This article is an updated version of comments which appeared in the article The Case For QQQQ in July 2005.
David Jackson, the founder of Seeking Alpha, wrote an article titled The Case Against QQQQ in which he argued that an index based on the exchange at which certain stocks trade is arbitrary and non-sensical.
In response to The Case Against QQQQ, I offer this cogent argument for why the ETF (now QQQ) is a useful and usable ETF for long-term investors.
David, I'm writing a counter-argument to your point about QQQ. My counter-argument has the following parts: 1) fundamentals, 2) correlation to the S&P 500, 3) inclusion policy, and 4) for an arbitrary, non-sensical index, look at the Dow Jones Industrial Average.
In principle, you're absolutely right: The exchange on which a stock trades seems like a silly criteria to base an ETF on.
But in practice (perhaps purely by chance!) QQQ happens to be a great collection of stocks that represents a slice of the future of America. And actually more than just America; there's some international exposure too.
In other words, by coincidence QQQ happens to contain most of the stocks my fundamental analysis (bias toward Growth) says I should own. Yes, it's got Microsoft (MSFT), Intel (INTC), Qualcomm (QCOM), Apple (AAPL), Cisco (CSCO), and other tech, but it's also got Starbucks (SBUX), Whole Foods (WFM), Bed Bath & Beyond (BBBY), Costco (COST), Dollar Tree (DLTR), Amgen (AMGN), Celgene (CELG), Paccar (PCAR), Comcast (CMCSA), Sears Holdings (SHLD), Pet Smart (PETM), Fastenal (FAST), generic drugs, a casino, satellite radio, and more.
You make mention of the fact that it's tech-heavy but does not contain Hewlett Packard (HPQ) or IBM (IBM). Again, perhaps purely by chance, the example is illustrative. I don't want Hewlett Packard and IBM. I want Dell (DELL), Intel, Apple, and one of the outsourcers - e.g., Congnizant (CTSH).
I like that it does not include Oil and Financials because I prefer to hedge with those separately.
So for my philosophy, the mix contained in the index happens to work out, but I realize that it may not for other fundamentals-oriented investors.
That said, I'm not totally happy... I would love for QQQ to include GE (GE), and a couple of others. But see point 2, "it's close enough".
Correlation to the S&P 500, but with a higher beta
Of course, if I had to choose 100 stocks individually, I cannot say that I would buy every single one of the 100 stocks in QQQ, and in those proportions. But this is true of any large basket of stocks. Buyers of such baskets are looking for broad exposure to American industry, and it sounds funny when you say it, but the fringe stocks, of which there are tiny percentages of in the basket, don't really matter. It's close enough! QQQ has very good correlation to the S&P 500, and I think that that's what's important. It has a higher beta. I believe this to be a benefit to me, because part of my philosophy relies on market timing. The higher beta lets me get in at lower lows and out at higher highs.
Inclusion and exclusion policy
I like the clinical inclusion policy. The index is reviewed every quarter and the top 100 capitalized non-financial stocks on the Nasdaq make it in. When a company in the index becomes smaller than the 125th in market cap, it is dropped and the new 100th is added. I like clinical objective policies (even though they may become somewhat random in the corner cases) and thus prefer this to more subjective ones in other indices.
I know there are disadvantages to market cap-weighted indices, but I do think there is a correlation between success and market cap. The objective inclusion policy should result in early detection of failure or diminishing success.
For an arbitrary, non-sensical index, look at the Dow Jones Industrial Average
For an index that does not make much sense, look at the most-cited index, the Dow Jones Industrial Average (DIA). Critics argue that with only 30 stocks, it is not an accurate representation of the market. Worse, it is neither a market-cap-weighted nor an equal-weighted index, but a price-weighted index, which gives higher priced stocks undue influence over the index. Crazy as it sounds, a $1 increase in a lower priced stock is negated by a $1 decrease in a higher priced stock, even though the lower priced stock had a higher percentage increase. Goofy.
Those things combined make QQQ more appropriate for me than SPY or DIA.