Investing in the NASDAQ

Key Concepts

• NASDAQ Exchange: An electronic stock market founded in 1971, initially as a system for distributing securities quotes electronically.
• NASDAQ 100 Index: A market capitalization-weighted index of the 100 largest non-financial companies listed on the NASDAQ Stock Market.
• Over-the-Counter (OTC) Market: A decentralized market where securities are traded directly between parties without a central exchange.
• Pink Sheets: Publications that historically listed OTC stock prices.
• Market Makers: Financial institutions that provide liquidity by quoting both buy and sell prices for securities.
• UNIVAC 1108: Early mainframe computers used in the initial NASDAQ system.
• Market Capitalization Weighted Index: An index where the weight of each constituent is determined by its market capitalization.
• Drawdown: The peak-to-trough decline during a specific period for an investment.
• Exchange-Traded Funds (ETFs): Investment funds traded on stock exchanges, mirroring the performance of an underlying index.
• Swap-Based ETFs: ETFs that use derivatives (swaps) to replicate index performance, often avoiding withholding tax on dividends.
• Physically Replicated ETFs: ETFs that directly hold the underlying securities of the index.
• Withholding Tax: A tax deducted at source from payments, such as dividends.
• Total Expense Ratio (TER): The annual fee charged by an ETF to cover its operating costs.
• Counterparty Risk: The risk that the other party in a derivative contract will default.
• Research and Development (R&D) Spend: Investment by companies in innovation and new product development.

The Genesis of NASDAQ and its Index

The video delves into the history and significance of the NASDAQ index, tracing its origins back to the NASDAQ exchange. Before the 1970s, trading stocks not listed on major exchanges like the NYSE occurred in the inefficient and slow over-the-counter (OTC) market. Brokers relied on "pink sheets" and manual phone calls to market makers to execute trades.

In December 1968, the U.S. National Association of Securities Dealers (NASD) contracted with Bunker Ramo to develop the NASDAQ system, standing for National Association of Securities Dealers Automated Quotations. This system was designed to electronically distribute quotes across the U.S. The core of this groundbreaking system comprised two UNIVAC 1108 computers located in Trumbull, Connecticut. The development was a monumental task, as no computerized information gathering system of this scale had been built before. Brokers used specially designed, user-friendly keyboards to enter quotes, which were then aggregated and distributed. A crucial innovation was the ability to calculate and distribute an index representing the average price of stocks in the system to newswires. The UNIVAC Exec 8 operating system was upgraded for real-time transaction processing, operating over transmission lines with limited capacity (a few thousand bits per second). The system launched with remarkable success, achieving 99.92% uptime in its first year.

The NASDAQ 100 Index: Composition and Characteristics

The NASDAQ 100 index, launched in 1985 alongside the NASDAQ Financial 100 index, comprises roughly the largest 100 non-financial stocks trading on the NASDAQ exchange. While the NASDAQ 100 gained prominence, the Financial 100 index did not capture investor attention. Consequently, the NASDAQ 100 excludes financial stocks.

The index is market capitalization weighted, but it incorporates special rebalancing mechanisms to prevent over-concentration. For instance, in July 2023, the weight of the seven largest stocks was reduced from 56% to 44%. A key requirement for NASDAQ 100 stocks is high trading volume, with a minimum of 200,000 shares traded daily, ensuring low trading costs due to tighter bid-offer spreads.

While often perceived as a tech index, its sector composition is more diverse. Information Technology constitutes over half of the index, significantly more than the S&P 500. However, it also includes sectors like utilities, materials, and energy, albeit in smaller proportions than the S&P 500. Notably, the NASDAQ 100 has a minimal allocation to financials, with PayPal being an exception, included in 2015. It also shows overweights in communication services and consumer discretionary sectors compared to the S&P 500. The innovative nature of NASDAQ 100 companies is reflected in their higher average research and development (R&D) spend, with an average weighted R&D spend of approximately $18 billion for NASDAQ 100 companies, compared to $13 billion for S&P 500 companies.

Investing in the NASDAQ 100: Risks and Exposure

Investing in NASDAQ 100 products carries inherent risks, including volatility and price fluctuations. Specific risks associated with NASDAQ 100 exposure include concentration in mega-cap stocks and a single country, as well as currency risk. For synthetic ETFs, risks related to derivatives and counterparty risk are also present.

Invesco offers various ways to gain exposure to the NASDAQ 100. Their UK-domiciled NASDAQ 100 tracking ETF, with ticker EQQ, has a fee of 0.3% and a 22-year track record, often outperforming other NASDAQ 100 trackers. To mitigate withholding tax on dividends, Invesco provides a swap-based version (ticker EQQS) with a 0.2% fee. This version utilizes total return swaps to increase the proportion of dividends retained, thereby enhancing total return.

Addressing the concentration risk in mega-cap stocks, Invesco offers an equal-weighted NASDAQ 100 ETF (ticker EWQX) with a 0.2% fee. This ETF maintains the index's composition but assigns equal weight to all constituent stocks, rather than market capitalization weighting.

The video distinguishes between swap-based ETFs, where returns are generated through derivatives, and physically replicated ETFs, where the fund directly buys the underlying stocks. Swap-based funds may have counterparty risk but benefit from no withholding tax on dividends, leading to higher total returns. Physically replicated ETFs incur some withholding tax.

Historical Performance and Drawdowns

The NASDAQ 100 has demonstrated strong historical returns. Between 1990 and 2025, its annualized return was 14%, significantly outperforming the S&P 500's 8.5% over the same period. This outperformance is attributed to the faster growth in revenue, earnings, and dividends of NASDAQ 100 companies compared to those in the S&P 500, as evidenced by growth rates from 2014 to 2024.

However, the index has also experienced significant drawdowns. The dot-com bubble and the global financial crisis led to substantial declines. The NASDAQ 100 fell by over 80% during this period, compared to about 50% for the S&P 500. The recovery for the NASDAQ 100 was also prolonged, with the drawdown that began in March 2000 taking nearly 16 years to recover from.

Ways to Gain Exposure to the NASDAQ 100

Investors can gain exposure to the NASDAQ 100 primarily through Exchange-Traded Funds (ETFs) that track the index. Several ETFs are available in Europe, offering different features:

• Income vs. Accumulation: Some ETFs pay out income, while others reinvest it (accumulation funds).
• Domicile: Funds domiciled in Luxembourg may incur higher withholding tax on dividends compared to those domiciled in Ireland, potentially leading to slightly lower returns.
• Synthetic vs. Physical Replication: Synthetic ETFs use derivatives and may not incur withholding tax but can have swap fees. Physically replicated ETFs directly hold the underlying stocks.

Invesco's QQQ ETF, launched in 1999 for U.S. investors, is a prominent example with over $370 billion in assets under management. The UK version is known as EQQ.

Conclusion

The NASDAQ exchange and its flagship index, the NASDAQ 100, have a rich history of innovation, starting with the automation of stock quotes. The NASDAQ 100, while heavily weighted towards technology, offers exposure to a diverse range of large, non-financial companies. Historically, it has delivered strong returns, driven by the fundamental growth of its constituent companies. However, investors must be aware of its inherent risks, including concentration and historical drawdowns. Various investment vehicles, particularly ETFs, provide accessible ways to gain exposure, with options catering to different investor preferences regarding fees, tax implications, and replication methods. As always, thorough personal research is crucial before making any investment decisions.