Surviving Despite Casualties
The index construction of the Nasdaq 100 is rather straight-forward, investing in the largest non-financial companies that are listed on the Nasdaq exchange. That list has changed quite a bit more than most would dare to assume over time, and that “changing,” is what allows an index to survive long periods of time despite many of its holdings being unable to do so. An index formed by a market capitalization factor is not expected to be nimble through every market cycle, but the changes that occur over time can be substantial. The process of letting stocks fall out when they lose capitalization helps the index survive by not being stuck with a bunch of securities heading to zero eventually. The image below helps to make this point, as we provide the list of Top 25 weights in the Nasdaq 100 Index today, as well as in March 2000. In both cases, these 25 stocks account for more than 70% of the total index weight. The Index has returned to roughly the same price as it was 16 years ago, but has done so with very different investments. For instance, we’ve highlighted (left) the stocks that are among the Top 25 today and that were also among the Top 25 back in March 2000 (there are only six). We also illustrate (right) how many of the Top 25 holdings in March 2000 are no longer in the Index at all today (the majority of them).
Sector rotation is a byproduct over time for an index of this kind. In the mid-90s the Technology sector accounted for about 1/4th of the weight of the Nasdaq 100, a level of saturation that would rise quite a bit as the index itself did in the 1990s. In a recent article titled, “My How Things Have Changed! A New Look at Nasdaq-100,” Nasdaq discussed some of the changes in complexion this Index has endured over time. “The tech boom of the mid-1990s helped perpetuate the idea that the Nasdaq 100 was a “tech index.” By November 1998, with the tech-driven bull market in full force, technology stocks accounted for an unprecedented 70% of the market cap of the Index. By the early 2000s, tech stocks continued to dominate the Index. Tech continued its prominence into the next decade. Even as recent as 2011, when tech companies were the driving force in the recovery of the financial crisis, technology represented 61.6% of the index market cap.” Today the Index is a little more than 50% weighted in Technology, which is quite a bit beneath its highest such levels, but also twice the Technology exposure observed prior to the 1990s. Leadership can change within a market cap weighted index, it just does so in a different manner and at a different pace. Ultimately, that process allows an index (and the investment products that track it) to have a much higher survival rate than the securities that comprise it.
The Electoral Map of the Market: House of Representatives vs Senate
The Nasdaq 100 Index is among the most widely followed growth indices in the world. When you look underneath the hood of the index you will find that not all stocks are created equal. This is because the stocks with the highest market capitalization receive more weighting than those with a smaller capitalization. Currently, Apple Computer AAPL has the highest market cap, and thus receives the highest weighting at about 10.5%. On the other hand, Bed, Bath & Beyond BBBY carries a weight of just 0.13% as one of the smallest companies in the Index. This weighting methodology creates a portfolio where only a small portion of the stocks in the index have a meaningful impact on the index as a whole. Hence, the Top 25 stocks account for more than 70% of the movement of the Index. The other 75+ holdings fight over the remaining 30% of this Index.
To help explain this concept to your client, consider an example of the Congress of the United States, specifically the House of Representatives. The House of Representatives consists of 435 members from across the United States; however, each state does not have an equal number of representatives. Rather, each state receives seats in the House based on the population (like market capitalization) of that state. So, the more people that live in a state, the more seats in the House they will receive relative to the other states. For instance, based on estimated July 2015 numbers from census.gov, the United States had a population of 321 million people. The most heavily populated state in the country is California, which had a population of about 39 million or 12% of the country’s population. Therefore, the state of California receives 53 out of the 435 seats (12%) in the House based simply on the size of the state in terms of population. This is very similar to the way that Apple Computer receives the largest weighting in the Nasdaq 100 based upon having the largest market cap. The allocation of seats in the House gives the state of California, essentially, a 12% weighting. Next would be the state of Texas, which has 36 seats in the House for 8% of the vote. New York and Florida both have 27 seats for a 6% voting share.
On the other hand, states that have smaller populations do not receive as many seats. Therefore, Alaska, Vermont, Wyoming and the Dakotas have only one seat in the House each, which amounts to just 0.23% of the vote! Clearly, the House of Representatives is not an “equal-weighted” body of Congress as some states receive a much larger weighting. On the other hand, the other body of Congress, the U.S. Senate, is an equal-weighted entity in which each state receives the same number of votes regardless of population. The Senate consists of 100 seats, two from each of the 50 states. Each of the 50 states receives a 2% weighting in the Senate. So, while California and Wyoming both have the same weighting in the Senate, California has more than fifty times Wyoming’s weight within the House.
We bring this example to your attention because we have found that it serves as a great analogy when explaining the differences between a traditional market capitalization weighted product versus an equal weighted product. In the case of the Nasdaq 100, an ETF exists to represent both the “House” (cap weighted) and the “Senate” (equal weighted) versions of this index. In fact, there are currently about 8 products that target many (if not all) of the names in the Nasdaq 100 in their own way (outside of traditional cap weighting). Below we highlight some of these products and how they are put together.
Nasdaq 100 Index: Cap-Weight vs Equal-Weight
The PowerShares QQQ Trust QQQ was the first ETF to begin tracking the Nasdaq 100 Index. It was launched in March 1999 and is currently the 9th largest ETF listed in the US, with about $39 billion in AUM. The “Q’s” were designed to mirror the “modified cap-weight” index, so it will naturally behave very much like the largest components of the Index. In fact, the top 10 stocks comprise nearly 50% of the Index (leaving the other 50% to the bottom 90 stocks). The top two holdings (Apple and Microsoft) make up 18% of the Index.
You can access exposure to those same 107 stocks included in the Nasdaq 100 Index through the First Trust Nasdaq 100 Equal Weighted Index Fund QQEW. However, unlike the QQQ, this ETF tracks the “equal-weighted” Nasdaq 100 Index NDXE, bringing each component of the Index to a weighting of roughly 1%. Relating this back to our example above, the “Q’s” are essentially the House of Representatives of the Nasdaq 100, while QQEW would be akin to the Senate.
The technical picture for both the equal-weighted and cap-weighted Nasdaq 100 products is positive. The default trend charts above have rallied nicely from their June pullbacks; however there are some differences between the two. Notice that while the QQEW still faces resistance around $45.5 from June of 2015, the QQQ has managed a new 52-week high and sits within one box if its all-time high set back in March of 2000. As a result, one would be correct in assuming that the larger weighted names have contributed to a great extent in the most recent push higher. We can look to an RS between the two funds to gain additional perspective on equal weightings versus cap weighting as it relates to the Nasdaq 100 stocks. Because the funds are highly correlated, we ran the RS comparison on a sensitive 1% scale shown below. The chart has maintained a Buy Signal since August 2011, favoring QQQ and provided further confirmation for cap weighted exposure. During this time, the QQQ is up about 105% compared to 88% for the QQEW (through 8/1/16). It is worth noting that both have outpaced the S&P 500 Index, which is up roughly 73% over the same time.
Nasdaq 100 Index: Tech vs Ex-TechIn 2006-2007, First Trust added a pair of products to their ETF lineup that allowed investors to delineate Nasdaq 100 exposure along sector categories, specifically Tech versus ex-Tech. The viability of these products, which total roughly $400 million in assets between the two today, speaks to the growth that the Nasdaq 100 has continued to experience through tertiary products even at the ripe old age of 31. The Nasdaq 100 inventory has evolved from the late-90s, at which point it truly was a “Technology” index, to its current composition today which includes a greater headcount of “ex-Technology” constituents. The First Trust Nasdaq 100 Technology Sector Fund QTEC launched in April 2006 with the mandate of tracking an equal-weighted basket of Nasdaq 100 components considered to fall within the broad Technology sector. Today, this fund invests in 36 such securities across the Semiconductor, Software, Internet, Computer Hardware, Computer Services, and Telecom sub-sectors. Meanwhile, the First Trust Nasdaq 100 ex-Technology Sector Index FundQQXT invests in all the “other” Nasdaq 100 companies, holding those in an equal-weighted fashion as well. At this time, the Fund has 69 holdings and is primarily overweighted in Consumer Cyclicals and Healthcare.
Both the “Tech” and “ex-Tech” products from First Trust that seek to track Nasdaq 100 sub-indices offer positive long-term trends (see charts above), with the “Tech” fund (QTEC) currently offering a stronger fund score at 4.81. The 2% scale relative strength chart (we used a 2% scale, instead of 1%, due to the Funds having no common holdings) between the two Funds confirms that strength lies with QTEC as the Fund has maintained an RS buy signal versus QQXT since June of 2014. In fact, with recent action QTEC gave a second buy signal on the RS chart toward the end of July.
Nasdaq 100 Index: Alternative Nasdaq-related ETFs
In the table below we have presented a full list of Nasdaq-related ETFs with at least $100 million in AUM. We will briefly discuss some of the funds that were not covered above in the following sentences. The Fidelity Nasdaq Composite Index ETF ONEQ launched in 2003 as a broader alternative to the Q’s, including exposure to the entire Nasdaq Composite Index of nearly 2,000 securities. It is a capitalization-weighted fund, and much of its exposure is dedicated to the Nasdaq 100 components. In June of 2008, PowerShares launched thePowerShares Nasdaq Internet Portfolio PNQI which is a modified market cap-weighted fund that primarily invests in large, liquid companies that are engaged in Internet-related businesses. The Fund has about 84 holdings as of August 1st and 14 of the Fund’s holdings can also be found the Nasdaq 100. In August 2012, theFirst Trust Nasdaq Technology Dividend Index Fund TDIV began trading, which uses a dividend value weighting methodology as well as a rising dividend screen to construct its portfolio. This Fund does use an inventory beyond that of only Nasdaq listed securities, however, and it can also have exposure to Telecom stocks as well. In February 2014, PowerShares and Nasdaq began utilizing a DWA index to enhance the PowerShares DWA Nasdaq Momentum Portfolio DWAQ, seeking to track a relative strength driven strategy. Like some of the aforementioned funds, DWAQ is not bound by strictly the Nasdaq 100, but rather uses a starting inventory of roughly 1,000 Nasdaq-listed companies. From there, we employ relative strength to reconstitute the portfolio of 100 stocks each quarter. Index components must earn their way into the portfolio with superior performance trends relative to other Nasdaq listings, and the current composition of DWAQ includes 22 such Nasdaq 100 components.
The purpose in discussing the different products out on the market that seek to track the NDX Index, or other indices, is to show that ETFs give investors the ability to take different investment approaches, while investing in similar baskets of stocks. The NDX is not the only index out there that has a number of products that seek to utilize the index differently. With the market rallying to new highs recently, it is worth taking time to assess the various products that follow an index your client is looking to gain exposure to. The ability to get more granular and focus on where we may want to gain exposure to an index is part of the innovation that ETFs provide to the marketplace.
Not only do these ETFs give your clients a myriad of ways to invest in certain segments of the market, but they are also useful in gaining perspective on the market or segment that you may be watching. With the Domestic Equity markets showing positive signs recently, it is worth taking the time to look at the different products that may track an index you are looking to gain exposure to. One of them may be just what you are looking for and could be a good addition to your shopping list of ETFs.
Nasdaq (Dorsey Wright’s parent company) provides the Nasdaq 100 Index for use in some of the products described above, and as a result receives licensing fees from the products’ sponsors. These license fees are calculated as a percentage of assets invested in the products.
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Neither the information within this email, nor any opinion expressed shall constitute an offer to sell or a solicitation or an offer to buy any securities, commodities or exchange traded products. This article does not purport to be complete description of the securities or commodities, markets or developments to which reference is made.
The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Relative Strength is a measure of price momentum based on historical price activity. Relative Strength is not predictive and there is no assurance that forecasts based on relative strength can be relied upon.
Unless otherwise stated, the returns do not include dividends for stocks or ETFs. Unless otherwise stated, returns of stocks and ETFs do not include all fees or transaction costs. Investors cannot invest directly in an index. Indexes have no fees. Past performance, hypothetical or actual, does not guarantee future results. In all securities trading there is a potential for loss as well as profit. It should not be assumed that recommendations made in the future will be profitable or will equal the performance as shown. Investors should have long-term financial objectives.