Will hedge funds be gremlin in Nasdaq-100 re-balancing?

In the wake of last week's announcement by the Nasdaq OMX Group Inc. that it will re-balance the Nasdaq-100 Index for the first time in 13 years, portfolio managers are warning that investors could see greater volatility in technology stocks over the next few weeks. “A change like this used to have predictable results before hedge funds,” said Gus Sauter, chief investment officer at The Vanguard Group Inc. “But we just don't know what the hedge funds are going to do.” Almost a year after the flash crash, Nasdaq's surprise announcement serves as yet another reminder how sometimes obscure technical issues can move securities prices, experts said. “This is another example of how fundamentals aren't the only thing that affects the stock market,” said Paul Weisbruch, vice president of exchange-traded-fund and options sales and trading at Street One Financial LLC. On May 2, Nasdaq will conduct a “special re-balance” of the Nasdaq- 100 Index, which comprises the 100 largest non-financial Nasdaq stocks. The index currently uses a modi- fied market-capitalization-weighted methodology it began using in 1998 to meet diversification rules for investment products whose vendors wanted to license the index. As a result of the re-balancing, the index will revert to its original market-capitalized version. Most notably, the shares of Apple Inc. Ticker:(APPL), would account for just 12% of the index based on share prices of last Tuesday — the day the announcement was made. That day, they accounted for more than 21% of the index. And Microsoft Corp. Ticker:(MSFT) shares would make up 8.32%, up from 3.41% on the day the announcement was made. Nasdaq is making the change because the index weightings had started to move too far from the actual market capitalization of the stocks, said John Jacobs, executive vice president of Nasdaq's Global Index Group. Nasdaq doesn't anticipate that the change will have any significant effect, he said. After the re-balancing, the old and new versions of the index will have a 99% correlation, according to Nasdaq's research, Mr. Jacobs said.

AGAINST THE RULES

But the change isn't in line with Nasdaq's own rulebook, which explains triggers for re-balancing, said David Nadig, director of research at IndexUniverse.com. According to those rules, Nasdaq will re-balance its index if a stock makes up more than 24% of the index or when an aggregate of smaller positions makes up more than 48% of the index. “Neither of those situations has occurred here,” Mr. Nadig said. “Every trader had models in spreadsheets running under the assumption of those rules. No one knew this was coming.” As a result, traders will be scurrying to re-balance their portfolios come May 2, experts said. “May 2 is going to be one of the most chaotic days in the past five years,” Mr. Nadig predicts. There are more than 2,900 financial products that track the Nasdaq-100 globally, about half of which are traded in the United States. Nasdaq estimates that there are 60 to 100 mutual funds that track the index to some extent. Just one ETF, the $24.4 billion PowerShares QQQ Trust, tracks the index. Experts predict that over the next few weeks, hedge funds will try to front-run the re-balancing, which will cause greater volatility in the stocks in the index. “In this world of high-frequency trading, where pennies make a difference, a lot has changed,” said Jim Rothenberg, an attorney and trading expert. But how hedge funds play the index is a big unknown, Mr. Sauter said. “The problem is that hedge funds don't work in concert with each other, so you don't know which ones will be shorting Apple or not,” he said. “This could end up being a big dump on the market or it could not.” Volatility will be most evident in the QQQ, which is already the fourth-most heavily traded ETF, said Robert Goldsborough, an ETF analyst at Morningstar Inc. “You will see the price whipping around until the end of the month, I suspect,” he said. Shareholders of QQQ may also get hit by capital gains taxes as a result of the index re-balancing — unless the value of Apple shares drops dramatically in the coming weeks, Mr. Nadig said. Usually, there is a fair amount of creation and redemption activity that an ETF can tap to make changes in its portfolio, but given the magnitude of this change, QQQ actually may have to trade the portfolio to sell shares of Apple and buy Microsoft, he said. “That theoretically could result in substantial capital gains for people,” Mr. Nadig said. Invesco PowerShares Capital Management LLC is working with the QQQ trustee, The Bank of New York Mellon Corp., to mitigate any potential capital gains, said Benjamin Fulton, head of the firm's global ETF business. Due to a large capital loss carry-forward accumulated in the QQQ trust, the firm doesn't expect capital gains to be an issue, he said. So far, financial advisers and other investors have been positive about the change in the index and what it will mean for the QQQ, Mr. Fulton said. “This re-balance brings it back in line with market cap weightings,” he said. “We have spoken to investors who have avoided the product in the past but now are going to look at it.” Mr. Jacobs disputes the notion that the re-balancing will cause any “chaos” in trading. “I am re-weighting the index in a very minor way that is going to take effect next month,” he said. “This is the most transparent change any index has ever made. You never see an index announcing a change a month ahead of time,” Mr. Jacobs said.

'WAKE-UP CALL'

One possible positive of the re-balancing is that it may serve as a reminder to investors that investing in an indexed product — such as an ETF — doesn't mean that they have the exposure that they think they do to the entire index, experts said. “This might be a nice wake-up call for investors to investigate the ETFs they own,” Mr. Weisbruch said. “[A fund that] says that it's an ABC sector ETF may be heavy one name or two.” E-mail Jessica Toonkel at jtoonkel@investmentnews.com.