Natixis has partnered with Nasdaq to launch a new smart beta index based on the value factor using the Nasdaq 100 as the parent index. The Nasdaq 100 Target 25 Index will track 25 stocks from the Nadsaq 100 that Natixis has identified as undervalued. The new index could be used as the underlying index for future ETFs.

The Nasdaq 100 has outperformed the S&P 500 and the Dow Jones Industrial Average in almost every year over the past decade.

The index seeks to reduce biases inherent in market cap-weighted indices. One such bias is over-concentration. As of 30 June 2017, the largest five stocks in the Nasdaq 100 (Apple, Alphabet, Microsoft, Amazon and Facebook) make up over 40% of the total index weight.

Weighting by market capitalisation also suffers from the drawback that as a stock rises in price, it will make up a larger part of the index by weight. This means that as a stock becomes more overvalued, it makes up a larger part of the portfolio.

Research by Natixis shows that the 50 largest stocks in the Nasdaq 100 have consistently displayed a higher price to book ratio than the smallest 50 stocks since 2001. In addition, the research shows that when divided by market cap and then equally weighted, the bottom half of the Nasdaq 100 has outperformed the top half since 2001. To take advantage of this, the new index will only select from the 50 smallest stocks in the Nasdaq 100.

In historical backtesting, the Nasdaq 100 Target 25 Index outperforms the Nasdaq 100 over the last cumulative 1, 3, 5, 7 and 10 years. The only years in which it has underperformed (2007, 2012, 2015) have seen significant gains in equity markets which are conditions that generally favour growth strategies over value.

Source: Nasdaq

The next step in the index methodology is to pick the 25 stocks with the highest free cash flow to enterprise-to-price ratio. Natixis has found that this ratio is the best predictor of future three-month returns from a list of fundamental ratios commonly used to make value comparisons including sales-to-price, book-to-price, net income-to-price, EBITDA-to-enterprise value and operational cash flow-to-enterprise value.

The final index constituents are then equally weighted in the portfolio so that each stock receives a 4% weight. Technology is currently the largest sector weight with 53% (versus 44% in the Nasdaq 100), followed by 25% for consumer services (Nasdaq 100 – 32%) and health care with 11% (Nasdaq 100 – 17%).

Source: Natixis