A new way to capture innovators
SCOTT KEFER, CFA 22-Oct-2020
Investors often look toward thematic approaches to capture what they believe will be above-market returns and boost the performance of an overall investment portfolio. Technology—or perhaps innovation—has been one area that investors will continue to exploit. But rather than looking to the very largest companies, an argument can be made be made for an approach centered on the innovators tracked by the Nasdaq-Q50® Index.
One of the most popular thematic tech approaches has been to invest in funds linked to the performance of Nasdaq-100® Index, which simply tracks the 100 largest companies, excluding financials, listed on the Nasdaq Exchange. The Nasdaq-100® Index is approximately 48% weighted toward the tech sector, and it has delivered annualized returns of in excess of 17% for the 10 years ended September 30, 2020*. It’s a fine approach and there’s little wonder why it has attracted so much investor attention (and capital).
But when it comes to investing in tech and innovation, there are alternative ways to allocate that need not rely so heavily on the continued success of a handful of high-profile companies. Consider that the top six constituents of the Nasdaq-100® Index make up approximately half the index, as of the end of the third quarter. So while the Nasdaq-100® Index offers exposure to iconic disruptors that have excelled in both pre-pandemic and current environments, it is these very largest companies that dominate and drive performance. As a result, the impact of the smaller constituents, although they are established and successful companies themselves, is diluted.
The chart above illustrates the point by depicting the 150 largest non-financial securities, ranked by market cap, listed on the Nasdaq Exchange. The largest 100 of these are in the Nasdaq-100® Index, and the next 50 largest are in the Nasdaq-Q50® Index. Both share an identical cap-weighting methodology and aim to offer exposure to some of the finest—and most disruptive—companies trading on the Nasdaq Exchange.
However, the smallest constituents in the Nasdaq-100® Index are dwarfed by the largest and can barely move the needle on performance of the index, no matter how robust. In contrast, the difference between the smallest and largest constituents in the Nasdaq-Q50® Index is markedly less extreme, which suggests that risk and the ultimate performance is spread more evenly across all its holdings.
There’s no doubt that the mega-cap companies have dominated the tech space in recent years. They represent today’s leaders, and they aim to continue innovating and pressing their competitive advantages. But who will be tomorrow’s leaders? There are scores of smaller companies with fascinating stories that investors may want to consider. These are not speculative per se, but rather mid-cap growth names that most likely already have demonstrated how they are disrupting the status quo in areas such as biopharma, artificial intelligence, software development and elsewhere. Fifty of these innovators are tracked by Nasdaq-Q50® Index.
Thematic investing remains attractive to many growth and tech-oriented investors. Finding a complimentary approach to the iconic Nasdaq-100® Index might be appropriate when looking for the next generation of innovators.