Nasdaq is making a big change to its most popular index. Here’s how it might impact your portfolio.

Nasdaq announced late last week that the Nasdaq 100
NDX,
+1.24%
will undergo a special rebalancing that will take effect prior to the market open on July 24. It’s only the third time that Nasdaq has announced such an impromptu rejiggering of how much individual stocks contribute to the index. Although Nasdaq can also reconstitute the index regularly every December, and there’s also a mechanism to rebalance every quarter as well.

In a statement announcing the move, the exchange alluded to the fact that the largest companies in the technology sector have too much sway over the index’s price. Nasdaq said special rebalancing can be implemented “to address overconcentration in the index by redistributing the weights.”

The rebalancing comes at a critical time. The Nasdaq 100 has risen 40% since the start of 2023, largely thanks to the “Magnificent Seven,” a handful of megacap technology names that have powered much of the U.S. stock market’s rally this year.

These gains have pushed the index to its highest level since mid-January 2022, meaning that Big Tech has now retraced nearly all of last year’s losses, and might soon be headed for the all-time highs from November 2021.

As of Thursday, the Magnificent Seven stocks — Nvidia Corp.
NVDA,
+3.53%,
Apple Inc.
AAPL,
+0.90%,
Microsoft Corp.
MSFT,
+1.42%,
Amazon.com Inc.
AMZN,
+1.57%,
Tesla Inc.
TSLA,
+0.82%,
Meta Platforms Inc.
META,
+3.70%
and Alphabet Inc.’s Class A
GOOGL,
+1.53%
and Class C
GOOG,
+1.62%
shares — accounted for 55% of the Nasdaq 100’s market capitalization, while the top five names account for more than 45%.

According to Nasdaq’s official methodology, the goal is to keep the aggregate weighting of the biggest stocks below 40%. In fact, it’s possible that Tesla Inc. surpassing 4.5% of the index earlier this month triggered the Nasdaq’s rebalancing announcement, according to analysts from UBS Group AG
UBS,
+1.87%.

Exactly how it plans to accomplish this isn’t yet known. Nasdaq said the new weighting scheme will be unveiled on Friday, likely after the U.S. market close. But the UBS team has an educated guess.

“The quarterly reviews would dictate that the aggregate weight to securities exceeding 4.5% be set to 40%. If that’s the approach Nasdaq takes, then we’d expect the weights of Microsoft, Apple, Nvidia, Alphabet, Amazon, and Tesla to be reduced,” the team said in a note shared with MarketWatch.

For investors trying to anticipate how this might impact their portfolios, here the answers to a few key questions.

Could the rebalancing kill the U.S. stock market rally?

Not likely. Or rather: if the rally in Big Tech does falter, history suggests it won’t be because of the rebalancing.

Here’s more on that from Nicholas Colas, co-founder of DataTrek Research, who discussed the topic in commentary emailed to MarketWatch on Wednesday.

“…[T]here is the natural inclination to think that the upcoming special reweighting is a sign that large cap disruptive tech is set to roll over because a handful of names have so handily outpaced the rest of its notional peers,” Colas said.

“History suggests otherwise. The last 2 one-off reweights were in 2011 and 1998. Neither proved to be the end of a Nasdaq 100/tech stock bull market. Not even close, really.”

More immediately, ETF experts expect trading around the rebalancing will be relatively muted.

“While it sounds scary, Investors are well positioned — this has been well bantered about,” said David Lutz, head of ETF Trading at Jones Trading, in comments emailed to MarketWatch.

How could this benefit investors?

Since megacap technology stocks don’t pay much, if anything, in dividends, the rebalancing could increase the amount of dividends that ETF investors receive each year, according to a team of analysts at JPMorgan Chase & Co.

Since the largest constituents pay a dividend yield well below the index average, the redistribution of weight from them to the rest of the index will result in a “meaningful boost” to the regular payouts received by investors, which will boost the total return of Nasdaq 100-tracking ETFs and mutual funds.

Will there be any short-term costs associated with the rebalancing?

There might be. Since the new index weightings will be announced in advance, investors will have plenty of time to front-run the rebalancing trade.

Still, there are plenty of hedge funds and proprietary trading firms that run strategies explicitly designed to profit from rebalancing. These firms profits have to come from somewhere, and the logical place would be the fund managers of the Invesco QQQ exchange-traded fund
QQQ,
+1.26%

QQQM,
+1.27%.

“There are prop traders and hedge funds that run the strategy of providing liquidity to indexes with the expectation that they’ll earn profits,” said Roni Israelov, president and CIO at Wealth Manager NDVR, during a phone interview with MarketWatch.

“if they are earning profits by providing that liquidity, the expectation is those profits are being paid by investors in those funds.”

So far at least, markets appear to have taken news of the rebalancing in stride. Megacap technology names tumbled earlier this week, but they’ve since recouped those losses and then some.

The Nasdaq Composite
COMP,
+1.15%,
another Nasdaq index that isn’t quite as heavily weighted toward Big Tech, rose 1.2% to 13,918.96.