What is the best ETF to hold for the long-term, you may ask? In this post, I will give my take on this question and explain my rationale behind it. In a nutshell, it is any ETF that tracks the Nasdaq 100 index. Yes, you heard that right. This will likely trigger many people. But, hear me out. I will tell you something that may give a fresh perspective.

There are two primary areas that I will address: future returns and risks.

What is the Nasdaq 100?

First, Nasdaq 100 (NDX) is not the same as the popular Nasdaq Composite index (IXIC). Nasdaq 100 consists of 100 largest non-financial companies listed on Nasdaq. Conversely, Nasdaq Composite index encompasses almost all equities listed on Nasdaq stock exchange.

Thus, Nasdaq 100 has a higher concentration of familiar big tech names. These include Apple, Amazon, Google, Meta and Nvidia. The top 10 holdings for Nasdaq 100 and Nasdaq Composite are similar.

The main difference arises in securities selection and their weights towards the tail end. Essentially, Nasdaq 100 cuts off a bunch of garbage that did not perform well in the Nasdaq Composite index (e.g. thousands of small-cap companies).

So, it is clear that Nasdaq 100 is less diversified compared to the Nasdaq Composite or S&P 500 index. I will later argue that this is a good thing. 

Nasdaq 100 Returns

Next, let’s take a look at returns. It is not a secret that the Nasdaq 100 index outperformed other major indices on a massive scale.

This graph shows cumulative price returns without dividends reinvested since 1986. Even if we include dividends, the massive outperformance does not change one bit.

Historically, dividends contributed about 32% of total returns for the S&P 500. As for Nasdaq indices, dividends were less important. Even if we double the price returns of the S&P 500, Nasdaq 100 still stands tall.

Will Nasdaq 100 Outperformance Continue?

Okay, you say. Historical performance does not guarantee future returns. True. So, this is where we may diverge. Here is my take.

First, in my view, big tech companies will continue outperforming the economy. Technology is playing a bigger and bigger role in our lives. Thus, concentrated holdings of big tech companies may perform better. The S&P 500 represents large companies in diverse industries (not only technology). So, I view the S&P 500 as a proxy for the general performance of an economy.

Also, I speculate that the market cap size correlates with economic moat and superior performance. This may not be true everywhere, but I argue that it is true in the technology sector. At least, the historical evidence is telling us so. Thus, this is reason number two of going with a concentrated portfolio of 100 big tech companies.

Nasdaq 100 Risk

The final stumbling block is the risk. And again, we may differ how you and I define risk. The standard textbook proxy for risk is volatility. The common performance yardstick is the return adjusted for volatility, called risk-adjusted return. The goal is to stay away from equities that fluctuate a lot with large price swings.

But, do you see the problem with this definition? Wouldn’t you be okay to stomach the volatility in exchange for much higher returns? Suppose I tell you that you can choose from two investments to hold for the next 10 years. You must invest and hold them without selling. Also, you must not look at the chart during those 10 years.

The returns by the tenth year are as follows. Investment A generates a cumulative return of 176%, while investment B generates 431%. Which one would you choose based on these figures? The answer is quiet obvious: investment B.

But, what if I tell you that investment B fluctuated a lot before it earned you 431% return? Would you change your mind? Or rather, would you prefer to keep your eyes closed and get those higher returns?

How Investment Risk Should Be Defined

As you see there is a problem with how risk is defined in the financial industry. It is understandable why. Howard Marks, the prominent value investor, has a different take on investment risk. He defines it as the probability of a permanent loss of capital. Of course, the problem is with measuring this probability. Usually, it has to do with intrinsic valuation and forecasting earnings and so on.

Modern portfolio theory has no place for that. It is too difficult, subjective and not readily available. Instead, the prevailing framework chose to focus on what’s easy.

Unfortunately, pundits tell investors to focus on risk-adjusted returns based on volatility. And this may prevent you and me from earning higher returns with index fund investing.

Stock Index Investing and Risk

Investing in relatively broad equity index funds largely eliminates the risk of permanent loss of capital. This is true since you are not investing in one or two stocks. It is much better to put your eggs in several baskets.

Also, failing companies will drop out of the index by design. If a particular company underperforms, its market capitalization shrinks. If it drops below a certain threshold, the Nasdaq will eliminate this company from its index. So, as you see, underperformers do not stick around in the Nasdaq 100 index.

Finally, there is a general assumption that the stock market tends to grow over the long-term. Based on historical data, the market indices tend to go up by at least 8% to 10% annually depending on the time horizon. So, if we accept that, the risk of permanent capital loss is minimized. Even if this assumption is not true, indices tend to fluctuate in unison. This means that if Nasdaq 100 is permanently down, it is very likely everything else is down too.

Prerequisites for Investing in Nasdaq 100

This brings me to the most important points that will determine if investing in Nasdaq 100 is right for you. This may be generally true for any index fund investing.

First, you must have a long-term horizon of at least 10-20 years. Funds invested in Nasdaq 100 fund should be untouchable. You must invest in Nasdaq 100 only the money you will not need for a very long time.

Second, you must learn to ignore large price declines during recessions. Historically, drawdowns of 40%-60% lasted about 4-5 years on average until recovery. But, it could be longer. The Nasdaq 100 index showed even higher drawdowns compared to other indices. It is very frustrating to see your entire portfolio’s gains go in smokes in a matter of months.

But, you must resist the urge to sell and hold it out. Barring some global cataclysm, markets always recover. Remember this and stay put.

Related:

If you feel like you are not psychologically prepared to handle large drawdowns, this strategy will not work for you.

ETFs Tracking Nasdaq 100 Index

As for ETFs that track the Nasdaq 100 index, there are 2 of them by Invesco: QQQ and QQQM. They have expense ratios of 0.20% and 0.15%. These ratios are a bit higher compared to Vanguard ETFs. But, it is still reasonable in the context of potential returns.

Investors Takeaways

The Nasdaq 100 index is very likely to continue outperforming other major indices in the future. So, it is an excellent long-term bet for young investors or someone who has at least 10-20 years to wait.

Of course, common sense tells us to have a separate stash of funds invested in low-risk assets (short-term treasuries, CDs or a high-yield savings account). Markets can go low and stay low for long. This makes your rainy day fund a must to wait it all out.