AVGO - Will Other Major ETFs Decrease Their Holdings Of Top Stocks As QQQ Is Doing?

2023-07-12 07:00:00 ET

Summary

• The Nasdaq 100 index, tracked by the Invesco QQQ Trust, is set to undergo a "special rebalance" due to its top holdings becoming overweight.
• This raises the question of whether other popular ETFs, where these top stocks are also overweight, will have to rebalance.
• We look at its methodology document to examine the fine points of how rebalancing works in the Nasdaq 100 index.
• We then check out the methodologies behind the indexes used by the S&P 500 ETFs, The Vanguard Total Stock Market ETF, and the two largest Tech Sector ETFs to see if they are in danger of a significant rebalance too.

The big news in the ETF world this week was that the Nasdaq 100 index ( NDX ), which is tracked by the Invesco QQQ Trust ( QQQ ) has become so overweight in its top holdings that its methodology requires that it perform a "special rebalance." The document describing the methodology by which NDX is constructed explains why this may happen:

A Special Rebalance may be conducted at any time based on the weighting restrictions described in the Index Rebalance Procedure if it is determined to be necessary to maintain the integrity of the Index.

The holdings of NDX are not available to the public without a subscription. But the holdings of QQQ, which tracks that index very closely are. Currently these are the weights of the top 10 stocks in QQQ.

Top 10 Holdings of QQQ As of 7/10/2023

Source Invesco.com

I had read that the reason for the rebalance was that the weight of stocks that each made up 4.5% or more of the index had exceeded 48%. But as you can see, that is not currently the case.

However, when I referred to the NDX methodology document it became clear that the 4.5% criterion only applied when selecting stocks for the index. The criteria for rebalancing the index are different. They are as follows:

If the aggregate weight of the subset of Index Securities with the five largest market capitalizations is less than 40%, Stage 1 weights are used as final weights; otherwise, Stage 1 weights are adjusted to meet the following constraints, producing the final weights:

• The aggregate weight of the subset of Index Securities with the five largest market capitalizations is 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 final index weight of the Index Security ranked fifth by market capitalization.

As you can see, the total weight of the five largest holdings in QQQ, which I have highlighted in the table above, is 43.176%.

Based on what we see in the methodology document it appears that the weight of the top 5 stocks in QQQ will have to be reduced to 38.5% of the total value of the index, which means a reduction of 4.7% of the amount held of those top 5 stocks. The changes will be announced on Friday, July 14, 2023, and applied on Monday July 24.

Other ETFs that track the Nasdaq 100 will also have to rebalance, most notably the Invesco NASDAQ 100 (NASDAQ: QQQM ) and the ProShares UltraPro QQQ ETF (NASDAQ: TQQQ ).

This is big news and will slightly reduce the impact of the top five stocks in the NDX, with the heaviest components, Microsoft, Apple, and Amazon likely to be trimmed the most.

What Other Major Indexes Might Run Into the Same Need to Rebalance?

The NDX is what is called a "Capped Market Weight" index, one where individual holdings are not allowed to make up more than a set amount of the value of the whole index.

This brings up the question of what other major broad market indexes might also be capped market weight indexes that might also have to be rebalanced to eliminate the dominance of a few mega-cap stocks.

The S&P 500

When I heard the news about QQQ, I immediately wondered whether a special rebalancing might also be in the future of the S&P 500 ( SP500 ). After all, It is also very overweight in those same top stocks, as you can see from the table below:

S&P 500 Top 10 Stocks As Of 7/10/2023

Source: ssga.com

However, the S&P Dow Jones Methodology Document makes it clear that the S&P 500 index ((SP500)) does not readjust its holdings based on any kind of cap. It is a purely market cap weighted index.

Thus the only way that SPDR S&P 500 Trust ETF ( SPY ), the Vanguard S&P 500 ETF ( VOO ) or the iShares Core S&P 500 ETF ( IVV ) would be affected by the overweighting of their top stocks would be if the changes to QQQ affected sentiment towards those top stocks.

S&P 500-Based Sector ETFs Are Capped

The Sector indexes provided by S&P Dow Jones are capped. Individual holdings are capped at 23% of the weight of the whole index. In addition,

If , on the second to last business day of March, June, September, or December a company has a weight greater than 24% or the sum of the companies with weights greater than 4.8% exceeds 50%, a secondary rebalancing will be triggered with the rebalancing effective date being after the close of the last business day of the month.

Since Apple, Microsoft, and Nvidia, the stocks with the heaviest weightings in QQQ, are all classified as being in the GICS Information Technology Sector ("the Tech sector), I wondered if the S&P Dow Jones index that tracks the Technology sector might be looking at a rebalancing, too.

That index is the Technology Select Sector Index, tracked by Technology Select Sector SPDR® Fund ( XLK ).

XLK Is Nearing A Rebalancing Level

Here are XLK's current holdings:

source: ssga.com

As you can see, currently neither condition has been met that would result in a reduction in XLK's holdings, however, Apple's share is less than 1% away from being 24% of the value of the entire index which would trigger a reduction in how much of it is held.

A reduction in holdings could also be triggered if Nvidia was to see its price rise to where it breached that 4.8% threshold. It is currently very close with a weight of 4.72%. If it reached a weight of 4.8%, since the sum total of Apple, Microsoft, and Nvidia holdings already have breached the 50% threshold that would then come into effect, it is only the fact that Nvidia's share is slightly under 4.8% keeps a rebalance from being required.

There is no provision for a special rebalancing described in the S&P Dow Jones Index methodology document. So XLK's next rebalancing will take place in September. Keep your eye on Nvidia's share price if you are a holder of XLK.

Would Vanguard Total Stock Market Need Rebalancing?

Vanguard's very popular Total Stock Market ETF ( VTI ) tracks the CRSP US Total Market Index ( CRSPTM1 ). The methodology used to construct this index is quite complicated. As I understand it, the basic rules that all CRSP indexes follow is that:

• No more than 25 percent of the value of the RIC’s [fund's] assets may be invested in a single issuer• The sum of the weights of all issuers representing more than 5 percent of the fund’s total assets should not exceed 50 percent.

The top 10 holdings of VTI which, as is the case with all Vanguard ETFs, are reported with data that is weeks behind, were as follows:

VTI Top Holdings at of 5/31/2023

Source: Vanguard.com

As you can see the weights of these holdings are far below the level that would cause any kind of rebalancing based on weight.

Would VGT, Vanguard's Tech Sector ETF, Need Rebalancing?

The Vanguard Information Technology ETF ( VGT ) follows a different index from the SPDR Select Technology ETF. VGT's index is another CRSP index, the MSCI US Investible Market Technology Sector 25/50 index. It's methodology is similar to that of the broader Total Market index described above.

...at the end of each quarter of its tax year no more than 25% of the value of the RIC's assets may be invested in a single issuer and the sum of the weights of all issuers representing more than 5% of the fund should not exceed 50% of the fund’s total assets.

Like XLK, which has very similar holdings its holdings are top heavy as you can see, though again, as is Vanguard's practice, they only give us data many weeks old:

VGT Holdings As Of 5/31/2023

Source: Vanguard.com

VGT's index is rebalanced as of the close of the last business day of February, May, August, and November.

Only 3 stocks in the index exceed the 5% cap and those three stocks made up 47.95% of the ETF, at the end of May. So at that time the index was not in need of a rebalance. However, as is the case with XLK, further increases in the prices of Apple and Microsoft, and to a lesser extent Nvidia, would cause VGT to have to decrease its holdings in those top stocks.

Unfortunately, since Vanguard's data is always way out of date, it is hard to know what its holdings will look like as it approaches its next rebalancing date in August.

Note that unlike the Nasdaq 100 index, the CRSP indexes used by Vanguard funds do not specify that special rebalancing events could occur outside of the usual schedule.

Bottom Line: For Now The Nasdaq 100 Is A Special Case

The prices of the handful of technology-related stocks that are driving the outsized gains of QQQ and several other heavily invested ETFs are impacted when those stocks see their holdings reduced by the largest ETFs.

But for now, despite how top heavy all the ETFs we have examined appear to be, only QQQ and QQQM that track the Nasdaq 100 have seen the tops stocks reach weightings that triggered a dramatic rebalancing and reduction of those top stocks' holdings.

The S&P 500 does not appear to have any rebalancing targets described in its methodology. VTI's huge number of holdings and very high bar for rebalancing keep its current level of top-heaviness from being an issue.

The two largest technology sector ETFs, XLK and VGT, are seeing their top stocks' weightings creeping up to levels that might force them to rebalance. However their cutoffs at 25% for an individual stock and 50% for the total stocks that make up 5% or more of the index are higher than the Nasdaq 100's criteria of rebalancing when the total of stocks each making up 4.5% of the index constitute more than 40% of the total index's value.

Here we have surveyed just a few very popular ETFs. If you hold ETFs that are top heavy in Apple, Microsoft, Amazon, and Nvidia right now, check out their indexes and look up those indexes' methodology to see if you are going to experience any significant changes in their holdings anytime soon.

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