Use The QQQ To Take A Bite Of Apple While Limiting Single Stock Risk

Feb.21.12 | About: PowerShares QQQ (QQQ)

With the recent talk of rebalancing the NASDAQ once again due to ongoing outperformance of Apple (NASDAQ:AAPL) versus the other constituents of the index, one decision ETF investors face is whether to own the Powershares NASDAQ ETF (NASDAQ:QQQ) or just own Apple outright. After all, wouldn't QQQ investors have been much better off owning the top holding, (currently about 16 ½% of the index), than the index itself?

A look at Apple (red line) versus QQQ (green line) on a weekly chart answers the question quite clearly:

It appears that everyone should sell their QQQ and load up on Apple, right? Perhaps, but first allow me to note that I am a big fan of Apple and, as I've mentioned before, if anyone can get to a trillion in market cap, Apple can. I like their products, I like their story, and the valuation seems reasonable, so this is not an article bashing Apple by any means. That being said, let's consider a little history to recall the reasons to purchase an ETF in the first place.

First, Apple is not the first stock to be considered the frontrunner in the race to become the first trillion dollar stock. Such market darlings as Cisco (NASDAQ:CSCO), Bank of America (NYSE:BAC), Citigroup (NYSE:C), and General Electric (NYSE:GE) were all on pace for such a distinction at one time. At the time, the idea that any of these stocks could be cut in half, or much worse, seemed ludicrous. As with Apple today, the mere suggestion that any of these could have so much as a down day ever again drew considerable ire from supporters of the stocks. Far be it for me to suggest such a fate for Apple, but these other stocks crashed hard, as beleaguered shareholders can attest.

In a couple even more extreme examples, early ETF investors may recall that the SPDR Utilities ETF (NYSEARCA:XLU) once had a large percentage in Enron and the iShares Telecom ETF (NYSEARCA:IYZ) featured Worldcom as a top holding. The important consideration is XLU and IYZ are still around - Enron and Worldcom, not so much. Once again, I feel compelled to point out that I am not comparing Apple to Enron and Worldcom, I'm only comparing individual stocks to ETFs in general.

Which brings me to the point. When a cap weighted index encounters a situation such as Enron, the weighting of the plummeting stock is reduced continually as the stock declines until such time as the stock has no effect on the index at all. The primary reason to own an ETF is to reduce company-specific risk to the investor. Notice I said reduce, not eliminate company specific risk. XLU shareholders certainly felt the effects of Enron, but they didn't lose all of their money, unlike Enron shareholders. In the highly unlikely even that Apple went to zero tomorrow, QQQ shareholders would feel it, but still have stakes in Microsoft (NASDAQ:MSFT), Google (NASDAQ:GOOG), and the like.

As with most investing, it comes down to risk and return. Investors that have held Apple for the past few years have been richly rewarded. QQQ investors have been rewarded as well, but not nearly as much. In addition, QQQ investors pay 0.2% in fees each year, where Apple shareholders do not.

So, which is best, buying an individual stock such as Apple, or an ETF such as QQQ? Why not both? One often overlooked idea is to own an index as a primary holding and trade stocks around it. There's no law that says you have to ether be a stock investor or an ETF investor.

It's perfectly fine to have extra exposure in stocks you believe in to go along with general market or sector exposure, however, few investors fall in love with ETFs the way they do individual stocks. Since the market has a way of leaving lovesick investors at the alter, having a little diversification via ETFs can help to avoid the devastation that comes with learning a stock doesn't love you back.

Each individual investor has their own risk tolerance that must be considered. The amount of a portfolio devoted to individual stocks versus ETFs depends on factors such as risk tolerance, portfolio size, and amount of time available to monitor holdings.

For investors who seek to participate in great stories such as Apple, but are concerned about individual stock risk, an ETF that is top heavy in a few of their favorite stocks can allow them to have their Apple and eat it too.

Disclosure: I am long GE, CSCO.