent of the Nasdaq 100 and is heading towards the weighting ceiling.

Furthermore, the index weightings are now far from being an accurate reflection of market capitalisation. As a result of the 1998 imposition of adjustment factors, Apple’s index weight was boosted from 0.4 percent to around 0.9 percent. At the end of 1998, Microsoft’s weight had been cut from an unadjusted 22.5% to an adjusted 14.5%.

But by mid-2010, Apple and Microsoft, while having similar capitalisations overall, represented 20 percent and 4.3 percent of the index, respectively, purely as a result of the adjustment factors that they’d inherited from the late 1990s. In fact Nasdaq’s description of its index as “modified capitalisation-weighted” didn’t make sense at all.

Recognising the new imbalance in the index make-up, Nasdaq announced on Tuesday this week that it will conduct an extraordinary rebalancing in early May to bring stock weights back into line with actual market capitalisations. Apple’s weight will fall from 21 percent to 12 percent, correcting the largest weighting skew.


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