By Matthew Hougan
After markets closed on Wednesday, Apple (AAPL) trounced expectations by reporting a 15% jump in its second-quarter earnings from a year earlier. That had to come as particularly good news for investors in the PowerShares QQQ (QQQQ).
Why? Because due to the QQQ's unusual weighting methodology, Apple accounts for 12.6% of the fund's assets. For comparison, Microsoft (MSFT) makes up only 4.8% of the ETF, despite having a significantly larger market cap than Apple: $166 billion vs. $108 billion.
The market-cap oddities don't end there. Google (GOOG) counts for just 4.7% of the fund, despite having a market cap of $120 billion, almost identical to Apple. And Google's weight is just a shade above Gilead Sciences (GILD), a biotech company that accounts for 3.5% of the fund, despite having one-third of the market-cap of Google.
The oddities trace back to the Nasdaq-100's methodology. The index is officially a "modified market-cap-weighted index." New companies entering the index are weighted essentially based on their market cap. But once they're in the index, the weight of companies rises and falls based on that company's stock price, with no real rebalancing as other components are added and subtracted from the index.
Apple was added to the index long ago, and the stock has been one of the better-performing equities over the past decade. As a result, its weight in the index has grown and grown and grown.
It's a potential weak point for the fund. If Apple stumbles, the QQQs will suffer.
Curiously, few people comment on the QQQ's unusual weighting methodology. Instead, there seems to be much more criticism of the fact that the fund is not a true "pure-play" technology fund.
People love to point this out, and it's true. According to PowerShares, the fund is 62% invested in technology, with significant chunks in health care (17%), consumer discretionary (13%) and industrials (6%).
When you buy QQQ, you are buying into companies like Apple, Intel (INTC) and Cisco (CSCO). At the same time, you're also buying the generic drug manufacturer Teva Pharmaceuticals (TEVA) (2.6% of the fund); retail shops like Starbucks (SBUX) (1.1%), Bed Bath & Beyond (BBBY) (0.9%) and Costco (COST) (0.9%); as well as industrial firms like Paccar (PCAR) (1.1%).
This criticism misses the point. There are plenty of pure-play tech ETFs out there, such as (by order of assets):
- Technology SPDR (XLK)
- iShares DJ Tech (IYW)
- Vanguard Info Tech (VGT)
- iShares GS Tech (IGM)
- PowerShares Dynamic Tech (PTF)
- First Trust Nasdaq-100 Tech (QTEC)
- Rydex S&P Equal Weight Tech (RYT)
- First Trust Tech AlphaDex (FXL)
If you truly want "Technology" (with a capital T), you'd buy one of these funds.
But I'm not convinced that most investors who buy the QQQs truly want "Technology" exposure. What they're looking for is high-beta, growth-oriented, tech-driven exposure. And to that end, the QQQs deliver.
Consider, for example, the second-largest sector in the fund: health care. Nearly all of the health care names in the QQQs - Genzyme (GENZ), Biogen Idec (BIIB), Intuitive Surgical (ISRG) - are tech-driven companies, even if they are technically not "Technology" firms. Even a decent portion of the consumer discretionary sector is made up of names that could be considered tech-related (Amazon.com (AMZN), Garmin (GRMN), DirecTV (DTV), Expedia (EXPE)). They don't fall into the official GICS Technology category, but they reflect the same general economic and market trends.
Investors who buy the QQQs may say they are looking for "Tech." But what they're really looking for is tech-driven, high-growth companies. And to that end, the QQQs deliver.
Now if they could just fix that strange market-cap issue...