Since its inception in 1985,the Nasdaq-100 Index has consistently demonstrated remarkable performance,amassing a staggering 22,900% increase (including reinvested dividends),resulting in an annual compound return rate of 14.8%.In stark contrast,the S&P 500 Index has achieved a return of 7,200% during the same period,with an annual compound return rate of 11.5%.This paints a vivid picture of the marketplace where technology-driven companies thrive,particularly on the Nasdaq.

However,it's crucial to recognize that the Nasdaq's superior performance can largely be attributed to its inherent higher risk.The volatility associated with the Nasdaq Index has consistently exceeded that of the S&P 500,and its drawdowns have been significantly more pronounced.For instance,the Nasdaq entered a downward cycle on March 28,2000,which culminated in a staggering drop of -81.76% by August 5,2002.It wasn't until February 12,2015,that the Nasdaq-100 Total Return Index finally rebounded to its pre-crisis peak.During the 2022 bear market,the Nasdaq experienced even sharper declines.

The Reliance on Information Technology

Contributes to the High Returns and Volatility of the Nasdaq

The Nasdaq Index's heavy reliance on the information technology sector substantially influences its overall returns,leading to higher volatility and a greater likelihood of protracted downturns.The 1990s marked an era where the Nasdaq became almost synonymous with the tech industry.While various sectors are represented within the Nasdaq Index,since its launch in 1999,the Nasdaq-100 Index has maintained an almost perfect correlation with the S&P 500 Information Technology Index.The correlation coefficient never dipped below +0.9 and occasionally soared as high as +0.98.Over the past 12 months,this correlation coefficient has persisted around +0.95.

The Nasdaq's status as a haven for tech stocks is,in many ways,a product of historical development.Established in 1971,the Nasdaq was the world's first electronic stock exchange.Its comparatively lenient income and profitability requirements for listed companies have made it appealing to tech firms from the outset.As time passed,a rich tech ecosystem took root in the Nasdaq,eventually dominating the Nasdaq-100 Index.

For investors looking to manage their tracking risk relative to the S&P 500 Information Technology Index,utilizing futures on the S&P Select Sector Technology Index serves as an effective strategy.Conversely,for those aiming to adjust their exposure to the tech sector significantly,without heavy concern for tracking risk,Nasdaq-100 futures offer a straightforward means to do so.

In recent years,the Nasdaq Index has exhibited a heightened correlation with non-essential consumer goods and telecommunications sectors.In contrast,its correlation with traditional high-dividend sectors,such as consumer staples,energy,and utilities,often remains low.This is primarily because companies in these industries tend to list on other exchanges.One notable exception occurs during market downturns when correlations across various stocks tend to rise.

Nasdaq's Insensitivity to Long-Term Bond Yields

While Facing Four Major Risks

The Nasdaq Index exhibits significant differences in interest rate sensitivity compared to other indices.Many constituent companies within the Nasdaq-100 boast substantial cash reserves,enabling them to garner significant returns through holdings in short-term U.S.Treasury securities and other short-term bonds.Consequently,a high short-term interest rate appears favorable for Nasdaq-100 companies.This contrasts sharply with the Russell 2000 Index,which has suffered as the Federal Reserve's continuous interest rate hikes have escalated financing costs for small and mid-sized businesses reliant on bank loans.

In stark contrast,the Nasdaq Index showcases a pronounced negative sensitivity toward rising long-term bond yields.Many tech stocks within the Nasdaq-100 possess elevated price-to-earnings ratios,including several company titans valued over $1 trillion.A significant portion of these companies' worth is tied to what analysts term "terminal value," which refers to the projected value far into the future.As such,their profits tend to be discounted according to long-term bond yields.Therefore,as yields increase,the net present value of future profits declines,branding rising long-term yields as a potential threat to their stock prices.Moreover,heightened long-term yields may prompt investors to rebalance their portfolios,favoring the relative stability of fixed-income securities over volatile,high-valuation stocks.

In 2022,the surge in long-term bond yields,fueled by expectations of tightened policies by the Federal Reserve and ongoing inflationary concerns,led to a sharp drop in prices,adversely affecting the Nasdaq Index.The high sensitivity of the index to long-term bond yields could explain this phenomenon.By contrast,despite the Fed's ongoing increases in short-term rates,which were maintained at elevated levels from October 2022 to July 2023,the Nasdaq Index has showcased resilience.This is partly due to the fact that many Nasdaq companies,with their ample cash reserves,benefit from holding short-term bonds.Furthermore,elevated short-term rates signal the Fed's commitment to tackling inflation,contributing to the stabilization of long-term bond yields,which ultimately benefits these firms.

Nevertheless,it would be a mistake to think the Nasdaq Index is immune to downside risks.Historical precedent underscores that risks are tangible,particularly during recessionary periods.During the economic downturn catalyzed by the 2001 tech stock crash,the Fed slashed short-term rates from 6.5% to 1%,yet long-term bond yields remained relatively high,a predicament unfavorable for the tech sector.In the wake of the tech crash,the Nasdaq plummeted by 82%,and during the global financial crisis,the Nasdaq-100 Index also faced significant declines,though not as severe as those in the S&P 500,which has a weighting skewed toward bank stocks.

Presently,the Nasdaq Index confronts several potential threats,including the looming specter of economic recession—which could erode corporate profits; interest rate cuts—which might diminish returns on cash holdings; substantial budget deficits and quantitative tightening—which could drive long-term bond yields upwards; and increasing regulation on the tech sector,both in the U.S.and globally.

This article reflects the views of the author and does not represent the stance of this publication.The mention of individual stocks is for analytical purposes only and does not constitute investment advice.