Nasdaq-100 Rebalance: What It Means for Your Portfolio

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. The Nasdaq-100 Index is getting a makeover. I’ll talk with an analyst about what it means for investors. Plus, JPMorgan Chase’s second-quarter results exceeded expectations. What Morningstar thinks about the big bank’s outlook. And money market mutual funds and CDs are offering competitive rates. Morningstar Inc.’s director of personal finance Christine Benz weighs in on the safe investments’ pros and cons. This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ivanna Hampton. Let’s get started with a look at the Morningstar headlines.

JPMorgan Starts Strong in Q3

JPMorgan Chase is entering the second half of this year in a strong position. The banking giant’s second-quarter earnings per share of $4.75 beat Morningstar estimates. Stronger income from loans, better trading results, and lower-than-expected expenses from buying First Republic Bank boosted the quarter. JPMorgan raised its net interest income, or lending profits, for 2023 by a few billion dollars to $87 billion. Higher interest rates are expected to stay around a little longer. And the amount JPMorgan is paying on deposits to savers is still going up, but a little slower than expected. Morningstar says this is positive. However, it points out that the economy could still slow, and competition for savers’ deposits will remain stiff. Indeed, JPMorgan didn’t update its lending profit outlook for the next several years. The big bank is likely seeing the peak. Morningstar doesn’t expect to significantly change its $153 estimate of JPMorgan stock’s worth and considers it as fully valued.

Threads Breaks Records, but Will It Produce Profits?

Meta’s Twitter-like app, Threads, launched with a fast start, but questions remain. More than 100 million users joined in five days. Investment research platform Quiver Quantitative says Threads is the fastest-growing app ever. However, it’s not clear whether Meta can keep or make money off those users. Morningstar says a lot of disgruntled Twitter users are testing out the new app while still scrolling through their Twitter feeds. It’s still not clear how many content creators and popular accounts will stick around. Facebook and Instagram have network effects, so their services become more valuable as more people use them. Threads is new and separate. It may not benefit from its sibling apps’ network effects. That uncertainty will likely keep advertisers on the sidelines for some time. Morningstar doesn’t expect all advertisers that leave or reduce spending on Twitter to go to Threads. If Threads can attract content creators, bring in popular Twitter accounts, and keep users, then the app could become a big moneymaker. Until then, Morningstar is keeping its $278 estimate for Meta’s stock.

Uber and Domino’s Deliver a New Deal

Uber and Domino’s Pizza are teaming up to deliver pizzas. A new deal between the ride-hailing company and the world’s largest pizza chain will allow Uber Eats customers to order from Domino’s. However, Domino’s will still deliver the food. The move marks a reversal for Domino’s. It has resisted working with third-party delivery companies. Uber’s network effect continues to drive restaurants of all sizes to the platform. That has pulled in more customers, making its service more valuable as more people use it. Morningstar believes that appealed to Domino’s, along with reaching Uber’s more than 130 million monthly users. The analyst doesn’t expect this agreement to affect Uber’s revenue significantly because it’ll likely make a low fee on orders. But Uber could bring in high-margin revenue if Domino’s begins marketing on Uber Eats. The service is expected to roll out across the United States by the end of this year. Morningstar is sticking with its $68 estimate for Uber shares and considers the stock undervalued.

The Nasdaq-100 Needs Changing

Several big-name tech stocks have surged in 2023. Their size in the Nasdaq-100 Index has triggered the need for some changes. Many funds track the growth-focused index. The list includes the world’s fifth-largest exchange-traded fund—Invesco QQQ Trust. Morningstar Research Services manager research analyst Ryan Jackson covers the QQQ ETF. He’s joining Investing Insights to discuss what the makeover means for investors.

What Is the Nasdaq-100?

Ryan, let’s start off with what the Nasdaq-100 Index is and its appeal among investors.

Ryan Jackson: Sure. The Nasdaq-100 Index is an index of the 100 largest nonfinancial stocks that trade on the Nasdaq Exchange. Stocks that meet that criteria are getting swept into the portfolio, and there’s going to be a modified market-cap-weighting approach, which effectively pulls the largest stocks to the top and kind of suppresses the smaller stocks toward the bottom. This is a tech-heavy index, that’s sort of its MO. The reason for that, the Nasdaq is a very, they call it innovation-friendly exchange. That’s where a lot of tech and tech-adjacent stocks trade. And also by omitting those financial stocks, you create a little bit more space for those tech stocks to run.

You see quite a handful of ETFs that track this index, but the most notable among them would be Invesco QQQ Trust, ticker is QQQ, also goes by “the Qs.” This is one of the most notable, one of the oldest, and right now the fifth-largest ETF on the market. That appeal for investors, we tend to see them use it almost as a tech substitute because it is so tech-heavy. It’s a very large fund. It’s very liquid. I think the trading community tends to look at it favorably for those reasons. And then when you look at the longer-term investment crowd, I think it’s a fan favorite really just because of the performance.

Frankly, this fund has been very good for a very long time. If you look back at the trailing 10-year and 15-year windows, you’ll see the QQQ ranked within the top 1% of all large-growth strategies. So, no doubt that combination of stature, liquidity, and strong performance makes for a pretty compelling case.

The ‘Magnificent Seven’

Hampton: Oh, wow. Some tech stocks have earned the nickname the “Magnificent Seven.” Who are they, and how have their performance affected the index?

Jackson: The Magnificent Seven is kind of the latest and greatest moniker for the stocks that are leading the market right now. Running through them quickly: That’d be Apple; Amazon; Alphabet, which is the Google parent; Microsoft; Meta; Nvidia; and Tesla are the Magnificent Seven. And they’ve earned that title because, quite frankly this year, their performance has been tremendous. You go top to bottom, I think the lowest return out of all of them is 35% in the first half. The highest would be Nvidia at 189% in the first half.

So, really jaw-dropping numbers from these companies. While there’s no doubt they’ve lifted the market as a whole, their impact has been even more pronounced for QQQ and the Nasdaq-100 because they constitute a much larger share of that portfolio. You got to think: Entering 2023, those seven stocks constituted about 47% of QQQ, only 17% of the Morningstar market index. So, with such a big footprint on that fund and on the Nasdaq-100, you’ll see its impact really drive the fund and the index higher.

The Nasdaq’s Special Rebalance

Hampton: And that’s a big difference. I guess that’s why Nasdaq is planning to perform something called a special rebalance. Can you describe what that is and what will happen?

Jackson: That’s right. I just talked a little bit about those seven stocks’ performance. As you see their stock prices rise, you’ll also see their market cap rise, also see their share of the index rise, that index portfolio weight. Well, the Nasdaq-100 has provisions in place to avoid concentration, make sure it doesn’t get too top-heavy. And sure enough, earlier in July, as all these stocks continued to fly upward, they broke that threshold and triggered a special rebalance for the index as a whole.

We saw on July 3, they represented about 55% of the portfolio. So, that kind of crossed the threshold for this special rebalance to come into play. So, what does that mean? Well, basically what we’re doing or what Nasdaq would be doing, is taking some of that portfolio weight from those top seven stocks, the ones that exceeded that threshold, and just redistributing it to the other companies in the portfolio. You’re basically taking from those top seven, those that have grown a little bit too lofty in the index, redistributing to all those that need a little bit more to balance it all out.

Which Companies Will Gain From the Rebalance?

Hampton: So, which companies could gain when this redistribution happens?

Jackson: Yeah, well, put it simply, every other company in the index will get a little bit of a boost, but it’s all going to be proportional to their size in the index as a whole, their position size. Those that will get the biggest absolute boost would be those that are closest to those top seven without actually getting into that territory. Specific companies right outside that top seven, we would see Broadcom would be the one to stand the benefit the most. Pepsi is right up there. You’ve got Costco and then so on and so on, Netflix, Adobe, as you kind of work your way down the portfolio. The important thing, though, is: It’s every other stock in the index gets a little something, just commensurate to how big its position is. Almost think about it like if you’re holding an ice tray directly under a faucet, you see it load up those first couple cubes first. After a while, it starts to trickle out to the very edges. I think of that as the bottom of the portfolio, so they get that little added extra increment.

How Will the Nasdaq’s Rebalance Affect ETFs?

Hampton: I like that analogy. We all should take a snapshot of what it looks like today and then see what it looks like next week and just compare it. You cover the Qs. How will this special rebalance affect investors of that ETF and other funds that track this index?

Jackson: You’ve got to remember, the goal of any index-tracking fund, first and foremost, is to hue as closely to the benchmark as it possibly can. For something like the Qs, that means as the Nasdaq-100 rebalances, it will be rebalancing right alongside it. For investors, the portfolio won’t look totally different, but there will be a couple of changes. I think first and foremost, you’re getting a portfolio that’s going to be significantly less concentrated. We’ve got about 12 percentage points of extra weight to redistribute. That’s a pretty notable sum, and that’s the intention of this whole special rebalance in general as to promote that diversification, avoid that concentration at the top.

Net-net, I think that’s a positive thing for investors. It was getting a little bit crowded at the top of the portfolio. Additionally, you’ll have a little bit less tech. Invesco put out a pro forma estimate of what these changes will look like, and they estimated that it’ll be about 5 percentage points less tech exposure going from about 62% to 57% after the rebalance. And you’ll see healthcare, industrials, communication stocks get a little bit of a boost in exchange. All in all, these aren’t huge material changes that really affect the fabric of the fund. At the end of the day, the shape of it’s going to look similar, it’s going to be exposed to very similar risk factors, but there are some changes that I think should benefit investors in the fund long term.

Hampton: Right. Well, Ryan, thank you for your time today and breaking down this upcoming special rebalance.

Jackson: Thanks for having me, Ivanna.

Money Market Funds vs. CDs: How To Choose

Hampton: Some CDs and money market mutual funds are offering competitive rates. But what should you consider when deciding where to stash your cash? Morningstar Inc.’s investment specialist Susan Dziubinski and Morningstar Inc.’s director of personal finance Christine Benz talk about the pros and cons.

Susan Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks to the Federal Reserve’s campaign to increase interest rates to dampen inflation, safe investments are offering higher yields than we’ve seen in years. Joining me to discuss how to choose between two popular options for your short-term funds is Christine Benz. Christine is Morningstar’s director of personal finance and retirement planning.

Nice to see you, Christine.

Christine Benz: Good to see you too, Susan.

Dziubinski: Let’s start with a portfolio question. Yields on very safe cashlike investments are the highest we’ve really seen in years, and we’ve seen a flood of assets into things like money market mutual funds and other cashlike investments. So, how should investors in this environment be thinking about their cash positions today?

Benz: Frankly, I’m a little worried that some investors might be overdoing their cash investments. It’s hard to deny that that safe yield is attractive. It certainly is. But I think you do want to be deliberate and strategic about how much you hold in cash. So, for people who are still working, I think the good rule of thumb is holding three to six months’ worth of living expenses in liquid reserves, in cash instruments, maybe a little bit more in cash if you’re an older worker with a more specialized career path, or if you’re the sole earner in your family and you’re supporting a household, you may want to think about more like a year’s worth of living expenses and that can support you through all sorts of trials and tribulations, job loss, and so forth. If you’re someone who is retired, I like the idea of holding a bigger cash cushion as an ongoing spending reserve that you can pull from on an ongoing basis. And so, I think one to two years’ worth of living expenses of portfolio spending is a good benchmark for people at that life stage.

And then, I would say for folks who like to be a little bit opportunistic about their investments, if you’re someone who knows that you like a good buying opportunity in the market, you like to go shopping when stocks are on sale, you might hold a little bit more of a reserve alongside your investment accounts that will let you be nimble, will let you put money to work in those market inflection points.

Dziubinski: Got it. So, if investors are looking for those higher-yielding options, certificates of deposit certainly look compelling today. Let’s talk a little bit about their pros and cons.

Benz: Yeah. So, the big pro really when you survey various cash options is that because CDs do require you to lock up your money for a period of time, typically the yields are better than is the case with investments that give you a lot of liquidity and access to your funds on an ongoing basis. I think for people shopping for cash instruments, that’s going to jump out at them right away. They’ll see that the yields are attractive, and you typically have FDIC insurance protection up to the limits that comes along with certificates of deposit. So, those would be the big benefits.

The big negative would be the fact that you’ve got to lock up your money for a period of time, that part of the bargain in order to earn that tantalizing yield is that you do have to agree to keep your money in the account. Otherwise you will pay a penalty if you need to get at those funds prior to the term being up. You’ll pay a penalty usually equal to a couple of months’ worth of interest. So, you need to really think about your own spending needs before signing on the dotted line with the CD.

Dziubinski: So, then who would CDs be right for?

Benz: They’re right for people who have very specific spending needs coming due. So, retirees, I would say, would tend to be good candidates for CD investments because they have specific expenses that are coming due on specific schedules. They can readily calibrate how much to put into various CDs. I would say those would be the best candidates. Or if you are someone who has cash investments set aside where you don’t have any specific purpose for them, you just have cash in your portfolio, the CDs would generally be your highest-yielding option as long as you understand that you’re not going to be able to pull the funds just on an ongoing basis without some penalty.

Dziubinski: Now, let’s pivot and talk about money market funds, which are another popular cashlike option. Now you say that there is a bit of a confusing terminology with money market funds. So, let’s start there. There are money market accounts, and then there are money market mutual funds. What’s the difference?

Benz: Right. It’s unnecessarily complicated, but it is what it is. Money market accounts are bank-offered accounts. Typically, they do come along with FDIC protection. Money market mutual funds are investment products, so they are not FDIC-insured. And so that’s the big distinction, and you typically will see higher yields on money market mutual funds, especially right now, relative to money market accounts, because money market accounts give you better safety protections.

Dziubinski: So then, what are the pros and cons of money market mutual funds?

Benz: Money market mutual funds are able to offer higher yields, and it will ebb and flow, but right now, they will offer higher yields than FDIC-insured instruments will. There’s also a convenience factor with money market mutual funds. Most of my cash is in a money market mutual fund that sits right alongside my other investment accounts. I’m able to make regular contributions to it. There’s just a seamlessness to the money market mutual funds. So, I would say those are the big advantages. The big disadvantage is that lack of FDIC protection. And in fact, we have seen a couple of bobbles with money market mutual funds. The biggie was during the global financial crisis in 2008, where we saw quite a large money market mutual fund, what’s called “break the buck,” where it didn’t necessarily make all of its shareholders whole, which is not something that investors in cash-type investments are typically expecting. So, there have been some tightening up of the rules around how fund companies are running money market mutual funds. In practice, money market mutual funds have been quite safe, and the SEC, the Securities and Exchange Commission, is considering some new regulations that would make them even more so.

Dziubinski: Christine, who might money market funds be a good fit for?

Benz: They are a good fit for people who do have that ongoing liquidity need where you have maybe your emergency fund, for example, parked in a money market mutual fund, where you may even have check-writing privileges depending on the provider. The key point I would make here, Susan, is that it’s really worthwhile to shop around, look at the yield, also look at that expense ratio, which you can find by hopping on your fund company’s website. And if you see a very high yield—maybe higher than other competing cash investments—and a high-ish expense ratio—so maybe something more than, say, 0.50%—that’s a signal that maybe this is an investment product that’s dabbling in some riskier security types in order to deliver that high yield. I think there’s probably safety by sticking with one of the really big providers who have a lot riding on other investment products, not just money market mutual funds. Do your homework. Even though these seem like commodities, I think that you can do a little bit of due diligence to make sure that you’re not venturing into a risky product.

Hampton: Thanks Susan and Christine. Subscribe to Morningstar’s YouTube channel to see new videos from our team. You can hear market trends and analyst insights from Morningstar on your Alexa devices. Say “Play Morningstar.” Thanks to video producer Daryl Lannert. And thank you for tuning into Investing Insights this week. I’m Ivanna Hampton, a senior multimedia editor here at Morningstar. Take care.

Read about topics from this episode.

JPMorgan Earnings: Revenue Outlook Increased Again as Higher Rates Boost Net Interest Income

Meta Platforms: An Impressive Start for Threads, but Questions Remain

Uber: Strong Network Effect Has Brought Domino’s Onboard

What the Nasdaq 100 Rebalance Means for ETF and Index Fund Investors

7 Charts on U.S. Fund Flows in the First Half of 2023

ETFs Close Mild First Half with an Exclamation Point

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