When most investors think of a market index, the S&P 500 (^GSPC +1.02%) probably comes to mind. That makes sense since it is the go-to measure of broad stock performance. But there are other indexes and different flavors of the same basic index. It can get confusing, so make sure you don't outsmart yourself. That's a real risk with the Nasdaq-100 and this nuanced exchange-traded fund (ETF) variation.
A little bit of index math
The Dow Jones Industrial Average (^DJI +0.63%) was probably the first index that investors followed closely. It is tragically flawed because it effectively weights the index's constituents by stock price. So the highest-priced stocks have the biggest impact on the index's performance. It's not an ideal methodology if you want to gauge the market's overall performance or the economy's health.
Image source: Getty Images.
The methodology used to measure the S&P 500 went some ways toward fixing the Dow's weighting problem, since it's market cap-weighted. Basically, the largest companies have the biggest impact on performance. That makes more sense since the largest companies are likely to be more economically important. And at its core, the S&P 500 index is meant to be more representative of the U.S. economy.
That said, there are good and bad companies in the index. Smaller companies often grow into bigger ones, even as bigger companies struggle and turn into smaller ones.
A different flavor of the S&P 500 index shifts from market cap-weighting to equal-weighting. The Invesco S&P 500 Equal Weight ETF (RSP +1.11%) is an ETF that does this. This ETFs methodology effectively allows each company to impact the performance equally. It's a reasonable approach for the S&P 500, given the way the index is constructed.
Good things don't always translate well
As the chart highlights, over the long term, Invesco S&P 500 Equal Weight ETF has outperformed the regular S&P 500 index, using SPDR S&P 500 ETF Trust as a proxy. But that easy win doesn't work in every case. The Nasdaq-100 index is a good example of why equal weighting could work against you.
The Nasdaq-100 is, very simply, the 100 largest companies in the Nasdaq Composite index. It is weighted by market cap, just like the S&P 500 index. But the method of creating this index is vastly different from that of the S&P 500 index. The S&P 500 is a hand-selected group of companies meant to be representative of the U.S. economy. The Nasdaq-100 is just the 100 largest companies on the Nasdaq stock exchange. By definition, the market cap is the only important selection feature.
Direxion NASDAQ-100 Equal Weighted Index Shares (QQQE +1.46%) is an ETF that uses an equal-weighting methodology with the Nasdaq-100 index. But, as the chart highlights, it has lagged the performance of the market cap-weighted index.
Data by YCharts.
As the chart highlights, the price drawdowns have been equally painful for both flavors of the index.
Data by YCharts.
So what investors buying Direxion Nasdaq-100 Equal Weighted Index Shares are getting is less reward and the same amount of risk. That's not a great trade-off.
One of the reasons why equal weighting works with the S&P 500 index is that it allows smaller companies that might be out of favor to have the same impact as larger companies on performance. That logic doesn't translate as well to the Nasdaq-100 index, which is just the largest, and likely best-performing, companies on the Nasdaq exchange.
Good ideas aren't always universally positive
At the end of the day, if you want to buy the Nasdaq-100 index, perhaps choosing an ETF like Invesco Nasdaq 100 ETF (QQQM +1.02%), you should probably just keep it simple and not try to get too fancy. The nature of the index is such that you are purposely focusing on large, top-performing companies. Equal weighting may work for a broad-based index like the S&P 500, but so far, this clever idea seems like a whiff when applied to the Nasdaq-100.
