Nasdaq 100 Special Rebalance and Its Impact

Nasdaq 100 is a weighted index with the 100 stocks having the largest market capitalization listed with Nasdaq. When a particular stock, or stocks, having a dominant presence such that the index is no longer a good representation of the top 100 stocks, Nasdaq can issue a special rebalance. This has happened before and can happen again soon.

The Rules Triggering Special Rebalance

1. A single stock reaching 24% or more in the overall weighting within the index due to its relative increase in share prices

2. The sum of all stocks with weighting in excess of 4.5% equals to or exceeding 48% of the overall weighting within the index

Once the rebalancing is triggered, the largest weighting components will all be haircut significantly in terms of their weighting within the index. The reduction will lead to increased weighting on all the other components where the haircut is not applied.

The Current Group of Largest Weighting Stocks

It is getting very close to trigger #2 of 48%.

It is also getting close to trigger #1 if Apple continues its parabolic rally in price for just another week.

Last Special Rebalance

That was announced in April 5, 2011 and done on May 2, 2011.

The reason for the special rebalance back then was for a similar reason like now – Apple.

Let’s take a look at the NDX daily chart to understand what happened during last special rebalance.

Notice the almost 100 points drop after the announcement.

Then a surge of 150 points higher.

And finally 200+ points drop after the rebalance is done.

The Reasons for Such Drastic Swings on the Index

Index funds that model after the official NDX index have to dump the stocks on those components that have been reduced in weighting drastically. Imagine the burst of selling on the heaviest weighting stocks by all the index funds at the same time. Of course there will not be enough buyers to absorb the selling hence the initial drop.

Next, these funds have to buy the other components that are moderately increased in weighting. They have to buy that as soon as they can raised the cash needed from selling the heavy weighted ones. That, led to chaotic buying you see from last year that popped NDX by 150 points higher.

And before you ask the question. The answer is no. The fund managers do not have enough cash on the sideline most of the time to carry out the adjustments to their portfolio all at the same time, not on a massive scale like this.

After the official rebalance kicks in, the index would be subjected to selloff easier within a short time span like 3 to 4 months.

Think of the rebalance operation as a form of market intervention that forcing everyone to buy the worse off stocks and dump the leading stocks. The worse performing stocks will not all of a sudden becoming better stocks as they are weaker companies with weaker earning capabilities. The leading stocks got dumped, however, increased their float significantly which in turn inducing higher volatility. When retail traders and speculators buying into these leading stocks no longer get the feedback of strong overall rally in the indices, they would easily panic and dump their positions.

Be Prepared

The rebalancing of NDX is not necessarily a sure thing to happen in the near future. For example, if the stock market starts to pullback from its current rally, or that Apple having a sudden correction in its stock price, then the rebalance will not be triggered. Even if special rebalance is triggered, it is not necessary that NDX will move in a similar way like last year, because the fund managers should have learned from their experience to handle this transition more thoughtfully.

If you own shares in NDX ETFs like QQQ, one or more of the top 5 stocks in NDX, then be ready for the rebalance and have a plan in place so that you will not panic and act irrationally to the price swings. The last thing you want is that you make a trading decision in a rush that you will regret right after.

Update on August 20, 2012 – For more information on Nasdaq 100 you can get that from Wikipedia article Nasdaq-100.

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