Why the Nasdaq-100 Isn’t a Particularly Good Investment

Welcome to Investing Insights. I’m your host, Ruth Saldanha. Let’s get started with a look at your Morningstar headlines.

T-Mobile Is Buying Mint Mobile

T-Mobile is buying the parent company of Mint Mobile. The cash-and-stock deal is worth up to $1.35 billion. Mint co-owner and brand ambassador Ryan Reynolds will stick around in a so-called “creative role.” The move keeps budget wireless provider Mint exclusively on the T-Mobile network, while keeping it out of the hands of competitors. The companies have not released the financial details or how many wireless customers Mint’s parent company has. Morningstar estimates it’s about 1% of the U.S. wireless market, given the sales price. Other than some high-margin wholesale revenue, Morningstar doesn’t see major long-term strategic benefits from the acquisition outside of some creative marketing. We’re sticking to our $165 estimate of what we think T-Mobile’s shares are worth.

Uber, Lyft, and DoorDash Drivers Can Remain Independent Contractors

Ride-hailing and delivery services scored a win in California where an appeals court upheld Proposition 22. Uber, Lyft, and DoorDash can continue to classify drivers as independent contractors under the state’s law. Morningstar believes the decision strengthens Prop 22 as a precedent for other states to follow. The appeals court reversed a lower-court ruling and concluded that Prop 22 was neither illegal nor unconstitutional. However, it ruled restrictions on the state’s legislators to make changes to the law must be removed. Morningstar doesn’t think the firms will contest that part and thinks it means lawmakers can amend Prop 22 without going through the judicial branch. We are maintaining our $68 estimate for Uber’s stock, a $34 estimate for Lyft’s shares, and a $159 estimate for DoorDash’s stock. All three currently appear undervalued.

Potential TikTok Ban in the U.S.?

TikTok’s uncertain future could test its users’ loyalty and benefit its rivals. The Biden administration is threatening to ban the China-based app over national security concerns. There’s also talk of a forced sale to an American company. However, as the information reports, China could reject that. Morningstar thinks this uncertainty could push some TikTok creators to focus on other platforms like Snap, Meta’s Instagram, and Google’s YouTube. Any ban would likely lead to a jump in content, number of users, and ad dollars for those companies. Any interruption or decline in the quality of TikTok could also push some users to other platforms. Morningstar still thinks that Google parent Alphabet shares are worth $154, Meta is worth $260, and Snap is worth $16.

Make Sure You Know Your Index

Many investors think that investing in one of the major U.S. indexes, such as the S&P 500, means they’re good to go. But not every index is a good investment. Ryan Jackson is a manager research analyst of passive strategies with Morningstar Research Services. He is here today to tell us why he thinks the Nasdaq 100 isn’t a particularly good investment.

Ruth Saldanha: Ryan, thank you so much for being here today.

Ryan Jackson: Of course. Thanks for having me, Ruth.

Saldanha: What are your thoughts on the Nasdaq 100 Index?

Jackson: We rate Invesco QQQ Trust ETF, ticker QQQ, and right now that has a Neutral rating, which means we have limited conviction that it’s going to outperform its category index, the Russell 1000 Growth, over the long term. Basically, how this fund is put together is it’s going to select the 100 largest nonfinancial stocks that trade on the Nasdaq exchange and weight those by their market capitalization. Sounds like a pretty straightforward approach, but there are some drawbacks that come with it.

First and foremost, selecting stocks based on where they are trading exchangewise is not an approach that has a ton of economic rationale behind it. It’s common for us to see index funds narrow their universes based on certain investment criteria, but something like an exchange is a pretty arbitrary decision. And the case here, it’s an example of Nasdaq, the exchange business, helping out Nasdaq, the index provider—not necessarily looking out for what’s best for the investor.

The analogy I would make there is it’s like a restaurant that is only shopping for ingredients at the grocery store right next door to it. Sure, it might be more convenient for the actual provider, but it might not lead to the actual best cooking. It might not leave the customer as satisfied as they could be. So, that’s one kind of drawback. And then additionally, with this approach of just plucking the 100 from the Nasdaq exchange, you’re going to be left with some pretty significant sector biases, the most obvious of which is the heavy tech exposure. That’s what the Nasdaq’s kind of known for, and you’ll see in QQQ, tech stocks represented about half of that portfolio at the end of February, but that’ll also push the fund a little bit toward communication services, consumer discretionary stocks—those both represented about 16% of the portfolio, and additionally, it’s completely without any financials, energy, basic materials, or real estate exposure. So, you’ve got a pretty concentrated portfolio under the guise of a broadly diversified index fund.

Saldanha: Tell us a little more about some of the exclusions in this index.

Jackson:  The most obvious ones are going to be those financial stocks that are precluded from the index. Berkshire Hathaway is one that jumps to mind right away—that came in as the seventh-largest U.S. stock at the time of this recording. Additionally, you’ve got some of those bulge bracket banks that don’t make the cut, like J.P. Morgan, Bank of America, and the like. So those are a little bit obvious and make sense given the construction. There’s some more surprising ones that should fit the bill that are excluded just because they don’t trade on the Nasdaq primarily. So, there you would have healthcare firms like Johnson & Johnson or UnitedHealth Group, both enormous stocks in the U.S. market. Then you’ve got some big energy stocks like Exxon and Chevron that don’t make the cut. You saw the knock-on effect of that back in 2022 when energy was really the lone silver lining in the U.S. stock market. So, no doubt the Qs would’ve liked to have those stocks in the portfolio come last year.

Saldanha: Tell us a little bit more about some of the reasons that people think that the Nasdaq is a shorthand for tech. You said that there is a heavy tech exposure, but is this a good thing at all, and why do people think that the Nasdaq is a shorthand for a tech index?

Jackson: It’s interesting because Qs has really emerged as the go-to tech shorthand for a lot of traders. It’s hard to pinpoint exactly why that is. If I had to speculate on it a little bit, I would think primarily its liquidity is its big advantage there. At the time of this recording, it had $167 billion behind it. It’s been around for over two decades, so it’s had some time to build that up. But when you think about its age, even SPDR sector ETFs have been around longer than this fund—that includes their tech fund. But when Qs really burst on the scene, it was very, very cheap for an index fund at a point in time when index funds were still a novelty and their low fees hadn’t really taken root yet. I think it planted its flag among traders and investors about two decades ago as this really a low-cost option. So even though it’s not the best pure play tech exposure, its liquidity and its familiarity with the trading community has established it as the go-to tech fund.

Saldanha: What are some alternatives for investors who do want exposure to American tech?

Jackson: It’s a good question because the Qs aren’t the best pure play technology portfolio. For that, I would look to something like Technology Select Sector SPDR ETF. The ticker there is XLK. It’s a great low-cost option for just pure play U.S. technology stock exposure. It’s just taking all of the tech stocks from the S&P 500 and weighting those by market capitalization. So, no frills around it, nothing fancy; you’re just getting a very accurate technology portfolio at half the price of QQQ as well. It only charges 10 basis points per year, which is a very competitive expense ratio, especially for something like a sector equity portfolio.

Additionally, if you’re not looking for just tech, but you want something kind of tech-adjacent, like QQQ, you can look at some of those large-growth index funds. Vanguard Growth ETF, ticker VUG, is a great option, as is iShares Russell 1000 Growth ETF, ticker IWF. These are both very low-cost, broadly diversified growth index portfolios that just by virtue of the kind of stocks they lean into are going to be pretty tech-heavy in their own right. So, you’re dialing back the technology exposure a little bit, but in return you’re getting oftentimes a more competitive fee, broader diversification and, overall, just a more sensible growth-oriented process.

Saldanha: Great. Thank you so much for joining us today, Ryan.

Jackson:  Yeah, always happy to do it. Thanks Ruth.

Saldanha: Very few people enjoy doing their taxes, and most of us—me included—just want to get the uncomfortable task of filing over as quickly as possible, get our refund, and then move on. But Maria Bruno, Vanguard’s head of U.S. wealth planning research, recently spoke to Morningstar Inc.’s director of personal finance Christine Benz and told her that we can all gain some valuable insights by paying attention to those tax forms. Here’s what they had to say.

What You Can Learn From Your Tax Return

Christine Benz: Hi, I’m Christine Benz from Morningstar. Tax season can be a grind, but our guest today thinks that you can gain valuable insights by paying attention to those tax forms. Maria Bruno is Vanguard’s head of U.S. wealth planning research, and she’s here to discuss that topic today.

Maria, great to see you.

Maria Bruno: Likewise, Christine. Thank you.

Benz: Thanks for being here. If people are working through their tax returns, you say that that 1040 form can actually be a source of information, a source of intelligence for improving your financial life. Can you talk about some of the high points that I want to be focusing on if I’ve done my own taxes or maybe I’ve outsourced them to a tax preparer?

Bruno: Good thing. The first thing is not to put it into a drawer and put it away. Take that tax return out and use it as a GPS for the current year. That’s what I’d like to say. The first thing would be, has anything changed, was anything different for last year or anything changed this year? Maybe if you’re going to have a baby this year, for instance, or maybe you had a bonus last year that you may not this year or your job might change. Look and see if there’s anything that might be changing. And then, also think about, well, what does that income picture look like and what do the deductions look like for this year. So, use that as a starting point to understand going into this current year what opportunities might present themselves. And I think we’ll talk a little bit more about some of those opportunities.

Lowering 2022 Taxes

Benz: I think people might be working through their taxes here in early 2023 and there might be a tendency to say, well, there’s really nothing I can do. My tax bill is what it is. It’s already cooked. What can people think about if they potentially want to try to lower the taxes that they owe for 2022?

Bruno: Well, at this point, the options are limited. But you don’t want to discount some of these contribution options that might still be open. If you have earned income, definitely look to consider making an IRA contribution for last year. April 18 is the tax filing deadline. So, you have until April 18 to make that contribution. So, I would encourage everyone to make that contribution. Also, if you have a health savings account, the deadline is the tax filing deadline as well. So, you still may be able to make a contribution to a health savings account. And lastly, if you want to make a contribution to a 529, by and large, most of the contribution deadlines for state tax deductibility is 2022, but there are a handful of states that extend that to April 18. You might just want to double check that if you’ve made or want to make a 529 contribution for the prior year.

Benz: Good advice. You think that working through our taxes can also be a lens to help us figure out where to make future contributions. So, if I’m making contributions to some type of account in 2023, my last year’s tax return can potentially help guide the way. Can you talk about that?

Bruno: Sure. Absolutely. Early in the year, you want to think about wherever possible, making those contributions early. So, if you’re going to make an IRA contribution, do it now if you can. If you’re getting a tax return, take that money and invest it into an IRA. Start that tax-free compounding growth early. Also look for other things. If you are making contributions to some of these tax-advantaged accounts, make them early to the extent that you can.

Gaining Insights Through Tax Returns

Benz: You also note that our tax returns can help us get some insights into how we are managing our investments, especially our nonretirement accounts, our taxable accounts. Can you talk about that?

Bruno: Absolutely. You want to take a look at what type of income has been generated by your taxable accounts. So, for instance, are you invested as tax efficiently as possible? For your stock holdings, for instance, might you be in actively managed funds that may be incurring high amount of turnover resulting in capital gains, for instance, these things that will cause taxation in the current year, whether it’s short-term capital gains or ordinary income taxation. You want to try and minimize those as much as possible. So, tax-efficient index funds or ETFs, for instance, might be a more prudent option. Also, if you’re in a high tax bracket and you’re holding bonds, think about whether or not municipal-bond funds or ETFs might be appropriate. These are funds that generate income, obviously, that are not taxable at the federal and potentially state level depending upon what you’re investing in. So, those are probably the two big things that I would suggest looking at for taxable holdings.

Benz: And certainly, yields are higher, so asset location matters more now than perhaps it did a couple of years ago. I wanted to ask about tax-loss selling. I think many of us consider this as a year-end type of activity, something we would have had to have done in late 2022. Can you talk about that, how potentially it’s not too late to consider doing some tax-loss selling to take advantage of the downturn that we’ve seen in equities?

Bruno: Yeah. Tax-loss harvesting is actually more of an evergreen planning topic. I mean, certainly, a couple of the obvious ones might be, hey, if there’s market volatility and you might have assets that may be depressed, and you might go in and take a look at your holdings and see what you might be holding at a loss and harvest some of those losses. That’s what we call the silver lining of market volatility. And the other one is at the end of the year when you have a pretty good tax picture. But think about activities that you may be doing in your portfolio, whether it’s rebalancing or if you have some realized gains set aside already accrued, look to see if you’re holding assets at a loss and harvest those losses. Certainly, be mindful when you’re transacting on the tax-loss harvesting to make sure that you’re not tripping the wash sale rules. But certainly, if you’re holding assets at a loss, it may be an opportunity to tax-loss harvest. Maybe use it as an activity much like rebalancing. We talked about going in and making sure that your asset allocation is prudent. Also take a look at your tax loss and see what you might be sitting on and if there’s an opportunity to build some tax efficiency.

What to Watch Out for When Reviewing Taxes

Benz: And I mentioned stocks were down last year, so were bonds. So, people may be able to do some tax-loss selling in bonds. I wanted to home in on the subset of people who are in retirement. What should they be looking for as they review their tax returns? Of course, a lot of the considerations we’ve already talked about would apply to them as well. But are there any specific things that people who are in retirement should be thinking about as they prepare their taxes?

Bruno: This is a good one and could provide some financial planning opportunities, particularly for those who have not started their required minimum distributions. Now they’re beginning at age 73. There’s a pretty good window there leading up to RMDs to plan for RMDs and managing that tax liability. Now, this may mean accelerating taxes, which may not be intuitive for many investors. But for many investors that have large tax-deferred balances, they’re sitting on these accounts that once RMDs start could trigger this tax torpedo, large taxation. So, the goal would be look for those years leading up to RMDs and see whether or not you can accelerate income taxed at a presumably lower relative rate.

There’s a couple of ways you could do this. One would be to spend from tax-deferred accounts, or it could be Roth conversions, doing a series of partial conversions to create that tax diversification. You do want to be mindful for a couple of things. One is, you want to take a look at Social Security. And if you are collecting Social Security, you want to be mindful of whether this additional income might cause Social Security to be taxable or taxed at a higher rate. And then, Medicare Part B premiums that are based upon income thresholds, you want to be mindful as well. But also take a look at where you are in your tax bracket and whether or not you might have low bracket dollars to use up, filling up that tax shelf space by accelerating income and smoothing out that tax liability. What that does is it lowers the traditional IRA balances and then the potential distributions that come with RMDs down the road.

Benz: Maria, great insights for tax time. It’s always great to see you. Thank you so much for being here.

Bruno: Thank you. Thanks, Christine.

Benz: Thanks so much for watching. I’m Christine Benz from Morningstar.

Thank you, Christine and Maria! That’s all for this week’s episode. Don’t forget to subscribe to Morningstar’s YouTube channel to see new videos about market news, personal finance, and investment picks. Thanks to podcast producer Jake Vankersen, who puts this show together. I’m Ruth Saldanha, an editorial manager at Morningstar. Thank you for tuning into “Investing Insights.”

Read about topics from this episode.

T-Mobile Takes a Small Strategic Threat off the Table by Buying Mint

Uber, Lyft, and DoorDash Receive a Favorable California Appeals Court Ruling; No FVE Changes

Potential TikTok Ban in U.S. Would Benefit Google, Meta, and Snap

Why the Nasdaq Isn’t a Particularly Good Investment