Nasdaq U.S. Large Cap Equities for Rising Rates Index™: Outperformance at the Exact Right Time
The Nasdaq US Large Cap Equities for Rising Rates Index (NQERR™) was launched on June 29, 2017. Its constituent basket consists of 50 securities selected across five sectors based on the strength of their correlations to the US 10-year Treasury yield (US10Y). Specifically, the index methodology evaluates the 11 Nasdaq US Large Cap ICB Industry indexes (Energy, Basic Materials, Industrials, Consumer Discretionary, Consumer Staples, Health Care, Telecommunications, Utilities, Financials, Real Estate, Technology) and ranks the correlations of their weekly returns over a trailing three-year period with the weekly change in the US10Y. The top 5 ranked Nasdaq US Large Industry Indexes comprise the initial pool of eligible constituents. Separately, each of the constituents in the Nasdaq US 500 Large Cap Index™ (NQUS500LC™) are similarly ranked vis-à-vis the US10Y. Finally, the top 10 ranked constituents within each of the five chosen sectors are selected and equally weighted within sector. (In the event that fewer than 10 securities exist for a given Nasdaq US Large Cap ICB Industry index, an identical ranking of the Nasdaq US 600 Mid Cap Index™ would be used to fill the gap.) The process is repeated every quarter using market data as of quarter-end. Initial sector-level weights are set such that the top-ranked sector receives 30% of the index weight, while the next-ranked sectors receive 25%, 20%, 15%, and 10%, respectively. Let’s review how NQERR has performed in the recent past and what its components look like today before considering what makes its underlying strategy so compelling in the current macroeconomic environment.
As one can tell just by looking at the top 10 constituents, NQERR is currently overweight Energy and Financials, both of which have exhibited a historical tendency to outperform other sectors during periods of rising rates. The next two largest allocations are Basic Materials and Industrials, which are also solidly procyclical sectors. In fifth place is Technology – a somewhat surprising observation that deserves contextualization.
First and foremost, US10Y correlations across the 11 ICB Industry groups are not normally distributed – at least, not based on recent market data. The top tier of strongest-correlated sectors includes Energy, Financials, Basic Materials, and Industrials, which tended to produce correlation values of 0.3-0.5 during the last two years. The middle tier includes Consumer Discretionary, Telecoms, and Technology, which tended to all cluster around 0.2. The lowest tier includes Consumer Staples, Health Care, Real Estate, and Utilities (i.e., the “defensives”), with correlation values consistently around 0.1 or lower. From the historical chart shown below since the inception of the index, one can see that only 8 of the 11 industries have been represented, leaving out Consumer Staples, Real Estate and Utilities. Noted above, despite being in the lowest tier, Health Care made it into the index in late 2018 and early 2019.
In the most recent quarterly evaluation as of December 31, 2021, Technology’s correlation was observed at 0.207 vs. Communications at 0.202 vs. Consumer Discretionary at 0.200; in other words, the margins separating the 5th-ranked sector from 6th (or even 7th-ranked) were razor-thin. One additional day’s worth of market activity may have been enough to keep Technology out. Indeed, of the handful of times Technology has appeared in the index since its inception, all but one instance was as the 5th-ranked sector. The exception was during the second quarter of 2020, immediately following the arrival of the Covid pandemic and its widespread market disruptions, including major cross-asset correlations.
The other interesting context around Technology’s inclusion is the constituent-level and subsector-level makeup: it does not include any of the largest mega-cap Tech names nor a single Software name. Five of the 10 companies are classified as Semiconductors, which tend to exhibit more cyclical behavior given their very high levels of capital expenditure and fixed costs at the industry level. The rest are Electronic Components or Computer Hardware, with the exception of Hewlett Packard Enterprise. Overall, this group of 10 Tech companies had an average market cap of around $40B as of February 28, 2022 – hardly resembling the typical Tech portfolio. This illustrates how NQERR’s underlying strategy distinguishes from more simplistic sector-level screens that might select a market-cap-weighted Technology portfolio such as those underlying the XLK or IGV ETFs. Instead, here is an equally-weighted group of Tech companies selected for their individual strength in US10Y correlation, in addition to being present in a moderately-correlated sector.
In terms of market capitalization for the overall group of NQERR portfolio companies, the average was $59.8B, while the weighted average was $70.2B (as of February 28, 2022). The median was $34.0B, and the range from largest to smallest was $404.2B. As can be seen below, the size segmentation of NQERR skews to the lower end of large-cap, with 70% of index weight coming from companies with market capitalizations below $25B.