In a move that could reignite debate over the impact of exchange-traded products on equity market volatility, NASDAQ announced on Tuesday that it will rebalance the Nasdaq-100 Index that serves as the underlying for the PowerShares QQQ (Nasdaq: QQQ) and as the benchmark for various mutual funds. The move will affect dozens of securities, though none moreso than tech giant Apple; AAPL currently accounts for more than 20% of the index, but that weight will be cut to about 12% after the rebalance. "The Special Rebalance reflects our commitment 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," said EVP John Jacobs. "The NASDAQ-100 Index will remain an objective, transparent, rules-based index and will be comprised of the same large-cap growth companies that have a legacy of leadership and innovation."

The Nasdaq-100 Index was originally designed to consist of the 100 largest non-financial companies in the Nasdaq Composite Index by market capitalization. But in the late 1990s, the company tweaked the benchmark in order to allow the index to serve as the underlying for an exchange-traded fund. At the time, an ETF linked to the Nasdaq-100 wouldn't have met diversification requirements imposed by the IRS, in part because a single stock accounted for too significant a portion of total assets. That stock was not Apple (Nasdaq: AAPL), but Microsoft (Nasdaq: MSFT); the 1998 rebalancing involved cutting the weight of MSFT in the index and increasing the weight of other smaller stocks.

In order to make the underlying index ETF-compliant, Nasdaq undertook an interesting modification process:

  • Divided the 100 components into large companies (making up 1% or more of the index) and small companies.
  • Cut Microsoft's weight to 20%, and cut the weightings of big cap companies by the same proportion.
  • Increased the weighting of the largest small companies to 1%.
  • Increased the remainder of the small companies by the same proportion.

One of those smaller companies was Apple, and the company's tremendous run over the last several years -- it gained more than 3,000% between the end of 1998 and the end of 2010 -- resulted in a huge weighing for the stock in the Nasdaq 100 [see Understanding the Quirks of QQQ].

The result now is that AAPL's weight in the Nasdaq-100 is not commensurate with the relative market capitalization of the company. For example, Microsoft has a market capitalization of about $217 billion but makes up only 3.4% of the Nasdaq-100. Apple has a market capitalization of about $312 billion -- or about 1.4 times Microsoft -- but has an index weighting nearly six times greater than MSFT. The rebalancing move, which would take effect before the market open on May 2, would create an index that more closely represents a traditional market capitalization-weighted benchmark. "The rebalancing won't affect the order of the stocks in the index or result in any stocks leaving or joining the index," writes Tom Lauricella. "But it will reduce Apple's outsize influence." [see all ETFs with significant AAPL exposure].

Shares of AAPL finished lower by 0.7% in Tuesday trading.

NASDAQ ETFs in Focus
According to Nasdaq, there are nearly 3,000 financial products linked to the Nasdaq-100 Index in 27 different countries. The best-known of those to U.S. investors is the PowerShares QQQ (QQQ), which had more than $24 billion in assets at the end of March. That makes QQQ the seventh largest U.S.-listed ETP; with an expense ratio of 20 basis points, the fund generates close to $50 million annually in management fees [see the top 25 ETFs by Assets Under Management].

First Trust also offers an ETF (QQEW) linked to the NASDAQ-100 Equal Weighted Index, the benchmark that maintains a base 1% weighting to each component of the more widely followed index.

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Disclosure: No positions at time of writing, photo is courtesy of David Sim.

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