Play the Nasdaq With the ONEQ

Editor's Note: This story was originally published Nov. 11, 2003 on RealMoney

Last fall, Fidelity launched an exchange-traded fund representing the Nasdaq Composite called ONEQ ( ONEQ). While the Nasdaq 100 tracking stock, the QQQ ( QQQ), remains one of the most heavily traded securities on any of the U.S. stock exchanges, the ONEQ enables investors to initiate a relative-value trade that wasn't possible before. A relative-value trade is a way to profit from a change in one security's value, relative to another.

Differentiating the Indices

The Nasdaq Composite is made up of more than 3,200 companies with a broad range of market capitalization, representing all Nasdaq National Market and SmallCap stocks. Of those 3,200 companies, 85% are small-cap, 11% are mid-cap and 3% are large-cap.

The Nasdaq 100, on the other hand, is composed of the 100 largest and most active nonfinancial issues in the Nasdaq Composite. By definition, then, the Nasdaq 100 is a large-cap subset of the Nasdaq Composite. The Nasdaq 100's market value is $1.82 trillion -- about half of the $3.74 trillion market value of the Nasdaq Composite.

One way to analyze the relative value of one index or stock vs. another is to create a ratio. For example, if you are studying the relative value of A to B, you could divide A by B; when A outperforms, the ratio will increase, and when B outperforms, the ratio will decrease.

When the Nasdaq 100 began trading in the mid-1980s, its level was roughly 45% of the Nasdaq Composite's level; in other words, the ratio of the Nasdaq 100 to Nasdaq Composite was 45%. Until the end of 1996, this association stayed fairly consistent, with the Nasdaq 100 trading at 50% to 60% of the level of the Nasdaq Composite index. After 1996, though, something happened in the market that drastically changed this relationship.


Market Capitalization Distribution
Market Cap Nasdaq Composite Nasdaq 100
Under $1 billion 85% 0%
$1 billion-$5 billion 11% 35%
Over $5 billion 3% 65%
Source: GNI Capital

After the Mexico peso devaluation in December 1994, the Fed launched a cycle of interest rate cuts starting in July 1995, and the bull market began. While the markets started their ascent, the Nasdaq 100 began to outperform the Nasdaq Composite. The spread between these two indices started to narrow at an increasing rate.


Herding Into the NDX Stall

As the tech bubble inflated, market participants bought the same few stocks: the large-cap favorites of both institutional and retail investors. As investors tend to run in herds, this move was dramatic, and the buying led to significant relative outperformance by the Nasdaq 100 over the Nasdaq Composite. In fact, at the March 2000 top, the Nasdaq 100 was trading at 90% of the level of the Nasdaq Composite. This ratio peaked at 99.2% in October 2000, when the Nasdaq 100 traded at 3457, while the Nasdaq Composite traded at 3483.

Since the market top in March 2000, the reverse has happened: The large-cap Nasdaq 100 has relatively underperformed, the spread has widened and the correlation has reverted back toward historical norms.


While the relationship has been moving back toward the historical average, the Nasdaq 100 is still 72% of the Nasdaq Composite (in price-level terms), so there's more room to go before the historical relationship is restored. In order for this to happen, large-caps would relatively underperform, while small-caps and mid-caps would perform better.

Before ONEQ existed, there was no easy way to trade this trend. But this ETF makes it tradable. For example, if you think the Nasdaq 100 will continue to underperform the broader Composite and eventually trade back toward the 50% to 60% level, you could buy ONEQ and simultaneously sell short QQQ.

Monitoring this relationship will not help determine an absolute level for either index, and it certainly cannot be used to determine a market top or bottom. Rather, it helps forecast where one index may trade relative to the other. In isolation, this makes small-caps and mid-caps seem more attractive than large-caps, as the relationship reverts to the historical mean over time.

At the time this piece was written, Norton's fund was short QQQ, though positions may change at any time.

Charles L. Norton, CFA, is a principal of GNI Capital, Inc., a registered investment adviser that manages a hedge fund, GNI Partners, L.P., as well as discretionary private client accounts. Norton had been a vice president in the equity research department of a New York-based hedge fund, where he was also a registered representative managing discretionary private client accounts. Prior to his experience on the buy side, Norton worked in the investment banking division of Salomon Smith Barney, where he was an analyst in the health care group, reporting directly to the head of the group. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Norton cannot provide investment advice or recommendations, he welcomes your feedback.

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