The NASDAQ Composite Index Is Useless


Posted in: Economics, General, Stock Market, Thought of the Week

Investors who watch the financial news networks have been inundated by commentary on the NASDAQ Composite Index this year. This index is gaining headlines due to it approaching an all-time high back in early March and ending the quarter with an impressive gain of 3.79% versus the S&P 500 at 0.95%.

Due to the attention from the media and the strong relative performance against the S&P 500, many investors, particularly conservative ones, are frustrated to see their returns well below that of the NASDAQ.

However, there are three main reasons why the overwhelming majority of investors should ignore the NASDAQ altogether: (1) Composition, (2) Volatility, and (3) Applicability.

Let’s begin with a comparison of the composition of the two indices. The NASDAQ Composite Index includes all companies listed on the NASDAQ Stock Exchange, which currently stands at more than 3,000 listed stocks. However, these companies typically represent higher growth ones and are concentrated into specific sectors like technology and biotech.

The S&P 500 includes 500 companies from all sectors of the economy with stocks listed on either the New York Stock Exchange (NYSE) or the NASDAQ Stock Exchange. The companies in the S&P 500 account for roughly 75% of the value of all U.S. equities and is therefore well-regarded as the most representative index for large-cap U.S. equities.

The differences in composition explains why the NASDAQ Composite outperformed the S&P 500 by such a wide margin in the first quarter. For example, energy stocks were hit hard as the price of oil continued to fall, and the S&P 500 has a much higher proportion of energy stocks, which created a drag on the index. Furthermore, high growth sectors like biotech remained strongly
in favor.

Simply put, the NASDAQ Composite Index is nowhere near a representative example of the overall U.S. equity market because it’s concentrated towards high growth stocks in specific sectors.

The second reason why investors should ignore the NASDAQ goes back to one of the most fundamental principles of finance. In March and April of last year, the NASDAQ Composite (dashed line) fell 8.22% vs. a drop of only 3.10% for the S&P (solid line). Go back over the last 20 years and investors will see that this type of heightened response to market dips in the NASDAQ is the norm.

Simply put, higher returns are only possible by accepting higher amounts of risk and/or volatility, and only those investors who can stomach major swings should consider tracking the index.

The third reason why investors should ignore the index is because professionals also ignore it, in that practically no money managers use the NASDAQ as a benchmark.

Based off a universe of just under 4,500 funds that are available in the US, a total of 759 (approximately 18%) are benchmarked against the S&P 500, whereas only 32 (less than 1%) are benchmarked to the NASDAQ Composite or NASDAQ 100 (a smaller universe of the 100 largest companies on the NASDAQ Stock Exchange).

Simply put, the NASDAQ is an index that may appear interesting to the media, but barely any mutual funds, exchange traded funds, or fund of funds consider the index to be relevant, and neither should you.

The single most desired characteristic of an investment is its ability to grow over time, and those investments that offer the opportunity to grow like weeds tend to garner more attention from the media because the stories are often far more exciting than conservative ones.

Investors can only profit from hyper-growth stocks if they are willing to accept hyper-risk. It’s that simple, and it’s a concept taught on day one of any finance class. For every high-flying tech stock that succeeds over the long run, there are dozens upon dozens that go nowhere and/or simply fail.

The bottom line is that even though the NASDAQ is an index regularly quoted on TV right next to the S&P 500, it does not provide broad U.S. equity market exposure. The index’s tilt towards more risky industries and characteristics make it a near useless barometer for a conservative investor.

Read this week’s Thought of the Week to learn more about the NASDAQ index.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.