What does the Nasdaq rebalancing mean for portfolios?

Financial Planning Dentist

News from Reuters about a “special rebalance” happening in the Nasdaq 100 index is making headlines – but what does it mean for investors who use benchmarks and indexes to drive their performance?

The Nasdaq exchange operator (NDAQ) is taking this step to reduce the dominance of heavyweight companies that currently account for almost half of the index’s weight.

This year, the Nasdaq 100 index has experienced a significant 37.5% surge, largely driven by the remarkable rally in growth and technology stocks. In comparison, the benchmark S&P 500 (SPX) has seen a more modest gain of 14.8%.

Companies such as Microsoft (MSFT), Apple (AAPL), Nvidia (NVDA), (AMZN), and Tesla (TSLA) currently hold a combined weight of 43.8% in the index as of Monday’s close. However, as part of the rebalance, their collective weight will be reduced to 38.5%. The concern behind this special rebalancing is that these few major names are potentially distorting the overall health of the stock market.

The changes in the index will be based on the number of shares outstanding as of July 3. Nasdaq announced the adjustments on July 14, and they will take effect before the market opens on July 24.

A special rebalancing like this is part of Nasdaq 100’s methodology to comply with a U.S. Securities and Exchange Commission rule on fund diversification. This has occurred twice before, in 2011 and 1998, the global head of index product and operations at Nasdaq. If the aggregate weight of companies with more than 4.5% weight in the index exceeds 48%, a special rebalancing is triggered. During the rebalancing, this weight is capped at 40%.

Microsoft has the highest weight at 12.91%, followed by Apple at 12.47%, Nvidia at 7.04%, Amazon at 6.89%, and Tesla at 4.50%, according to Refinitiv data. The recent surge in Tesla’s shares pushed the aggregate weight above 48%, prompting the rebalance.

The article also discusses the possibility of a similar rebalancing in the S&P 500, which takes place when the aggregate weight of companies with a weight greater than 4.8% exceeds 50% of the total index, according to S&P Dow Jones Indices.

The changes in the Nasdaq 100 index are expected to impact investment funds that track it, including the popular $200 billion Invesco QQQ ETF (QQQ). The rebalancing will likely require portfolio managers to increase their positions in smaller companies, potentially boosting their share prices.

Following the news, Apple and other mega-cap stocks experienced some declines. Apple, which had recently reached a market capitalization of $3 trillion, fell 1% on Monday, while Microsoft, Alphabet, and Amazon also saw declines ranging from 0.7% to 2.5%.

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Kevin Taylor

The Wizard of OZs: What you should know about opportunity zones.

What is a Qualified Opportunity Zone Property? The 2017 Tax Cuts and Jobs Act created special tax incentives for those willing to risk their own capital to improve and develop the real estate in traditionally underinvested sections of the country called opportunity zones. The goal was to raise long term capital by incentivizing investors that historically wouldn’t invest in these types of opportunities due to the inherent risk. They’re designed with the purpose to benefit the denizens of those locations and investors looking for sizable tax incentives to commit capital. The Qualified Opportunity Zone program is the solution that provides that tax incentive for private, long-term investment in economically distressed communities. What makes it a Qualified Opportunity Zone (QOZ)? The definition for this type of zone is “economically-distressed communities where new investments, under certain conditions, may be eligible for preferential tax treatment.” The process for designation of the OZ is pretty straight forward. All 50 states are allowed to submit a list of blocks of low-income tracts across their state based on census data. The Treasury then approves their inclusion in the program or not (most were approved). Plans are now in place with municipal and state governments to commit to projects that bring new construction projects into these areas. What are some unique risks you should be familiar with before you invest in an OZ? Market Liquidity – the markets for these investments are immature. There is a sizable pool of available capital for investment, but most of it is from long view institutional investors. The long term, committed and disciplined capital on the ask side, and the insurability for most investors in this space supplying the bid likely means that the spreads widen and limit overall liquidity for investors. Vehicle Liquidity – The types of vehicles offering exposure to this space are limited, largely non traded REITs. These agreements have a very long view of the investments and capital and few offer the liquidation windows and frequency temperamental investors might be used to. Asking yourself what kind of liquidity and income requirements do you have in your investment plan is more important than ever. Investors seeking income starting day 1 may need to find investments that reflect that and will see their upside limited as a result. Those seeking to “time the market” through this development will be frustrated by the duration of these investments.  Investment Risk – investment in “economically-distressed communities” carries a very unique risk that the investment will not perform on par with other parts of a city or market. Their unique performance risk with these investments will never go away, simply put you are buying into a major turnaround story in some parts of the country that may never come. This is mitigated by a few factors, the managers selecting and overseeing the projects are more important than ever. Picking the right project, with the right builder, in the right neighborhood is more important than ever.  Intent – why are you committing capital to these projects? Is it only for income? Are there parts of the country that have an emotional connection to their success? Is this a good attribute or a negative? I think it’s important to have a real honest sense of purpose in these investments. Not only to help understand and mitigate the risks involved but to help you price in the purpose of this investment. More and more people want to know that the dollars they are investing are being used for societal benefit, but make sure you are handicapping that expectation appropriately. Tax – The tax benefit for OZ’s has a pretty long ark, and the year over year benefit changes over time. Before you enjoy the tax benefits afforded here you should confirm a couple of assumptions. First, that your tax liability is ample enough to enjoy the full benefit, second, that your tax strategy for the next decade marries well with the long term requirement of this investment and third, there are no alternative strategies for a similar tax benefit with less inherent risk. Confirming these three elements of taxation and its accompanying strategy is an essential step for your CFP and CPA before you should consider the upside of this program.  Statutory Risk – the Tax Cuts and Jobs Act (TCJA) is current law, and planning for current law is not the issue. Tracking and making sure this new tax strategy stays intact going forward should be on an investor’s mind and having a plan of action if and when conditions change is part of the monitoring process for both your entire plan and this specific investment. Laws change and this opportunity is set to expire 12/31/2026.  Regulatory Risk – as I said before, the inclusion of a region in an opportunity zone is pretty straight forward, but the regulatory requirement for maintaining that acceptance by the U.S. Treasury is still important. Making sure that the project, builder, and fund all stays focused on the regulations that keep it inside the tax purview is eminently important. Selecting a manager that is versed in the regulations and will do the property due diligence to stay in the lane is important. The risk is the loss of the tax benefits you have likely priced into your expectations.  Opportunity Zones have the ability to be truly transformative for communities and investors. A fantastic marriage of social benefit, long term capital investment, and tax benefit make for an appealing place to see a reasonable return. But taking advantage of this program for non-institutional investors is going to have a few parties you should consult to confirm the investment is right for you: a CFP to confirm that this investment works in your personal financial plan a CPA that understands the full tax benefits of this investment an estate plan that can accommodate the long duration of this type of an investment an investment manager that understands and mitigates the risks as best as possible an investment advisor that helps

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Account Types: SIMPLE IRA

Simple without being simplistic Annual Contribution Max: $13,500 Why we like SIMPLE IRA’s: They are easy to set up and require little to no fiduciary oversight Employee’s can direct the assets with total control Low contribution limits {Total elective contribution = $13,500 (2020)} Works well at a startup, or low revenue business The commitment is predetermined (Employer contracts with employee to have salary reduction) Earnings grow tax deferred on all contributions Not required to meet all of the nondiscrimination rules applicable to qualified plans and don’t have the burden of annual filing requirements Employer deposits match on regular basis tax deferred without payroll tax Employee elective deferrals are not subject to income tax but are subject to payroll tax Why we don’t like SIMPLE IRA’s: They have low contribution limits They match a small percent of the income Employer cannot have more than 100 employees Employees who earned $5,000 during any two preceding years OR are expected to earn $5,000 during the current calendar year qualify 100% vesting in all contributions and earnings Employer is required to make either matching contributions to those employees who make elective deferrals or, alternatively, to make non-elective contributions to all eligible employees Simple IRA’s are available for employees who want to be very hands off but still provide a benefit to employees.  The employer has two options, match contributions or make non-elective contributions to employees. If matching is selected, the employer is generally required to match the employee’s deferral contributions on a dollar-for-dollar matching basis up to three percent of the compensation of the employee (without regard to covered compensation limit) for the entire calendar year.  Alternatively, instead of matching the employees contributions, the employer can make non-elective contributions of at least 2% of each eligible employee’s compensation (up to the covered compensation limit of $280,000 for 2019) . The employee can then choose to make additional contributions as well. If the employer makes the contribution, it must make non-elective contributions whether or not the employee chooses to make salary reduction contributions. If the employer chooses a 2% contribution, it must notify the employees within a reasonable period before the 60-day election period for the calendar year. These plans are generally simple to set up, but the larger the company grows and the more the company wants to raise the contribution amounts these plans become less effective. 

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Investment Bias: Loss Aversion

Loss aversion is the tendency for people to strongly prefer avoiding losses at the detriment to obtaining gains. This puts an unnecessary fear on an investment not supported by the risk prima. This might be one of the most common biases that hinders the success of a retail investor. Simply put, investors refuse to sell loss-making investment with the hope of making their money back. A fear of making the loss “permanent” and along the way missing other opportunities, and likely impairing their returns. The fear of losing, causes more losing. It is reminiscent of the gambler who goes back to the same table to get “back on top.”  Traders are reluctant to abandon a loss maker for a fidelity to risk that they are not being rewarded for. What is important to remember, is that these stocks don’t know we own them, and there is no reason a stock cannot be rebought if/when conditions improve. Likewise, it’s important to note that the money doesn’t need to be gained, the same way it was lost. This tunnel vision on a stock or industry is another by product of loss aversion.    The loss-aversion tendency breaks one of the cardinal rules of economics; the measurement of opportunity cost. It breaks the second rule by letting emotion drive the decision. To be a successful investor you must be able to properly measure the opportunity cost available. Similar to anchoring, Loss aversion is being attached and inflexible to a previous value or cost and stems from a human tendency to avoid losses. Investors who become anchored due to loss aversion will pass on mouth-watering investment opportunities to retain an existing loss-making investment in the hope of recouping their losses. It is hard to determine when a cost is “sunk” if the purchase price is always contaminating the rational. Instead investors should resort to the valuation metrics that have likely deteriorated in the stock, and evaluate that to the opportunities they are missing by caring their overweighed fidelity to a position.

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