Felix Salmon

Adventures with stock market indexes, Nasdaq 100 edition

By Felix Salmon
April 8, 2011

Dave Nadig and Paul Amery of Index Universe have the best explanation (and excoriation) of the weird Nasdaq 100 Special Rebalance this week. In a nutshell, when the Nasdaq 100 wanted to become an exchange-traded fund and make lots of money in the process, Microsoft would have accounted for more than 25% of the index if it was simply cap-weighted. So the index gurus artificially depressed Microsoft’s weighting in the index, while boosting the weighting of smaller companies.

Fast-forward to today, and you end up with a rather silly situation where Microsoft and Apple, with similar market capitalizations, account for 4.3% and 20.3% of the index respectively. Enter the rebalancers:

Here’s the rule, which was just triggered: When any security gets over 24 percent; or when the aggregate of positions of more than 4.5 percent is greater than 48 percent; or whenever Nasdaq feels like it—seriously, that’s the trigger this time—a rebalance is triggered.

Apple isn’t over 24% of the index, and the aggregate of positions of more than 4.5% is just 25.25%, well below the 48% maximum. So there’s no reason at all to do this rebalancing now, beyond an unpredictable desire “to ensure the NASDAQ-100 Index remains a relevant benchmark for investors around the world who track the performance of the U.S. equity market.”

But the bigger picture is that all indexes are arbitrary by nature. For instance, the Nasdaq 100 itself is very weirdly comprised, as Nadig explains:

To get into the Nasdaq 100, here’s what you have to do:

  1. Happen to have Nasdaq as your primary listing
  2. Not be a financial company (for no particular reason)
  3. Be “seasoned,” which means being on Nasdaq for two years, or being in the top 25 percent of the Nasdaq 100 in terms of market cap

And other indexes, while not being as bad, are also pretty arbitrary:

If you’re new to indexing, you may be surprised to find out that the membership criteria for companies entering the world-famous S&P 500 and Dow Jones Industrial Average indices are also highly subjective.

The Dow’s components are chosen by an “averages committee” comprised of the managing editor of The Wall Street Journal, the head of Dow Jones Indexes research and the head of CME Group research.

Selection for the S&P 500 is also at the discretion of an index committee, the goal of which is “to ensure that the S&P 500 remains a leading indicator of US equities, reflecting the risk and return characteristics of the broader large cap universe on an ongoing basis”.

According to one well-founded analysis of the S&P 500 index committee’s stock picking record, the committee members are subject to the same style biases and drift as the average active manager. They boosted the index’s weighting in tech stocks during the bubble of the late nineties, only to remove several of the same names shortly thereafter; and they relaxed a longstanding prohibition on including holding companies in 2001, allowing lots of real estate investment trusts to be added to the index during the greatest real estate bubble in US history.

Amery concludes that “when you’re selecting a tracker product it’s worth casting a very sceptical eye over the index being used.” But it’s also worth noting that stock-market indices tend to outperform the broad market, at least according to this paper. And that at the margin, the narrower the index, the more it’s likely to outperform — at least in bull markets. (In bear markets indices underperform, but stocks do tend to go up more than they go down.) That might explain how Dimensional Fund Advisers tends to outperform the S&P 500 by following an indexing strategy: it just invests in narrower indices which perform better.

I had a great conversation with Bob Pozen yesterday, who was in town to plug his new and exhaustive book on mutual funds. We talked a bit about active vs passive investment strategies; Pozen reckons that passive strategies won’t ever be much more than about 20% of the market. But the fact is that just about all funds use some big index — often but not always the S&P 500 — as their benchmark. And insofar as that index is a bit arbitrary, that skews the entire market in unhelpful ways. I doubt I’ll ever get the everything bagel I’m looking for in terms of a single global fund. But as far as US stocks are concerned, many people think the S&P 500 performs that role very well. And I’m not at all sure that it does.

5 comments so far | RSS Comments RSS

Simply put, Nasdaq is just an index. It will make Apple less volatile during a program traqding signal in the future. It doesnt affect any stock’s earning power. i.e. Berkshire has no desire to be in any index. Thi srebalance is just a way to make more transaction fees for the so called “professional managers”.

Posted by emessage | Report as abusive

felix – I agree with Nadig about the random-ness of NASDAQ doing this rebalance now (as the triggers have not been met), but apart from that, their membership requirements are quantitative -they aren’t subjective at all: it’s easy for those with the data to predict exactly which companies will be added and deleted each December in the annual reconstitution of the index: it’s strictly rules based (although Nadig thinks the rules are silly, i think). The same can’t be said for S&P 500 index changes, which are much more subjective (Although can be said of SPX quarterly reweightings)

Posted by KidDynamite | Report as abusive

In the penultimate paragraph, you’re telling us that indices are riskier than the broad market, but over the course of a business cycle, slightly outperform? Is the Sharpe ratio the same as for the broader market?

Posted by dWj | Report as abusive

I thought it was common knowledge that the S&P500 is bollixed; has been since Obama classmate Jason Zweig noted it is “rigged” more than a decade ago.

Posted by klhoughton | Report as abusive

It would make sense to have this index product capped at something like 10 per cent so that if something really bad happened to one component of the index the downside would be limited.

Posted by paul2d | Report as abusive

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