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The Worst Index In The World
By Dave Nadig | 06 April, 2011 13:42 (GMT)   

The Nasdaq 100 is the index behind one of the largest ETFs in the world—the US-listed PowerShares Q’s (NYSEArca: QQQ). According to yesterday’s Wall St. Journal, over US$300 billion of investor money is managed according to the list of companies in the 100. Why?

When we look at an index at IndexUniverse, we focus on two things: selection, and weight. The 100 is broken on both counts.

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

In other words, the list is based entirely on “what’s working now for Nasdaq.” Because of Nasdaq’s history as the home base of the dot-com bubble, the list is peppered with technology names, but also includes companies ranging from Staples to Sears. If a NYSE company wanted in, presumably all they’d have to do is change exchanges and wait six months. A rigorous selection process this ain’t.

But as arbitrary as the inclusion criteria for the 100 is, it’s the weighting scheme that really makes the 100 the worst index ever made by man.

As I wrote about last fall in a blog called “QQQQ Follies,” the index uses a modified market-cap weighting scheme but, in this case, that’s like suggesting that a garbage truck is a “modified” roadster—you could win a case in court on the distinction, and it would still stink.

Before Nasdaq wanted to launch mutual funds and ETFs based on the index—and what index owner doesn’t?—it was pretty vanilla, and Microsoft was over 25 percent of the index (back in 1998). To bring Microsoft down to an investable level (’40 Act funds have difficulties at 25 percent in any one holding), they created a crazy system that turned the 100 into a quasi-equal-weighted index.

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.

Once triggered, what’s supposed to happen is that the weights of all stocks that are over 1 percent of the index are reduced in tandem until the offense is cleared up; that is, when either the big stock goes to 20 percent, or the aggregate 4.5 percent positions get to 40 percent. The pool of weight that was freed up in that ratcheting down is then distributed, issue by issue, to those stocks under 1 percent of the index. So if a company has a 0.99 percent weight, it gets pushed up to 1 percent. If there’s weight left over, the process works down the list to the stock with a 0.98 percent weight, and so on.

It’s an arbitrary and ridiculous way to try and “equal-weight” the bottom end of the index, and honestly, typing it now, it seems too silly to be true. But if you don’t believe me, read the rule book.

But here’s where it gets really ridiculous. As crazy as all this is, at least it’s predictable and in the rule book. But in this case, Nasdaq seems to be throwing the rule book away. As of last night, Apple was only 20.36 percent of the index, and only one other stock was over the 4.5 percent cap—Qualcomm at 4.89 percent. So Nasdaq has just decided to reconstitute the index by fiat, and apparently arbitrarily. Here’s the official rundown.

What it comes down to is a giant reset button: On May 2, the index will just magically change from its current weighting scheme to an actual market-cap weighting scheme, or at least, one that puts the arbitrary list of 100 securities in market-cap order and in market-cap weights.

And then, apparently, Nasdaq will send the 100 out into the wilds again, until the next time one of the true magic rules is triggered. Or they just decide to mess with it again.

This isn’t index management, it’s index mismanagement. Is the new 100 “better” than the old 100? Probably. Is it worth the rather substantial chaos this move will cost the markets for the next month? Doubtful.

The 100 is broken by design. Putting the Band-Aid on now, without fixing the underlying methodology, is just kicking the problem down the road.

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