Adventures with stock market indexes, Nasdaq 100 edition
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:
- Happen to have Nasdaq as your primary listing
- Not be a financial company (for no particular reason)
- 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.