NDQ or IVV: what is the best ETF for US exposure?
The answer requires examining your investment strategy and understanding the exposure of each ETF.
Mentioned: Betashares Nasdaq 100 Currency H ETF (HNDQ), iShares S&P 500 AUD Hedged ETF (IHVV), iShares S&P 500 ETF (IVV), Microsoft Corp (MSFT), BetaShares NASDAQ 100 ETF (NDQ)
I recently wrote on article on how investors can build a portfolio using a 4-step process. I boiled the process down to a couple foundational concepts. The first is that simplicity is an advantage that we should only reluctantly give up. The second is that when constructing a portfolio and researching ETFs investors should focus on the exposures each ETF provides and the overlap between the ever-expanding list of ETFs available to Australian investors.
This article applies those foundational concepts to ETFs that provide exposure to US shares. There are multiple attractive attributes of US shares for an Australian investor. The US market gives us access to industries and companies that are in short supply locally. Some US companies are global leaders while many Australian companies are domestically focused.
I am going to explore two popular ETFs focused on the US market. They are the iShares S&P 500 ETF (ASX: IVV) and the BetaShares NASDAQ 100 ETF (ASX: NDQ). Both ETFs track an index which means they are passively managed. A key step of researching a passive ETF is to understand the index criteria. This includes how shares are selected for inclusion, the weighting of each holding and how changes to the index are made.
iShares S&P 500 ETF
IVV tracks the S&P 500 index which is made up of the 500 largest companies listed in the US. The index covers approximately 80% of the total value of US shares. There is some discretion on which shares are included and a company must meet certain liquidity and profitability standards to be added to the index. In practical terms this has little impact on the index as these companies are on the periphery of the 500 largest shares in the US and have low weightings in the index.
The index is market capitalisation weighted which means larger companies make up a higher percentage of the index. This is a common approach for major indexes and limits rebalancing which may lead to poor tax outcomes for investors.
The implication of market capitalisation weighting is that companies and sectors with strong share price performance make up a larger part of the index over time. This can create concentration risk if the relative performance of certain companies and sectors is high for long period of time.
Since the global financial crisis (“GFC”) growth shares and particularly technology shares have outperformed. This is reflected in the current weightings.
Technology shares currently making up approximately 33% of the index. This is the highest percentage since the .com bubble burst in the early 2000s.
On a historical basis there is also high concentration in the top 10 holdings in the index which make up approximately 35% of the index. This is a multi-decade high.
The ETF has an ultra-low total cost ratio of 0.04%.
BetaShares NASDAQ 100 ETF
NDQ tracks the NASDAQ 100 Index which is made up of the 100 largest nonfinancial firms listed only on the Nasdaq. The index a share is listed on has little usefulness for an investor. Specifying a certain index is a function of the Nasdaq’s desire to market the index and does not improve investor outcomes. In fact, it may hurt investors as recent high performers including Eli Lilly, Visa and Mastercard have been excluded.
The index is market capitalisation weighted. The holdings and weighting are reflective of the fact that many technology shares list on the Nasdaq.
Around 50% of the index is made up of technology shares.
Nearly 51% of the index is in the top 10 shares.
The ETF has a total cost ratio of 0.48%.
Which ETF is right for your portfolio?
The answer is up to each investor and should align with your investment strategy and your goals. There are however considerations for an investor trying to decide between the two options.
How will large technology shares perform?
Future differences in performance will be heavily influenced by how large US growth shares in the technology sector perform. Both ETFs have large allocations to technology shares but NDQ’s exposure is meaningfully higher.
This is an article about ETFs but we need to explore how certain types of shares perform when there is such a high allocation.
There is a reason that investors love technology shares. Many of them have great business models. Software delivered through the cloud can make a business extremely scalable. Once the software is developed each new sale primarily flows to the bottom line. That is why over time technology companies can increase their margin or how much of each dollar of sales they get to keep as profits. As sales grow, margins grow. We can use US tech giant Microsoft (ASX: MSFT) as an example. In 2016 Microsoft’s net margin was roughly 19%. In the last 5 years it averaged 34%.
Imbedding technology into individuals’ day-to-day lives and into core business functions can lead to network effects and switching costs. These are two of Morningstar’s moat sources or drivers of sustainable competitive advantages. Unchecked by regulators winners in the technology space can grow to capture large parts of the market. This increases their power as they amass more data on their customers.
The compelling case for investing in scalable technology companies with durable competitive advantages and enviable margins is not a secret. And as more investors flock to investing in technology the valuations go up. Once again, we can use Microsoft as an example. In 2016 the shares traded a price to earnings (PE) ratio of 29.73. Currently shares are trading at 36 times earnings.
All things being equal higher valuation levels equate to lower future returns. Investor expectations for the future are reflected in valuation levels. High valuations mean high expectations which are harder to exceed. In Microsoft’s case we can argue that the increase in margins was a factor that influenced the increase in valuation. But now the company must maintain and grow those margins to justify maintaining the valuation or growi it in the future.
The margin example is just one of many influences on Microsoft's high valuation. Other factors like growth of earnings come into to play. But it is illustrative of the danger of investing in shares with high expectations for the future.
This is a universal truth of investing. There are three drivers of share returns. Increases in valuation, growth in earnings, and dividends. When valuations are historically high it is less likely they can keep increasing. Higher share prices generally mean lower dividend yields. That lowers another source of future returns.
It can be argued that on a historical basis both the S&P 500 as represented by IVV and the Nasdaq 100 as represented by NDQ are expensive. But the Nasdaq 100 trades at a higher valuation level. The Nasdaq 100 index is trading at ~26 times earnings compared to ~21 times earnings for the S&P 500.
Is the higher valuation justified? That is the question that an investor needs to answer when choosing one ETFs over the other.
Is diversification important?
The S&P 500 is more diversified than the Nasdaq 100. You get more exposure to different sectors and exposure to more companies. The S&P 500 is less concentrated within the top 10 holdings which increases single security diversification.
Is volatility important?
For several reasons NDQ has been more volatile than IVV. The reasons include the greater exposure to single companies and the fact that when investors get nervous about risk they tend to sell down technology companies. As investors become more comfortable with risk they buy those same technology companies. That leads to larger swings in NDQ.
One commonly used measure of volatility is standard deviation. Standard deviation measures volatility as a dispersion of returns around the average return. Higher standard deviations indicate more volatility than lower standard deviations. Over the past five years IVV’s standard deviation was 13.16 vs. 17.14 for NDQ.
How much this matters is a function of your investment strategy and time horizon. I’ve argued that long-term investors shouldn’t care about volatility and should focus on generating the return needed to achieve their goals. But for some investors approaching the time when they need to sell assets volatility can be harmfull. An example is the transition to retirement.
Do you care about dividends?
Neither of these ETFs are going to provide a flood of dividends. Valuation levels are high which lowers dividend yields and US shares typically pay a smaller percentage of earnings in dividends than Australian shares. Technology shares also typically have low dividend payout ratios and both indexes are heavily exposed. The S&P 500 currently has a dividend yield of approximately 1.5%. The Nasdaq 100 has a dividend yield of less than 1%.
How important are fees?
There is a large relative fee differential between the two ETFs. IVV has a total cost ratio of 0.04% vs. 0.48% for NDQ. In isolation the fee level of NDQ is relatively low but this exercise compares it to IVV. Lower fees are better. Over a 10-year period if $10,000 was invested in both ETFs and the returns before fees were 7% you would end up with $756 less in NDQ.
Does currency exposure matter?
Both ETFs have exposure to currency changes between the US dollar and the Australian dollar. If the Australian dollar gets weaker against the US dollar returns will be enhanced. If the Australian dollar gets stronger against the US dollar it will detract from returns.
No real difference here between the ETFs. Both also come in hedged versions which remove currency risk. HNDQ is the currency hedged version of NDQ and IHVV is the currency hedged version of IVV. The holdings in the non-currency hedged version and currency hedged version of both ETFs are the same. Only the impact of changes in currency has been removed.
What do our analysts think?
Our analysts have awarded IVV a Gold Medallist Rating and NDQ a Neutral Medallist Rating. It should be obvious that IVV is their preferred ETF. Below is a summary of the ratings of both ETFs:
iShares S&P 500 ETF: Best-in-class option for large-cap investors
iShares Core S&P 500 funds offer well-diversified, market-cap-weighted portfolios of 500 of the largest U.S. stocks. The funds accurately represent the large-cap opportunity set while charging rock-bottom fees, a recipe for success over the long run.
The funds track the flagship S&P 500, which selects 500 of the largest U.S. stocks—roughly 80% of the U.S. equity market—and weights them by market cap. An index committee has discretion over selecting companies that meet certain liquidity and profitability standards.
While a committee-based approach may lack clarity, it adds flexibility to reduce unnecessary changes during reconstitution, taming transaction costs compared with more-rigid rules-based indexes.
The end portfolio is well-diversified and accurately resembles the U.S. large-cap opportunity set. This allows the strategy to capitalize on its low fee, ultimately delivering sound long-term performance on both an absolute and risk-adjusted basis.
The bedrock of this strategy is market-cap weighting, which harnesses the market’s collective wisdom of the relative value of each holding with the added benefit of low turnover and associated trading costs. It’s a sensible approach because the market tends to do a good job pricing large-cap stocks. The companies in this portfolio attract liquidity and widespread investor attention, such that prices reflect new information quickly.
However, when few richly valued companies or sectors power most of the market gains, market-cap weighting may expose the strategy to stock- or sector-level concentration risk, as is the case at year-end 2023. As of December 2023, the top 10 holdings made up the largest portion of the index (30%) in several decades, and the 30% allocation to technology stocks was the highest since the dot-com bubble. But this is not a fault in design, the S&P 500 simply reflects the market composition. In the long run, its broad diversification, low turnover, and low fee outweigh these risks.
BetaShares NASDAQ 100 ETF: Strongly positive performance history dimmed by index construction lacking in rationale.
BetaShares Nasdaq 100 ETF is an investible option for Australian investors looking to gain technology sector-oriented US equities exposure.
The rules underpinning the construction of the Nasdaq 100 Index are likely borne from Nasdaq's desire to promote its exchange. The benchmark picks the 100 largest nonfinancial firms listed only on the Nasdaq and weights them by market cap.
It automatically excludes stocks listed on other exchanges, which shrinks the fund’s opportunity set, leading to a suboptimal portfolio in our view. Some of the large-cap market’s best recent performers, like Eli Lilly, Visa, and Mastercard, respectively, are precluded from the portfolio because of these constraints. If one of the fund’s marquee holdings moves from the Nasdaq, the fund would have to sell it. The fund’s Nasdaq-only remit causes sector concentration in the fund. Over the past five years, up to 90% of the index has been represented by the technology, communications, and consumer cyclical sectors, with at least 50% attributed to technology. These sectors have higher than average levels of volatility, especially in risk-off environments.
BetaShares Nasdaq 100 ETF has a reasonable fee (0.48% per year), is serviced by an adequate and tenured team, and has been a high performer since its inception in May of 2015. However, its outlook is dampened by its compromised index methodology and higher concentration risk relative to broader benchmarks like the MSCI USA Index or S&P 500. As such, we have higher conviction in more well-founded strategies in the category.
The primary vehicle from which this strategy’s pillar ratings are derived is BetaShares Nasdaq 100 ETF, ticker NDQ.
Should you invest in both?
That is a decision for each investor. I would argue that there is too much overlap between the ETFs to include them both in your portfolio. I am also a proponent of simplicity which I outlined in my article on building a portfolio with ETFs.
I put a hypothetical position with a 50% allocation to IVV and a 50% allocation to NDQ into Morningstar’s correlation matrix. Below are the results. The 86% correlation between the two means there are significant overlaps between the weighted holdings in each ETF. If I was using ETFs to get exposure to the US market and wanted to add a second ETF I would look for one that had lower correlation and would diversify your portfolio more.
Which is right for you?
Only you can answer that question. I’ve tried to explain the differences between the two ETFs. Each investor should align each investment with your investment strategy and goals.
