December 15, 2003
HEARD ON THE STREET
Nasdaq 100 Castoffs
May Offer Investors
New Opportunities
By KEN BROWN
Staff Reporter of THE WALL STREET JOURNAL
When the Nasdaq Stock Market announced its annual changes to the Nasdaq-100 Index last week, investors responded predictably: Stocks that were added to the index generally rose, while those that were tossed out fell.
But if history is any judge, investors made the wrong bet.
A quick study of the stocks added and dropped in the past few years shows that investors would have been far better off buying the companies dumped from the widely watched index and selling those given the honor of joining the Nasdaq 100.
As a group, the stocks that Nasdaq dumped at the end of last year, including PMC-Sierra Inc., Protein Design Labs Inc. and Integrated Device Technology Inc., are up 140% this year. The stocks that were added to the index, including American Power Conversion Corp., Pixar Animation Studios and First Health Group Corp., returned an average of 24% so far this year. The Nasdaq-100 itself is up 45% for the year, meaning the new stocks were a drag on the index.
The shifts are significant because the Nasdaq-100, which was launched in 1985 and contains the 100 largest nonfinancial stocks traded on the Nasdaq, is one of the most important indexes in the market. It is tracked by about 400 financial products, according to Nasdaq, including the Nasdaq-100 Index Tracking Stock, known by its ticker symbol as the QQQ, which has total assets of $21 billion and is the most heavily traded stock in the U.S.
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The Nasdaq changes the index every December. The latest changes were announced Thursday after the market closed and will take effect before the market opens on Dec. 22.
Not surprisingly, the stocks removed from the index tend to fall immediately after the announcement because the funds that track the Nasdaq 100 must sell them and buy the index's new names. Ultimately, these stocks tend to bounce back, making the initial selloff a potential buying opportunity.
In 2001, both the adds and drops from the index fell over the next year, a rough one for the market. The shares added fell 48% in 2002, while the stocks that were dumped fell a slightly less painful 42%.
The results were more stark for the stocks added and dropped in 2000. The next year, the stocks that were added fell 60% while those that were dropped rose 55%.
In trying to explain the phenomenon, investors say that new stocks in the index tend to be among the market's hottest. That often means the investors who track the index are buying stocks that have peaked and are heading for a fall.
Clifford Asness, managing principal at AQR Capital Management LLC, a New York hedge fund, says that momentum strategies like this one can be extremely volatile. "Momentum is a pretty dangerous strategy when used alone, and this is also a very coarse way to use momentum," he said.
John Jacobs, the executive vice president at Nasdaq who oversees the index, says the companies in the Nasdaq 100 are chosen using objective, transparent rules based largely on the size of the companies, with restrictions designed to keep out young, hot stocks. He says investors essentially choose the stocks in the index by pushing up their market caps. "I'm very happy that the companies that have been removed have performed well," Mr. Jacobs said.
This year's new stocks are: Marvell Technology Group Ltd., Garmin Ltd., Career Education Corp., Lam Research Corp., Level 3 Communications Inc., Intersil Corp., ATI Technologies Inc. and Research in Motion Limited. As a group, they have returned more than twofold in 2003, so far.
This year's drops returned a not-too-shabby 62%, with the best performer, Telefon AB L.M. Ericsson, rising 141%. The rest of the dropped companies are: ADC Telecommunications Inc., Brocade Communications Systems Inc., Ciena Corp., Human Genome Sciences Inc., Icos Corp., Monster Worldwide Inc. and RF Micro Devices Inc.
One reason for the performance oddities is that the Nasdaq tends to add and drop stocks in the same industries. Of the 14 stocks dropped last December, for instance, 11 of them were from only two industries -- six were semiconductor stocks and five were biotechnology companies. Both industries soared this year, with semiconductors up 72% and biotechs up 40%.
The Nasdaq-100 is filled with mega-size tech names such as Microsoft Corp. and Intel Corp., that are likely to be in the index permanently. But some smaller and more volatile names move in and out, even though Nasdaq's system for picking stocks is designed to prevent that. At least eight stocks have made round trips into and out of the index in the past three years, and in many cases they registered their best performance out of the index.
For example, Integrated Device Technology was added to the index in December 2001 and promptly lost 69% in the subsequent year. The stock was then dumped, and the next year returned twofold. Protein Design Labs was added in 2001, after which it fell 74%. It was dropped at the end of 2002, and, of course, rebounded 94% the next year.
Write to Ken Brown at ken.brown@wsj.com1 |
