Investing in the Nasdaq-100®: Equal-Weight Version Presents a Tactical Choice
For the Nasdaq-100® Index (NDX®), 2021 marked the culmination of an extraordinary period of performance driven by its constituents’ unparalleled growth and innovation. At the end of 2006, NDX was still recovering from the dotcom crash in the early 2000s, but the seeds of the next secular bull market were already being planted by the likes of Apple, Microsoft, Google, and Amazon. For those who were invested in NDX at yearend 2006, the rewards during the subsequent 15 years were superb: 829% on a price-return basis, and 976% on a total return basis through year-end 2021. The index’s outperformance of the S&P 500 (approximately 3x on a total-return basis) was likely beyond what most financial forecasters could have guessed a decade and a half ago, albeit at an order of magnitude lower than the period since NDX was launched in 1985 through its peak in 2000, when returns exceeded 3,000%. The difference now being, of course, that NDX constituents are generally more mature companies with vastly better fundamentals – from revenues to cash flow to dividends – underpinning their market valuations.
The global pandemic backdrop of 2020-2021 supercharged the trend, transforming many of the index’s biggest constituents into truly defensive, consensus plays that benefitted immensely from the acceleration of this century’s strongest investment themes around technological disruption. In 2022, one-third of these extraordinary gains were given back, as a highly unfavorable and uncertain macroeconomic environment prompted many investors to abandon the world’s preeminent large cap growth index in favor of longunderperforming areas such as Value and Energy. Despite all that, the fundamental backdrop for much of the index remains strong, and the economy’s reliance on technological innovation is unlikely to decrease in the long run. The question beckons, then: should investors continue to be invested in the Nasdaq-100 during the next decade, and if so, how?
A Brief History of the Biggest Names in NDX
One can remain optimistic about the future performance of NDX, but it is always useful to look at the historical evolution of the index for some additional context. Doing so reveals a simple truth that is not unique to the Nasdaq-100, or even the US: it is not easy to stay on top. Of the top 10 biggest names in the Nasdaq-100 at the turn of the century, only 1 remains there today: Microsoft. Cisco has migrated just outside the top 10, into 11th -biggest, while Qualcomm and Intel have dropped a bit further into 19th and 22nd -biggest, respectively. Oracle continues to remain a market leader, although it is no longer Nasdaq-listed and thus ineligible for index inclusion. Dell has undergone multiple corporate transformations into being privately owned, separated into enterprise-focused vs. consumer-focused units, and eventually relisted on NYSE as well. The rest either faced ignominious ends through corporate scandal or years of painfully drawn-out mismanagement and decline. What about if we look at a few more recent historical snapshots?
Nearly five years after the peak of the dot-com bubble, a couple non-Tech constituents reached the Top 10 rankings (Amgen, Starbucks) while Apple, eBay and Nextel (eventually merged with Sprint) climbed into the ranks. Of these new names in EOY 2004’s Top 10, only Apple remains in the Top 10 today. That does not take away from nonetheless impressive performance, with Amgen (currently ranked 17th) up 446% on a totalreturn basis through December 31, 2022, and Starbucks (ranked 20th) up 693%. While these companies have grown substantially and tend to support the overall valuation of the index in periods during which Tech underperforms as a sector, they have simply been supplanted by newer, even faster-growing names.
Nearly 10 years after the peak of the dot-com bubble, Alphabet (Google) had emerged as one of the most formidable companies in Tech, BlackBerry reached its peak popularity and began its decline, and Amazon was just getting started in its expansion beyond online bookselling. Meanwhile, Meta Platforms (f/k/a Facebook) and Tesla had not even publicly listed yet, NVIDIA was about to hit its stride, Netflix was still mostly in the DVDs-by-mail business, Adobe was trading at one-eighth of its current valuation, and PayPal was still a subsidiary of eBay. Corporations and entire industries go through natural stages of ascent and decline. Some go through multiple such stages and emerge stronger as a result; others fade away into the dustbins of financial history. Why should an investor tracking the Nasdaq-100 care?
Equal-Weighting vs. Market-Cap Weighting
Because NDX is a modified market-cap-weighted index, it essentially “doubles down” on its best-performing constituents. Over the past decade and a half, this has been a good thing for investors, as large-cap Tech has trounced most other corners of the public equity markets. Looking ahead, though, it is useful to keep in mind the context of the historical turnover at the top, especially given today’s outsized weightings to the Top 10 NDX firms (52.8% of the index). If an investor is looking to diversify within the universe of the Nasdaq-100, she can consider allocating to NDXE™, the Nasdaq-100 Equal-Weighted Index™. While not proven to be always superior from a return or risk perspective, NDXE offers investors the benefit of maintaining stable, 1%-each weightings to all 100 of NDX’s companies, rebalanced quarterly (as opposed to NDX’s annual rebalancing schedule). This means that, instead of allocating more than half its weight to the Top 10 constituents, NDXE allocates only 10%. It also means that, on a sector level, weights are more diversified and less concentrated in Technology.
Finally, it means that there is less of an implicit bet on mega-cap firms in general. Instead of a weighted-average market cap of $694Bn, NDXE’s average market cap of $133Bn reflects an 81% reduction in the index’s typical constituent size. Practically speaking, it means that if Microsoft, Amazon, Alphabet or Apple (currently weighted between 6.0-12.5% each in NDX) were to experience a particularly bad day or month or year (down 50%, for example), the impact of a loss is muted by approximately 80-90%, reducing total portfolio drag. Indeed, this is what we observed in 2022 as the biggest NDX constituents entered bear markets and disproportionately drove losses in the index. Of the NDX’s 32.4% total-return loss for the year, the seven largest constituents were all ranked at the very bottom in terms of return contribution, down by 46% on average and contributing a loss of 21% -- or nearly two-thirds of the overall index total, despite averaging just under half of the index weight. In stark contrast, these names contributed only 3.3% of the 24.3% loss in NDXE, or roughly one-seventh of the overall index total return. On average, the negative return contribution for these seven constituents was 83% lower in NDXE vs. NDX, doubtless helping drive an outperformance by the equal-weighted version of 8.1% in 2022 (7.9% in on a price return basis).
Historical Performance & Current Potential to Outperform
If we look at NDXE’s recent outperformance in the context of its historical record which dates back to December 1998, we find that the last time it outperformed NDX by a larger amount was back in 2003, a gap of +14.5%. In 1999, substantial underperformance marked the final run-up of NDX to its secular peak in March 2000, after which NDXE outperformed in six of the seven calendar years from 2000-2006. Its only year of underperformance during this timeframe was 2002, a gap of -3.9% vs. NDX. Across the other six years, the outperformance averaged 5.4% per year. This is not to suggest that the Nasdaq-100 is about to enter into a similarly prolonged and pronounced bear market. Index valuations during the most recent peak topped out in the upper 30s, vs. in excess of 200 at the end of 1999. Fundamentals remain generally strong, even in the face of an acknowledged slowdown in growth rates given the “reverse bullwhip” effect of post-pandemic normalization. But history, if it does not always repeat, often does tend to rhyme – and after many years of the cap-weighted version of the Nasdaq-100 outperforming, it appears that the equal-weighted version may be poised to assume leadership until the next secular bull market arrives.
Summary
Our prior research on the evolution of the Nasdaq-100 since the Internet/Tech Bubble demonstrated that today’s index is simply not comparable in terms of its fundamental strength vs. at the turn of the century. Our most recent research attempted to contextualize NDX’s weak performance in 2022 vs. the uniquely uncertain and unfavorable macroeconomic environment for growth and technology stocks, arguing that a number of structural advantages exist across the index that may lead it to outperform the broader US large cap space over the course of several years of elevated interest rates and/or inflation. Among them, relatively lower levels of debt vs. the S&P 500; above-average pricing power; below-average sensitivity to wage inflation; more balanced business models with respect to recurring revenue; and historically attractive valuation levels bode well for the Nasdaq-100 in the 2020s, even if the prior one and half decades’ worth of superb performance may not be repeatable.
Investors who recognize the exceptional nature of the Nasdaq-100 may look beyond products tracking NDX, the modified market-cap-weighted index, and consider NDXE – an equal-weighted version with the same underlying constituents, but with a reduced concentration in the biggest firms and the Technology sector more generally. History shows that the extended dominance of market leaders is the exception rather than the rule. In today’s environment, at least some of the names at the very top of the Nasdaq-100 that have so consistently propelled its outperformance appear at risk of underperforming, echoing prior market cycles. For investors who remain committed to the long-term growth potential of the Nasdaq-100, the equal-weighted version of the index may provide the ideal tactical hideout in the coming years.
Products currently tracking NDXE include the First Trust Nasdaq-100 Equal Weighted ETF (Ticker: QQEW) and the Direxion Nasdaq-100 Equal Weighted Shares ETF (Ticker: QQQE).
Sources: FactSet, Bloomberg, Nasdaq Global Indexes.
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Nasdaq® is a registered trademark of Nasdaq, Inc. The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as , either on behalf of a particular security or an overall investment strategy. Neither Nasdaq, Inc. nor any of its affiliates makes any recommendation to buy or sell any security or any representation about the financial condition of any company. Statements regarding Nasdaq-listed companies or Nasdaq proprietary indexes are not guarantees of future performance. Actual results may differ materially from those expressed or implied. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.
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