Why the Nasdaq Isn't a Particularly Good Investment

Ruth Saldanha: Many investors look at the major U.S. indices, the S&P 500, the Dow Jones Industrial Average and the NASDAQ, and think that if they invest in one of those three, they're good to go. But we think that one of those is not like the others. According to us, the NASDAQ is not a particularly good investment. Morningstar's Ryan Jackson is here to tell us why. Ryan, thank you so much for being here today.

Ryan Jackson: Thanks for having me, Ruth. Excited to be here.

The Nasdaq 100 Looks Out for the NASDAQ, Not the Investor

Saldanha: So what are your thoughts on the Nasdaq-100 Index?

Jackson: So the Nasdaq-100 is a very interesting index. This is the benchmark for Invesco QQQ Trust. We have a Morningstar analyst rating of neutral on that fund, which means we don't think this fund will meaningfully outperform its category index, in this case the Russell 1000 Growth on a risk adjusted basis over the long term. So when you think about the Nasdaq-100 Index construction, really all it's doing is taking the 100 largest non-financial stocks that are traded primarily on the NASDAQ exchange and weighting them by their market capitalization. On the surface it seems like a very harmless approach, but there are some really big problems that spring from this tactic.

First and foremost, it really does not make much sense to select, include or exclude stocks based on where they trade. You know, it's very common to see fund's select stocks or narrow their selection universe based on some set of investment criteria, but these are almost always backed by something that resembles some sort of economic rationale. That is really not the case here, where stock trades has no bearing on its investment merit. And we see this as almost more of an effort by NASDAQ, the index provider, to promote the business of NASDAQ, the exchange provider. I kind of equate this to ordering food at a restaurant that exclusively shops for ingredients at the grocery store right next door. You know, it might be more efficient, it might be better for their business, but at the end of the day the finished product might be missing something that you kind of have to venture outside the lines for.

Another big drawback to the Nasdaq-100 Index and Invesco QQQ Trust is that we have some pretty meaningful sector concentration here. Tech is obviously the best known technology stocks represented about half of the portfolio at the end of September. But you've also got some fairly sizable tilts towards consumer discretionary stocks and communication services stocks, each of which represented about 16% of the portfolio at the end of September. On the other hand, QQQ does not hold any real estate, energy, financials or basic materials stocks. So while these tilts are pretty common for growth funds. This fund takes it a little bit too far and could leave some investors with some undesirable outcomes like we've seen so far this year when it's lost about one-third of its value and finished in the bottom half of the large growth category.

You're Missing Some Big Stocks if You Buy Only the Nasdaq - Even in Tech

Saldanha: I'd like to follow up on a couple of things you said. First up, what are some of the notable exclusions to the index?

Jackson: Yeah. So, I touched on a little bit, but there are really two main reasons that we would see large stocks that meet the size criteria excluded from the Nasdaq-100.

Number one, it's automatically excluding any financial stocks. The financial sector isn't the largest part of the U.S. market, but it definitely includes some heavy hitters. Berkshire Hathaway (BRK.B) comes to mind. That was the 6th largest stock in the U.S. at the end of September. And then some of those bulge bracket banks here, you know, Bank of America (BAC), JPMorgan (JPM), you will not find in this portfolio either.

The other reason that we would see stocks excluded from the index is because they do not trade primarily on the NASDAQ exchange, you usually find them on the New York Stock Exchange. You know, this leads to some notable exclusions. You've got your big health care firms, some of which don't make the cut, Johnson & Johnson (JNJ), United Health Group (UAHC), couple of big energy players like ExxonMobil (XOM) or Chevron (CVX), names that this fund certainly would have really liked to have so far this year.

And then there are even some surprises that you don't find in this portfolio. You know some tech stocks like Salesforce (CRM), Oracle (ORCL), IBM (IBM). You'd think these would be good candidates to fit in the tech heavy NASDAQ, but because they primarily trade on the New York Stock Exchange, they are not eligible for inclusion here. So this kind of just reinforces that the Nasdaq-100, while we think of it as a tech index, doesn't necessarily fit that peer mold.

The Nasdaq 100 Isn't the Best Tech Index

Saldanha: I want to talk a little bit more about that? Because investors often use the Nasdaq-100 Index as a shorthand for a tech basket. You went into it a little bit, but could you expand and tell us why this is not such a good idea?

Jackson: Yeah, it's hard to say exactly how NASDAQ emerged as the go to tech option for investors. I think we'd have to go back and trace through a couple of decades of trading and investing history to find that out. But for me, it seems to me like an issue of liquidity more so than anything else.

Invesco QQQ Trust is an enormous ETF entered this year with over $200 billion in AUM and that's something that's very easy for investors and traders to easily get in and out of and that's certainly an asset in the investing world. How it exactly got to that size? Well, it's had, you know, over 2 decades to get there. This is a fund that launched in 1999. You know, that was very early on in the ETF days. Actually wasn't the first tech ETF to hit the market or the first tech fund by any stretch, but it was very, very cheap, comparatively speaking back then. It was cheaper than a lot of tech options and by the time the rest of the herd kind of caught up to them on a cost basis.

They had built up quite a big following and quite a big investor base. So I think that legacy of both being NASDAQ the kind of tech brand and that early on just establishing themselves as number one it's been a hard legacy brand for them to shake.

Where Should You Invest?

Saldanha: So finally what are some alternatives for investors who do want exposure to American tech.

Jackson: Yeah, for technology alone, Invesco QQQ Trust is not a perfect tech fund. You know, we've touched on this a little bit. So if you want to look elsewhere, I think the best pureplay tech fund on an ETF basis to go to it would be Technology Select Sector SPDR ETF that trades under the ticker XLK. You know this is a very cheap tech option. All it does is take all of the technology firms in the S&P 500 and weight them by market capitalization. And by taking such a sensible simple approach, it's able to charge a very low fee. So this is a very low cost, investor friendly option.

Elsewhere it's worth noting that the large growth market as a whole is very, very tech heavy as it is right now. So investors hoping for a little bit of tech exposure without necessarily going all in can look to something like Vanguard Growth ETF, ticker VUG, or iShares Russell 1000 Growth ETF, ticker IWF. Even these are, you know, more broadly diversified growth strategies, they're still going to have, you know, between 40% and 50% of that portfolio stashed in tech. So investors would certainly still be getting their technology fix.

Saldanha: Great. Thank you so much for joining us today, Ryan.

Jackson: Thank you, Ruth.

Saldanha: For Morningstar, I'm Ruth Saldanha.