QQQ Is About To Get A New Look; Here's What's Changing
Apple, Microsoft, Amazon, Alphabet and NVIDIA are all about to get reduced exposure.
Tech stocks have been all the rage once again in 2023. The combination of an expanding U.S. economy that has lasted longer than expected and the mania surrounding the emergence of AI has pushed the benchmark Nasdaq 100 index up nearly 40% so far this year. While net flows into tech ETFs have been tepid relative to sector performance, there’s still a lot of money invested in this space by retail investors.
The largest fund, by a wide margin, is the Invesco QQQ Trust (QQQ), which has more than $200 billion invested in it. It’s cheaper sibling, the Invesco Nasdaq 100 ETF (QQQM) has a more modest $13 billion in assets, but it’s been steadily since its debut back in late 2020.
Shareholders in both of these ETFs should be aware that their fund is about to change. The “super 7” stocks that have driven most of the U.S. equity market’s gains this year are about to see their influence shrink.
Nasdaq 100 Index Rebalance
Last week, Nasdaq announced that it would be conducting a “special” rebalance of the Nasdaq 100 index. At issue here is the top heaviness of the index. It’s been top heavy for a while, but 2023’s mega-cap rally has made it even more so. Per the index’s methodology, it must take steps to reduce component weightings if they exceed specific pre-determined parameters.
I know most of you probably don’t want to do a deep dive into the legal jargon around this, so here’s the Cliffs Notes version.
When certain portfolio weighting limits are breached, the index can rebalance to bring them back within range. This occurs automatically on an annual basis, but Nasdaq maintains the right to do it intermittently if things get too out of whack. That’s what’s going to happen later this month.
These are the rules that must be adhered to.
No security weight may exceed 14% of the index.
The aggregate weight of the securities with the five largest market capitalizations will be set to 38.5%.
No security with a market capitalization outside the largest five may have a final index weight exceeding the lesser of 4.4% or the weight of the security ranked fifth by market capitalization.
Here are the top 10 holdings of QQQ as it stands today.
The first bullet point isn’t an issue. Microsoft and Apple are both at over 12%, but nowhere near the 14% cap.
The second bullet point is an issue and the third may be.
The top five market caps belong to Microsoft, Apple, Alphabet (whose two share classes get combined in this scenario), NVIDIA and Amazon. They combine for nearly 46% of the index. These are the stocks whose collective weight is going to get reduced to 38.5%.
The third bullet point says that component weightings beyond the top 5 get capped at 4.4%. Right now, Tesla and Meta are both right at that limit. Barring a huge rally in either stock over the next week or two, their allocations are likely to be reduced only by an imperceptible amount, if they’re reduced at all.
Impact of the Nasdaq 100 Rebalance
On the surface, a lot of people might view a weighting reduction in the MAANA stocks from 46% to 38% and be disappointed because this is where all of the gains have been coming from. On the other hand, I view this as a good thing.
One of the basic tenets of investing is to “buy low, sell high”. A lot of investors end up doing the opposite. They performance chase and end up buying stocks or ETFs only after they’ve experienced their gains. Conversely, they’re often quick to dump anything that has lost value in their portfolio.
Rebalancing after a run such as this is essentially selling high and locking in gains. This is what investors should strive for. Yes, QQQ could still go higher from here and investors may be tempted to ride the wave for as long as they can, but I really believe they’re being done a solid here by Nasdaq, even if it’s only being done as a result of a legal mandate.
It’s important to note that the components of the Nasdaq 100 aren’t changing. There are no adds or deletes. Just a re-weighting of existing components. That 8% that’s going to get taken away from the mega-cap names will ultimately filter down through the other index components with Broadcom at #9 likely to get the biggest boost. It’s the largest allocation beyond the top 5 companies and the Meta/Tesla combo, which are likely to be capped at or around current levels. Most of the remaining changes will likely be minor to the point of not even being noticeable.
In the grand scheme of things, this is a relatively minor change. The Nasdaq 100 and its derivative ETFs are still going to have mostly tech and tech-adjacent exposure. It’s just pivoting away somewhat from its mega-cap overweight. Investors shouldn’t be adjusting their positions based on this alone, although you could consider the Vanguard Information Technology ETF (VGT), the Technology Select Sector SPDR ETF (XLK) or the iShares Russell Top 200 Growth ETF (IWY) if you want high FAAMG exposure without the rebalance.