2023-07-12 04:29:31 ET
Summary
- First Trust NASDAQ-100 Equal Weighted Index Fund invests in the Nasdaq 100 Index in an equal-weighted manner.
- The Nasdaq 100 Index's 'Special Rebalancing' event may weaken the strength of mega-cap stocks and funds, potentially benefiting the QQEW ETF.
- I recommend investors put on a ratio spread, targeting a 4-6% technical rebound in the ratio between the QQEW ETF and the QQQ ETF.
In the past few months, stock markets, especially the Nasdaq 100 Index, have skyrocketed higher based on the extraordinary performance of a select group of mega-cap stocks.
However, all good things must eventually come to an end and I believe a 'Special Rebalancing' of the Nasdaq 100 Index may sap the near-term strength of the mega-cap stocks and funds based on the Nasdaq 100 Index like the Invesco QQQ Trust ETF ( QQQ ).
At the same time, a rebalancing of the Nasdaq 100 Index weights into smaller companies should benefit the First Trust NASDAQ-100 Equal Weighted Index Fund ( QQEW ), which tracks the Nasdaq 100 Index in an equal weighted manner.
I am bullish on the QQEW ETF on a short-term relative basis compared to the QQQ ETF and recommend investors put on a ratio spread, targeting a 4-6% technical rebound in the ratio between the 2 funds.
Fund Overview
The First Trust NASDAQ-100 Equal Weighted Index Fund tracks the Nasdaq-100 Equal Weighted Index ("Index"), which contains the stocks in the Nasdaq-100 Index, but with each security set at a rebalanced weight of 1.0%.
The QQEW ETF has $1.88 billion in assets and charges a 0.58% expense ratio (Figure 1). The QQEW ETF is reconstituted annually and rebalanced quarterly.
Figure 1 - QQEW fund details (ftportfolios.com)
Portfolio Holdings
Figure 2 shows the top 10 holdings of the QQEW ETF which comprise 15.0% of the fund.
Figure 2 - QQEW top 10 holdings (ftportfolios.com)
Figure 3 shows the sector allocation of the QQEW ETF. The largest sector weight is Technology at 35.8%, followed by Health Care at 14.5%, Consumer Cyclicals at 14.0%, Industrials at 10.3%, and Communications at 10.3%.
Figure 3 - QQEW sector allocation (morningstar.com)
Overall, the QQEW ETF is considered a large-cap growth oriented ETF (Figure 4).
Figure 4 - QQEW style (morningstar.com)
Although still growth-dominated, the QQEW's portfolio is nowhere near as concentrated as the more popular Invesco QQQ ETF Trust, which tracks the Nasdaq-100 Index. The top 10 holdings of the QQQ ETF comprise 58.8% of the fund (Figure 5).
Figure 5 - QQQ top 10 holdings comprise 58.8% of ETF (invesco.com)
Distribution & Yield
The QQEW ETF pays a nominal quarterly distribution with a trailing 12 month distribution of $0.63 / share or 0.6%.
Returns
Figure 6 shows the historical returns of the QQEW ETF. Overall, the QQEW ETF has done well, with 3/5/10/15Yr average annual returns of 10.7%/12.6%/14.2%/12.7% respectively to June 30, 2023.
Figure 6 - QQEW historical returns (morningstar.com)
However, QQEW's returns have lagged the QQQ, particularly YTD 2023, as QQEW only returned 21.0% compared to QQQ's 39.2% (Figure 7).
Figure 7 - QQQ historical returns (morningstar.com)
Could Special Re-Balancing Spur QQEW To Outperform?
The main reason for QQEW's recent bout of underperformance relative to QQQ has to do with the group of 'Magnificent Seven' stocks that I have written about in a recent article on the Nasdaq 100 Covered Call ETF ( QYLD ).
The narrow group of seven high flying stocks, which include Apple, Microsoft, Amazon, Nvidia, Meta, Alphabet, and Tesla, are collectively the largest weights in the Nasdaq 100 Index (54.6% combined weight) and have returned on average 88.6% YTD to July 10th (Figure 8).
Figure 8 - YTD performance of top 10 holdings in QQQ (koyfin.com)
When the largest weights in an index have also performed the strongest, it is no wonder that the equal weighted QQEW ETF has lagged far behind. However, could that underperformance be set to reverse in the coming days?
On July 7th, 2023, after markets closed, Nasdaq came out with a press release announcing a 'Special Rebalancing' of the Nasdaq 100 Index 'to address overconcentration in the index by redistributing the weights'.
As a bit of background, although the Nasdaq 100 Index is a market capitalization-weighted index, it does have concentration limits. For example, at the quarterly weight adjustment, if there are no issuers with weight greater than 24%, then the initial weights are used. Otherwise, the largest individual issuer weight is capped at 20%. For issuers with weights greater than 4.5%, the aggregate weight of the group is capped at 40%.
At the annual weight adjustment, if no security exceeds 15%, then the initial weights are used. Otherwise, the largest weight is capped at 14%. Furthermore, the aggregate of the top 5 issuers is capped at 38.5% and no issuer with market cap outside of the top 5 may have an index weight greater than 4.4% or the 5th largest index weight.
At this point in time, it is unclear whether the Nasdaq will be using the quarterly adjustment or the annual adjustment as the guideline for the Special Rebalancing event. However, what is clear is that due to the extraordinary performance of the Magnificent Seven in the past few months, the largest holdings in the Nasdaq 100 Index will need to be trimmed.
Using the quarterly guidelines, currently Microsoft, Apple, Nvidia, Amazon, and Alphabet exceed 4.5% each. The sum of this group is 46.0%, so 6% points will need to be shaved off. Using the annual guidelines, the aggregate of these top 5 holdings will have to be reduced to 38.5%.
With $245 billion in ETF assets tracking the Nasdaq 100 Index alone plus tens (if not hundreds) of billions of mutual fund and other institutional AUM tracking the Nasdaq 100 index, this special rebalancing could cause significant shifts in fund flows (Figure 9).
Figure 9 - $245 billion in ETFs track the Nasdaq 100 Index (etf.com)
Working with the $245 billion in ETF assets tracking the Nasdaq 100 Index, the quarterly rebalancing guidelines imply $15 billion (6% of $245 billion) of selling in the top 5 names to buy the other 95 names. While most stocks within the Nasdaq 100 Index are liquid enough to absorb this demand ($150 million per security), at the margin, this rebalancing should tip the scale in favor of the smaller companies within the index in the short-term.
Additional details on the rebalancing will be announced on July 14, 2023.
Technical Picture Suggest A Developing Rebound In QQEW/QQQ Ratio
Looking at the ratio between the QQEW ETF and the QQQ ETF, I believe a technical rebound is shaping that could see the QQEW outperform in the short-term, as the YTD underperformance has been simply too great (Figure 10).
Figure 10 - Technical rebound shaping in QQEW/QQQ ratio (Author created with price chart from stockcharts.com)
I believe it is possible that the QQEW / QQQ ratio may rebound to 0.306 (38.6% Fibonacci retracement) or 0.312 (50% retracement), even if ultimately the large cap companies remain in favor. With the ratio currently sitting at 0.294, that could translate into 4 to 6% relative outperformance.
I recommend using recent lows in the ratio of 0.287 as a stop loss, or 2.5%.
Conclusion
The QQEW ETF is an equal-weighted fund based on the constituents of the Nasdaq 100 Index. In the past few months, the QQEW ETF has vastly underperformed the QQQ ETF, as the Magnificent Seven drove QQQ's outperformance.
However, with an upcoming Special Rebalancing event, I believe a technical rebound in the QQEW/QQQ ratio is developing. I am bullish on the QQEW ETF on a short-term relative basis compared to the QQQ ETF.
For further details see:
QQEW: Special Rebalancing May Spur Outperformance Against QQQ