Everyone can stop all the hand-wringing over the “over-concentration” of the Nasdaq 100: The index provider is doing something about it, as expected, in a sign that the system is working as intended after all.
As Nasdaq announced late last week, it plans to carry out a “special rebalance” on July 24 to redistribute weights after the run-up in mega-cap stocks. Although the out-of-cycle move was rare and blindsided some investors, it should come as little surprise to those familiar with the index’s methodology.
The Nasdaq 100, of course, is a modified market capitalization-weighted index that is rebalanced quarterly (in March, June, September and December) and then reconstituted annually.
- In the quarterly review, the sum of all highly weighted stocks (4.5% and more) may not exceed an aggregate of 48%; if they do, they must be reset back to 40%.
- In the annual adjustment, no security weight may exceed 15%; if so, it must be reset to 14%.
- Also in the annual adjustment, the five largest market capitalizations may not exceed 40%; otherwise, they will be reset to a total of 38.5%.
Although Nasdaq’s initial press release was sparse on the details, it was clear that the index had crossed some of those red lines. Specifically, as of July 6 (the day before the press release), the index was in violation of Nos. 1 and 3, thanks to the extraordinary run-up in shares of Microsoft Corp., Apple Inc., Nvidia Corp., Amazon.com Inc., Meta Platforms Inc., Tesla Inc., and Google parent Alphabet Inc. — the so-called Magnificent Seven, which collectively accounted for about 77% of the broader index’s advance this year. Unsurprisingly, the index creators did what they’ve always said they’d do.
Index rebalancing has a number of consequences. In the immediate term, the announcement led the equal-weighted version of the Nasdaq 100 to outperform the capitalization-weighted version on Monday and Tuesday. According to analysis from Wells Fargo, the Magnificent Seven will be the biggest “downsizers” in the rebalancing, while the biggest “upsizers” will be Starbucks Corp., Mondelez International Inc. and Booking Holdings Inc. But this is the way it’s supposed to work; rules-based rebalancing promotes responsible diversification while smoothing out portfolio volatility. In short, it makes you trim the stakes in your biggest winners.
For much of the year, investors have bemoaned the concentration of the main US indexes, but the latest developments show that these issues tend to be self-correcting.
It’s also worth remembering why the indexes became so “over-concentrated” in the Magnificent Seven in the first place: Their stock prices went up. The religious fervor with which some investors pursue diversification at any cost can sometimes miss the point of investing: to buy the securities that maximize returns for a given level of risk, consistent with one’s personal financial goals and time horizon. Mindless diversification at any cost — or “de-worsification,” as it’s sometimes called — isn’t always the best way to check those boxes.
At Berkshire Hathaway’s annual meeting in May, for instance, Chairman Warren Buffett and Vice Chairman Charlie Munger were asked about the concentration of Apple stock in their portfolio. Munger responded with some of his signature wisdom:
"One of the inane things that’s taught in modern university education is that a vast diversification is absolutely mandatory in investing in common stocks. That is an insane idea. It’s not that easy to have a vast plethora of good opportunities that are easily identified. And if you’ve only got three, I’d rather be in my best ideas instead of my worst. And now some people can’t tell their best ideas from their worst, and the act of deciding if an investment already is good — they get to thinking it’s better than it is. I think we make fewer mistakes like that than other people ... if you know the edge of your own ability pretty well, you should ignore most of the notions of our experts about what I call de-worsification of portfolios."
Needless to say, most of us aren’t as good as Buffett and Munger at weeding out our best ideas from our worst; that’s why index investing has become so widely important. But as Munger reminds us, the obsession with concentration risk sometimes misses the point if it prompts investors to reflexively flee the best opportunities.
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