The world of exchange-traded funds is filled with heavy weight indexes geared towards a variety of stock selection criteria. The venerable SPDR S&P 500 ETF (SPY) is the largest and most heavily traded of the top ten funds by asset size. SPY is known for its meaningful diversification, tremendous liquidity, and low costs. It’s the benchmark by which nearly every stock-focused strategy is ultimately compared against.
Having a benchmark is important because it allows investors the opportunity to compare similar investment styles to determine if a fund is meeting their expectations. It can easily identify consistent trends that are worthy of greater interest or evasion.
One such outlier among the largest U.S. stock ETFs is the pattern of outperformance demonstrated by the PowerShares QQQ (QQQ) over the last decade. Per Yahoo Finance data, this ETF has outperformed SPY in 8 of the last 10 years. The only two negative divergences being 2008 and 2016.
What Is QQQ?
One of the primary reasons for this consistent strength is the unique nature of the QQQ portfolio. This ETF is constructed using a market-capitalization weighted asset allocation. This method gives the largest share of assets to the biggest stocks within the index.
Its security selection criteria includes the 100 largest non-financial domestic and international stocks trading on the Nasdaq Stock Market. The index is rebalanced quarterly and constituents are re-evaluated annually to ensure they make the cut.
Nasdaq is widely regarded as a landing spot for technology stocks, which is why QQQ has nearly 58% of its exposure in this single sector. Consumer discretionary and health care stocks round out the top three groups, with 21.52% and 11.46%, respectively.
It’s worth noting that Apple Inc (AAPL), Microsoft Corp (MSFT), and Amazon Inc (AMZN) represent over one quarter of the total exposure within QQQ. That means these three mega-cap stocks are going to have an outsized impact on the fund’s total return and have been top performers over their tenure.
At present QQQ has $46.5 billion in assets under management, making it the seventh largest ETF listed on U.S. exchanges. It also charges a relatively modest expense ratio of 0.20% annually for investors to access this strategy.
Historical Performance And Risks
QQQ has recorded an impressive 10-year annualized gain of +12.60% versus +7.51% in SPY through 2/28/17, per fund company data. Despite its relative weakness in 2016, this fund is off to an impressive start in the first quarter of 2017 as well. The technology-heavy index fund carries a 5% lead over the broader benchmark and continues to demonstrate momentum divergence signals at each new all-time high.
This strength has become second-nature to the those who prefer the more aggressive, growth-oriented style that QQQ conjures. However, there are always risks to consider after a prolonged period of robust returns as well.
The dominance of the QQQ portfolio has been its concentration in high-flying technology and consumer discretionary stocks, while eschewing value sectors like finance. There may ultimately come a time when those stocks falter (like the 2000 tech crash) and QQQ falls by the wayside relative to the broader market and more defensive ETF alternatives.
Furthermore, future outperformance in QQQ will need to be driven by either earnings growth of the underlying holdings or continued expansion of valuation statistics. The latter leaves open the possibility of sharper corrections as fundamentals become stretched.
The Bottom Line
Like many passive ETFs that shine bright in the spotlight, QQQ’s strengths during the current bull market may ultimately be a weakness during the next cycle. That is why it is critically important to evaluate the underlying holdings and their weighting within any ETF you are considering for your portfolio. Security selection and position sizing are the two most important factors in long-term returns.