The Nasdaq 100 Is Wildly Popular. It’s Also Deeply Flawed.

With $196 billion in assets,
Invesco QQQ
(ticker: QQQ) is the largest Nasdaq 100 exchange-traded fund and the fifth-largest ETF in the U.S. It has been a stellar performer, up an annualized 17.2% in the past 10 years and 33.6% this year, thanks to weightings in artificial-intelligence stocks like
Nvidia
(NVDA). Its popularity has led to many other Nasdaq-related funds being launched, some leveraged, others hedged, such as the rapidly growing
J.P. Morgan Nasdaq Equity Premium Income
(JEPQ), which uses options and has already captured $5.5 billion since its May 2022 launch.

“They’re some pretty head-scratching flaws with how this index is constructed,” says Ryan Jackson, a research analyst at Morningstar. In June, Jackson published an article titled “Choosing a Better Index ETF,” recommending that instead of the Invesco QQQ, investors should purchase traditional growth index funds such as
Vanguard Growth
(VUG) and
iShares Core S&P U.S. Growth
(IUSG). If they’re more sector-focused, he argued, they could buy pure tech funds such as
Technology Select Sector SPDR
(XLK) or
Vanguard Information Technology
(VGT).

Jackson’s biggest problem with the Nasdaq index is that it is limited to only 100 stocks that trade on a specific exchange. “When you think about sensible [index] investment criteria, you want to make sure you’re trying on as large of an opportunity set as possible, and you’re not constraining yourself for any non-obvious reasons,” he says.

The non-obvious reason for the Nasdaq 100’s unique construction: Companies must pay listing and ongoing annual fees to Nasdaq to be on its exchange. Without such payments, companies are excluded from the benchmark, and their stocks don’t receive investor dollars from Nasdaq index ETFs.

“This is just Nasdaq, the exchange business, helping out Nasdaq, the index provider,” Jackson says. “The whole purpose [of the index’s design] was to drive up awareness of the Nasdaq exchange.”

In an emailed response, Nasdaq’s Jennifer Lawson wrote: “The Nasdaq-100 Index has a history of unrivaled performance compared to other indexes, and it has consistently performed substantially higher when compared to leading US Large Cap Growth benchmarks. Since the end of year 2007 through June 30, 2023, the Nasdaq 100…was up 750%, and the Russell 1000 Growth…463%.”

Invesco cited similar performance data in its response to Barron’s.

But past performance shouldn’t be the primary reason investors choose a benchmark, says Rodney Comegys, global head of Vanguard’s Equity Index Group, which oversees some $5 trillion in index products.

“I don’t want people to choose [an index fund] because of performance chasing. I want them to have a sound investment reason for doing it,” he says. Historically, stocks that have outperformed in the past tend to underperform in the future, a concept known as “reversion to the mean.”

Morningstar categorizes the Invesco QQQ ETF as a Large Growth index fund, though the fund leaves out major companies that qualify as growth stocks in Vanguard’s and iShares’ ETFs, such as
Salesforce
(CRM),
Visa
(V), and
Mastercard
(MA), because those stocks aren’t listed on the Nasdaq.

For the same reason, the fund excludes
Oracle
(ORCL) as well as Salesforce, which are included by pure tech funds such as Technology Select Sector SPDR and Vanguard Information Technology. All four of Jackson’s recommended alternative ETFs also have lower annual fees than the Invesco QQQ’s 0.20%.

Lawson declined to comment on Nasdaq’s listing fees. Regarding the absence of non-Nasdaq-listed stocks from the benchmark, she stated: “An index or strategy being classified as large-cap growth doesn’t mean it has to include every single large-cap growth company.”

The designers of other popular indexes don’t charge exchange-listing fees to be included in their benchmark. Instead, they apply either purely quantitative stock selection criteria or have an arm’s-length relationship with their firms’ other business interests. At S&P Dow Jones Indices, for instance, an investment committee selects the stocks in the S&P 500, but the committee doesn’t require any listing payment to be included in the index.

Moreover, the selection criteria is quantitative for S&P’s factor indexes like S&P 900 Growth, which invests in large companies with higher-than-average sales and earnings growth and is tracked by the iShares Core S&P US Growth ETF.

The S&P index committee “maintains an index methodology and undertakes the index rebalances that are outlined in publicly available documents,” says Hamish Preston, head of U.S. equities at S&P Dow Jones Indices. “There’s a clear separation from that side of the house versus the commercially facing people, such as myself.”

Similarly, in selecting benchmarks for its ETFs, Vanguard is careful that the designers have a rational investment objective and an arm’s-length relationship with its construction.

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