Reader Mark Karwowski of San Francisco wants to know why PowerShares QQQ, a popular exchange-traded fund that tracks the Nasdaq 100 index, has about 20 percent of its assets in Apple and less than 5 percent in Microsoft when the two companies have similar market values. "I thought that index was market-cap weighted," he says.The answer dates to a decision made in 1998 and tells a lot about the risk of market-cap weighting, the importance of knowing what's in your index fund and the spectacular comeback of Apple, which recently passed Microsoft as the world's most valuable tech company.
The Nasdaq 100 is a modified market-cap weighted index designed to track the 100 largest non-financial companies on Nasdaq.
From 1985 to 1998, it was a straight market-cap weighted index, which means that each company's share of the index equaled its market value divided by the combined market value of all the companies in the index. If a company is worth $1 billion and all companies in the index are worth $100 billion, its weighting is 1 percent. Market value or capitalization is a company's share price multiplied by its shares outstanding.
In a cap-weighted index, each company's weighting changes as its stock price and share count changes. If one company's stock outperforms the others, its weight in the index grows. Funds that track an index buy stocks in proportion to their weight in the index.
In 1998, when a Nasdaq subsidiary was getting ready to launch an exchange-traded fund tracking the Nasdaq 100, Microsoft exceeded 25 percent of the index. To preserve its tax status, a mutual fund can't have more than 25 percent in one company. So Nasdaq modified the index to shrink Microsoft and other big companies and beef up small-company weightings.
It first divided all 100 components into large companies (with more than 1 percent of the index) and small ones (with less than 1 percent). Next, it reduced Microsoft's weight to 20 percent, then cut the other big-company weightings by the same proportion.
To reallocate the leftovers, it increased the weighting of the largest small company to 1 percent, then increased the weightings of the remaining small stocks by the same proportion.
At that time, Apple was one of the smallest companies in the index and Nasdaq increased its weighting substantially.
Nasdaq couldn't say by how much exactly, but by the end of 1998, Apple's weight in the index was 0.9 percent. Unadjusted, it would have been only 0.4 percent. Microsoft's weight was 14.5 percent versus 22.5 percent on an unadjusted basis.
As Apple's stock soared - it's up about 2,500 percent since the end of 1998 - its position in the index grew, but the one-time adjustment exaggerated its weight gain. As Microsoft's market value fell, the adjustment magnified its weight loss.
At the end of May, Apple was worth $233 billion versus $226 billion for Microsoft. If the Nasdaq 100 were based strictly on market cap, both stocks would weigh in at close to 11 percent.
In reality, Apple today is about 20 percent and Microsoft is 4.3 percent.
It's ironic that an adjustment made to prevent one stock (Microsoft) from dominating the index has led to another stock (Apple) dominating the index, says Larry Petrone, research director with Financial Research Corp.
Once a year, Nasdaq replaces companies that have gotten too small for the index with larger ones. But it has never reweighted the index like it did in 1998, nor does it plan to unless one company gets to be larger than 24 percent.
Nasdaq estimates that investors worldwide have $25 billion indexed to the Nasdaq 100 (including about $18 billion in the QQQ fund, which Nasdaq turned over to PowerShares in 2007). Rejiggering the weightings would be very costly for them.
Most investors buy the PowerShares fund - which goes by its ticker symbol QQQQ or the Q's - to get big-cap tech exposure. But they should understand that its performance is being driven largely by Apple.
"One of the great advantages of the Q's last year is that Apple was its biggest holding and was doing so well. One of the biggest disadvantages from a risk standpoint is that Apple is the largest holding," says Christian Wagner, chief executive of Longview Capital Management.
Petrone concurs. "If Apple moves sharply, it's going to take the Q's with it," he says, adding that it gets "a little worrisome" when any stock surpasses 5 or 10 percent of a fund's assets.
Investors take a risk whenever they buy a fund that tracks a cap-weighted index, including the Standard & Poor's 500, because they tend to become dominated by whatever is hot.
"If a company doubles in price, it gets twice its previous weight. Tacitly, you are assuming it has better investments prospects after it has doubled than before it doubled. That just makes no sense," says Robert Arnott, chairman of Research Affiliates. His firm believes index funds should be weighted by companies' revenues, profits and other fundamental factors.
Another way to get the diversification of an index fund but avoid the extremes of cap-weighting is to buy a fund that invests equal amounts in each company in an index, such as the First Trust Nasdaq 100 Equal Weighted Index exchange-traded fund (ticker QQEW). It has about 1 percent in each of the Nasdaq 100 companies.
Another alternative to the QQQ is the Fidelity Nasdaq Composite Index exchange-traded fund (ticker ONEQ). It tracks the Nasdaq composite index but is dominated by the Nasdaq 100. It is a true cap-weighted index without funky adjustments. Apple and Microsoft each account for 6 to 7 percent of the index.
Apple larger than life
Top 10 companies in the Nasdaq 100 index, with their actual weightings and what their weightings would be on a true market-cap weighted basis.
| Company | Actual weighting in index{+1} | Straight market-cap weighting{+2} |
| Apple | 20.2% | 10.9% |
| Microsoft | 4.3 | 10.6 |
| 4.2 | 5.5 | |
| Qualcomm | 4.0 | 2.8 |
| Oracle | 2.8 | 5.3 |
| Cisco Systems | 2.7 | 6.2 |
| Intel | 2.3 | 5.5 |
| Teva Pharmaceutical | 2.2 | 1.8 |
| Amazon.com | 2.1 | 2.6 |
| Gilead Sciences | 1.9 | 1.5 |
Sources: Bloomberg, Nasdaq
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