Nasdaq’s Unprecedented Rebalance
“Investing in tomorrow’s technology today is more critical than ever.”
A quick trawl through recent data points and statistical analysis suggests that investors in public markets are taking the words of Bill Gates a little too literally. So far this year, we have seen an enormous AI-enthused tech rally.
The Nasdaq 100 is the world’s pre-eminent benchmark for the performance of publicly listed growth stocks and serves as the underlying reference index for numerous financial products, with hundreds of billions of US dollars in AUM.
Following stellar performance this year that has partly been spurred by demand for mega-cap tech stocks, amid a broader-themed technology rally, the index has become distorted to the extent that the six largest constituents collectively account for more than 50% of the index’s total exposure (as illustrated below).
However, it would be fallacious to believe this is a 2023 problem. The penchant among public-market investors to simply ‘buy the tech sector’ as cheaply and efficiently as possible has been largely driven by the near-zero interest rate policy pursued by Western Central Banks from 2009 to 2021. After a rout in 2022, the tech rally has been revived by a widespread conviction that AI will redefine our future and a belief that the Federal Reserve’s hiking cycle is nearing its peak.
Nasdaq Inc reports that the rebalance will occur on July 24 and “address overconcentration in the index by redistributing the weights”. Further rebalances could occur in the future to ensure that the index’s exposure to the ‘big six’ is no greater than 40%.
Chasing the rally…
Although the Nasdaq 100 is a capitalization-weighted index, meaning that passive investment flows are automatically directed in favor of the largest index constituents, equally weighted technology gauges1 have also enjoyed a stellar year, implying this is an indiscriminate tech rally. This is also illustrated by capital flows to technology stocks which are at, or near, multi-year highs.
However, chasing the stock market rally in 2023, really just involves jumping on the tech bandwagon, as analysis of the S&P 500 Index – a broad gauge of the US equity market – clearly shows. Like the Nasdaq 100, the S&P 500 is capitalization-weighted. But, unlike the Nasdaq, the broad diversity of the S&P 500 typically ensures that there is no performance basis in favor of the largest constituents.
According to an analysis carried out by the Bank of America Institute, the capitalization-weighted S&P 500 Index has typically underperformed an equally weighted gauge of the same companies by an average of c.5% during the first six months of the year. Yet, in the first half of 2023, the capitalization-weighted index outperformed by almost 20%. The same analysis shows that 72% of overall gains were driven by the seven largest stocks in the capitalization-weighted index. These comprise Apple, Microsoft, Amazon, Nvidia, two different share classes of Alphabet (the parent of Google), and Meta Platforms (formerly Facebook).
However, the steepness and extent of the rally in publicly traded tech stocks mean that valuations are now looking stretched. The same seven stocks are trading at a trailing price/earnings (P/E) ratio of around 40, while the P/E of the remainder of the index is 15. The P/E is an important gauge of relative valuations because it tells the investor how long (in years) it will take to recoup the capital cost of buying a stock in accrued earnings. Tech stocks inevitably trade at a premium because of their potential to grow their earnings – but a differential of 25 is substantial by historical precedent.
Mind the gap…
The current landscape in growth equity secondaries showcases a significant disparity in valuations and the latest market trends due to the unprecedented demand for public market tech and an overcorrection in private market growth equity. This has created the largest gap witnessed in the last ten years and presents a compelling entry point for investors.
This trend is beginning to reverse as we shift towards a buyers’ market, as early investors, employees, and founders, who anticipated an IPO in the preceding two years seek to sell a proportion of their holdings. With evidence emerging that private market asset prices are beginning to creep upward, we have, in all likelihood, already entered the sweet spot.
The IPO market has largely been frozen over the last two years because market conditions have proved a disincentive, causing companies to remain private for longer. The unfavorable environment has been illustrated by the Renaissance IPO ETF, which aims to provide investors with exposure to the largest and most liquid newly public companies in the US. The index suffered a peak-to-trough fall of 68%2 during the 2021-22 period. However, in the first six months of 2023, it rebounded by 34%2, suggesting a renewed appetite for newly quoted companies and the likelihood of a more vibrant IPO market going forward.
ETF-style investing in growth equity…
The spectacular performance of the Nasdaq 100 year to date, not only illustrates the voracious appetite for publicly listed tech stocks but flows into the numerous financial products that use the Nasdaq as a reference index epitomize the penchant among investors for index-related products. This has necessitated the imminent and unprecedented rebalance of the Nasdaq 100 Index.
Until recently, there have been no index-related options for investors in private markets, and the entire universe has been characterized by significant barriers to entry, including high investment minimums, long lock-up periods, and professional investor restrictions.
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An attractive entry point…
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Massive investor appetite for publicly listed tech stocks and the associated valuation gap provides the potential for multiple expansions as the gap closes amid continuing optimistic sentiment towards technological innovators. Meanwhile, private companies will be the prime beneficiaries of the prospective reopening of the IPO market, regardless of any stated intention to go public in the near term.
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1. Such as First Trust Exchange-Traded Fund-First Trust Nasdaq-100 Equal Weighted Index. 2. Source: Bloomberg.
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