Research Note - Why NASDAQ is Not in Main Portfolios

Background – NASDAQ and the 2020 Recovery Portfolio/Sleeve

The Focused 15 Investing publications have included a 2020 Recovery Portfolio or Sleeve since April 4, 2020.  A key contributor to its return has been NASDAQ-linked ETFs.  The NASDAQ stock index has a high concentration of technology companies. The top 10 holdings of the largest NASDAQ ETF are the following.

 

Name	% Assets
Apple Inc	13.00%
Microsoft Corp	10.70%
Amazon.com Inc	10.62%
Facebook Inc A	4.42%
Alphabet Inc A	3.89%
Alphabet Inc C	3.78%
Tesla Inc	3.22%
NVIDIA Corp	2.75%
PayPal Holdings Inc	1.94%
Adobe Inc	1.91%

   Source: https://finance.yahoo.com/quote/QQQ/holdings/

The top three holdings – Apple, Microsoft, and Amazon – make up over 30% of the total ETF.  Many of companies represented in these top holdings have done well during the pandemic. 

The 2020 Recovery Portfolio/Sleeve has been a good addition to the publication in terms of performance, but for many subscribers there has not been an easy way to incorporate it into their accounts.  The recent change (Oct 30, 2020) in the Shares-to-Trade worksheet makes it easier to incorporate this sleeve. 

As shown on the weekly publications, the 2020 Recovery Portfolios have performed well since their introduction and over the last few years (in simulations).  This raises the question as to whether the NASDAQ ETFs should be permanently included in the main model portfolios. 

The bottom line is that NASDAQ has performed well in 2020, but it is too soon to conclude that NASDAQ should be permanently added to the main model portfolios. Companies prominent in NASDAQ currently have high stock valuations, and, while NASDAQ has outperformed the DJIA (which pays a central role in our main model portfolios), this outperformance may not last in a manner that we can capture it. 

The rest of this post covers:

• An MRI-Based Analysis of NASDAQ: the performance of NASDAQ and the success of MRI-based decision rules
• Comparison of DJIA and NASDAQ Sleeves

 

An MRI-Based Analysis of NASDAQ

At the time I designed the approach we use in Focused 15 Investing (2007-2010), the NASDAQ was clearly an important index.  Yet its price history was short (beginning in 1972) and was dominated by the internet/tech boom of the late 1990s and the following bust.  I had no trouble at that time developing algorithms that effectively participated in the upside and avoided the downside of this boom and bust.  But I had little confidence that those algorithms would be effective in future cycles because the success was proven over just one cycle. 

Instead, I developed algorithms for the NASDAQ that were informed not only by this relatively short time span but also reflected the principles that had proven useful with DJIA and other major indexes. With those algorithms in place, I have been monitoring performance of NASDAQ-linked sleeves since then. 

The graph below shows the available price history of NASDAQ.  The prominent peak is in 2000.  This chart is on a log scale to show the variability over the entire historical period.  The decline from the peak in 2000 to the low point in October of 2002 is roughly 80% — a very painful decline. 

The chart also shows a vertical blue line at the end of 2007, which is when the NASDAQ algorithms were finalized. 

The graph below shows the performance of the NASDAQ algorithms that were finalized as of the end of 2007. One can see that, overall, the NASDAQ algorithms (yellow line) performed well relative to NASDAQ buy-and-hold (red). Yet, because these algorithms incorporate principles from other indexes, they do not participate in all the upside of the NASDAQ nor avoid all the declines after the peak in 2000.

 

 

There are four important periods in this history. 

1. From 1990 to 2000, the performance of the traded sleeve shown by the yellow line (rotating out of NASDAQ using MRI-based algorithms) underperformed the NASDAQ buy-and-hold (red). This pattern is expected in the MRI-based approach – after long positive price trends, the market tends not to decline during periods of vulnerability as investors become more euphoric.
2. During the decline of the NASDAQ from 2000 to October 2002, NASDAQ declined in price and in the unsustainably high valuations of the late 1990s. The traded sleeve avoided some of the losses of the NASDAQ buy-and-hold but still had meaningful losses.
3. During the period from about 2004 to about 2015, the traded sleeve had smaller losses than the buy-and-hold.
4. During the period from about 2010 to present, the traded sleeve avoided some of the losses of the NASDAQ buy-and-hold but still tended to underperform the buy-and-hold. Underperforming on a long positively-trending market, and in both periods A and D, is not unusual for the Focused 15 Investing algorithms.

Although not shown as a separate period, one can see in the graph above that the traded sleeve had positive returns in 2020 through 11/27/2020. 

 

Comparison of DJIA and NASDAQ Sleeves

The graph below shows the performance of two sleeves.  The top sleeve (in yellow) is the DJIA sleeve using ETF DDM (DJIA x2).  The next sleeve is the NASDAQ signal set using ETF QLD (NASDAQ x2).  The lower line is a buy-and-hold mix of the DDM and NASDAQ for comparison.  As you can see, the DDM sleeve (yellow) clearly performed better than the QLD sleeve (blue line) up until the end of 2019.  For this roughly 20-year timeframe, the DJIA sleeve had superior returns.  This is especially true just after 2000, where the NASDAQ sleeve had losses (this period was marked “B” in the prior graph).  

The image also highlights the most recent performance in 2020 when the DDM sleeve moves lower and the NASDAQ sleeve moves higher.  This has been unfortunate but can, I believe, be associated with the pandemic and does not necessarily indicate a permanent shift.

If we look at the same sleeves but end the graph 52 weeks ago, we see that the DDM sleeve has a better return and lower variability. 

This is shown by the statistics in the table below. 

Return and Variability (1/7/2000 through 11/29/2019)

                                          DDM                     QLD

  Rate of Return (ann)       28.8%                    26.1%

  Variability (ann)              20.4%                    25.4%

  Ratio (RoR/Var)               1.42                       1.03

 

Now, at the end of 2020, the question is whether NASDAQ-linked ETFs should be included in the regular model portfolios.  My current thought is that 2020 should be viewed an aberration.  If we respond by changing the approach significantly to what would have worked in 2020, we may be poorly positioned for the future.  In addition, we might be simply chasing past performance only to catch price declines associated with correcting the currently high valuations, as in phase B in the graph above. 

If this view is accurate, then gaining exposure to the NASDAQ may be best done using the add-in sleeves in measured amounts as is currently available to subscribers.  The add-in sleeves allow us to move away from the NASDAQ completely during long periods of NASDAQ decline. 

Even if the NASDAQ does indeed represent companies with a more promising future than those in the DJIA, the current economic strains and NASDAQ’s high valuations make it difficult to justify a move to include NASDAQ as a permanent holding in the model portfolios right now. 

As part of ongoing research, I have a range of model portfolios that integrate NASDAQ, and so I monitor this issue.  But the best course of action right now is not to make fundamental changes in the model portfolios. 

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