In a recent blog ‘This is where Warren Buffett wants his money to be invested….‘, we talked about how the S&P 500 Index is a good investment option if you want to diversify outside the Indian equity market.
But, going the S&P 500 way isn’t your only choice. Another, popular and widely tracked US equity market index is the Nasdaq 100.
How does it compare with the S&P 500? Which of the two should you pick?
Read on to find out more.
About the indices
S&P 500 – is made up of the 500 largest publicly listed (either on the New York Stock Exchange or the Nasdaq Stock Market) US companies across sectors. It accounts for 80% of the US stock market capitalisation and is regarded as a broad indicator of the country’s equity market.
Nasdaq 100 – is composed of the 100 largest domestic and international non-financial companies listed on the Nasdaq Stock Market. Unlike the broad- based S&P 500, the Nasdaq 100 is a tech-heavy index.
See the tables below.
While the S&P 500 can help you diversify across a wide range of industries (fast-growing as well as mature industries), the Nasdaq 100 will give you a concentrated exposure to the technology sector.
Investing in the Nasdaq 100 can therefore prove to be highly rewarding (via exposure to the high-growth tech companies) or disappointing (as in the dotcom bubble burst of the early 2000s), depending on the fortunes of the sector at that time.
Let’s see some data on how the indices have fared in the long run.
For our analysis, we calculate 5-year rolling returns using 33 years’ data on the S&P 500 TR (INR) and Nasdaq 100 (INR) from Jan-88 to Apr-20.
The US market indices, S&P 500 TR and the Nasdaq 100 have been converted into their rupee (INR) equivalents using the relevant USD-INR exchange rate. TR indicates total return and includes dividends (assumed to be reinvested in the index). The Nasdaq 100 (INR) returns have been adjusted to include 1% dividend yield.
Data shows you had a greater chance of getting higher returns with the Nasdaq 100 (INR) than with the S&P 500 TR (INR).
Over the last 33 years, the Nasdaq 100 (INR) has given investors an annualised 5-year return of 15% or higher, 61% of the time. The S&P 500 TR (INR) has done this only 54% of the time. See the table for more details.
But, what about volatility? Was the higher-return Nasdaq 100 also more volatile than the S&P 500? We check this using a few indicators.
We use a maximum drawdown chart to see how the two indices have performed in the down-market years. The chart plots the fall in an index value each day relative to its peak value until that day, over a period of time.
A more volatile index will have steeper drawdowns. You can see from the chart that the Nasdaq 100 has been more volatile and significantly so during the 2000s.
We also picked out a few cases of sharp drawdowns (from the chart above) across different time periods. See the chart below.
Except for on 23 Mar-20, the Nasdaq 100 (INR) falls have been steeper than those of the S&P 500 TR (INR).
Intra-year maximum drawdown
The difference in the volatility of the two indices is highlighted further when you look at the intra-year volatility charts. The charts below display the decline in an index value each day relative to the peak achieved by it in that particular year.
What do we find?
In 26 out of 33 years, the Nasdaq 100 (INR) intra-year drawdown has been sharper than that of the S&P 500 TR (INR)!
Wider range of six- month returns
Another way to gauge the extent of the volatility of an index is to check the range of its 6-month returns over a period of time. Wider the returns range, greater the volatility. See the tables.
Had you invested in the Nasdaq 100 (INR), your 6-month returns could have varied from -60% to as much as 99% over the last 33 years. With the S&P 500 TR (INR), your returns would have fluctuated within a narrower range, from -36% to 74%.
Further, we refine our results by excluding the extreme returns (top and bottom 2.5% returns) for each index. Let’s look at the second table which shows the ranges that contain 95% of the return possibilities. Even after the extreme returns are excluded, the range is still wider for the Nasdaq 100 (INR) than for the S&P 500 TR (INR), though both are narrower than before.
So, while the Nasdaq 100 (INR) holds a greater possibility of higher long-term returns, it is likely to come with greater volatility in the short run.
Diversify your risk
Just like the S&P 500, the Nasdaq 100 too can help you diversify your geographical investment risk beyond the Indian market and into the US and globally too, to an extent.
In general, the objective of diversification is best met when you invest in assets (stock indices in our cases) whose movements are not coordinated. That’s how it is for the Sensex and the S&P 500 (see earlier blog).
It is also so for the Sensex and the Nasdaq 100. See the charts below.
As you can see, the calendar year performance of the Sensex and the Nasdaq 100 has been very different from each other across most years. When one index has done extremely well, the other hasn’t quite so or has even ended the year down.
By investing in the Nasdaq 100 index (or S&P 500), in addition to staying invested in the Sensex, you can therefore mitigate your risk from investing purely in the Indian equity market.
Further, as with the S&P 500 (or any US index for that matter), investing in the Nasdaq 100 also brings you the benefit of rupee depreciation. When the rupee weakens relative to the dollar, you can earn a better return from the S&P 500 in rupee terms, for the same dollar return.
During Jan-88 to Apr-20, while the Nasdaq 100 (USD) grew 55-fold, the Nasdaq 100 (INR) grew 324 times! This was thanks to the 6-fold depreciation in the rupee from Rs. 13 to Rs. 77 a dollar during this period.
Currently, the Nasdaq 100 is trading at a trailing twelve month P/E of nearly 27 times (Bloomberg). This is higher than its 10-year average of 22 times and is at the upper end of its historical range of 15 – 28 times from Dec-09 to Dec-19 (Motilal Oswal). Given the above-average valuations, investors can invest in this index in a staggered manner.
The S&P 500, on the other hand is trading at 19.3 times (Bloomberg), closer to its historical average. Though note, historically, the Nasdaq 100 has traded at more expensive valuations than the S&P 500 given the large percentage of high-growth tech stocks in it, which also have a lot of buzz around them.
If you want global diversification with the potential for higher long-term returns and low volatility, then you can consider putting 10-20% of your equity allocation into the S&P 500.
If you want to target higher returns (better than the S&P 500) and are prepared to take higher volatility, then you can consider investing 10-20% of your equity allocation in the Nasdaq 100. This is for those who are bullish on tech companies.
Investment in either index will help you diversify your investment risk and also fetch you the benefit of rupee depreciation.
Whichever index you choose, we recommend that you stagger this investment over the next 3-6 months instead of a one-time lump sum. This is because the US market (both the S&P 500 and the Nasdaq 100) have already rallied from their lows in late March despite the continuing uncertainty over the Coronavirus and the lockdowns.
It is difficult to say whether the markets have bottomed out or may fall further. By staggering your investment, you ensure that you do not lose out on any attractive buying opportunity in future, if the markets fall further.