QQEW: Limited Benefits From Smart Beta
Summary
- QQEW is the largest and the oldest fund offering exposure to an equally-weighted version of the Nasdaq-100 index.
- QQEW has larger exposure to value stocks if compared to QQQ. Its allocation to growth and momentum plays is much lower.
- Hefty expenses are partly to blame for its underperformance.
- Its large counterpart is ahead in almost every possible sense, with better Momentum, Dividends, Expenses, and Asset Flows, except for Risk that is elevated given top-heaviness.
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Smart-beta funds are an area of particular interest of mine. Today, I would like to discuss another one - the First Trust NASDAQ-100 Equal Weight Index ETF (NASDAQ:QQEW). The fund is the largest and the oldest in the duo offering exposure to a recalibrated version of the Nasdaq-100 index, with every constituent (except for companies with two common-share classes) having a weight of no more than 1% at rebalancing. The second one is the Direxion NASDAQ-100 Equal Weighted Index Shares (QQQE), with the AUM almost 3x lower.
The highly-concentrated Invesco QQQ ETF (QQQ) rich with much-hyped tech names that drove outsized returns of the U.S. stocks in the previous decade and supercharged a staggering market recovery from the coronavirus lows unquestionably has not lost its allure, at least not yet. The tech dominance is not going anywhere, though it also goes without saying that stock prices in the IT space are extreme.
The problem that is on the surface is that QQQ's returns are essentially being driven by a concentrated cohort of most prominent players. Another way of saying, QQQ is dangerously top-heavy, with almost 53% allocated to ten main stocks. Risk dispersion is out of proportion. For example, while Apple (AAPL) and Microsoft (MSFT) together account for over 21%, Incyte (INCY) has just 0.1% weight.
And smart beta comes to the rescue here. The purpose of the equal-weight principle is to make the top lighter and optimize the sector, style, and size exposures. As anecdotal evidence suggests, this should translate into higher safety, e.g., lower drawdowns.
Today, I would like to analyze two main themes. First, I'll look at the QQQ and QQEW portfolios through the lens of the Quant rating to unveil how the differences in weighting approaches impacted the funds' exposures to five top factors: value, growth, profitability, momentum, and EPS revisions. I also would like to assess its historical returns, as well as risk measures, to find out if the smart-beta strategy has an edge over the traditional one in this particular case.
Let us begin with the Quant data.
Smart beta boosts exposure to value, dents momentum
As a quick reminder, the Nasdaq-100 is the flagship benchmark encompassing one hundred largest companies listed on the eponymous stock exchange. Tech, communication services, and consumer discretionary are its favorites together accounting for 85%, while utilities, industrials, healthcare, and consumer staples all have weights in single digits.
The only adjustment that was applied to the index tracked by QQEW is that the constituents were weighted equally, another way of saying, each one was given the 1% share of the net assets; since Alphabet (GOOGL) (GOOG) and Fox Corporation (FOX) (FOXA) have two common-share classes, each class was given a 0.5% weight.
However, this seemingly tiny adjustment precipitated a tectonic shift in the sector mix, as well as material differences in factor exposure. Though QQEW remains tech-heavy, its allocation to this sector is lower by around 10%. At the same time, healthcare has a much higher allocation, around 14% vs. QQQ's 6.6%. Industrials also have a greater impact on QQEW in its current iteration given their over 9% weight vs. just 2.7% in the case of QQQ.
Additionally, the alternative weighting scheme allowed the First Trust fund to increase the tilt towards large-caps while reducing the exposure to mega-caps (there are no mid-caps stocks in its portfolio). Mega-caps (over $200 billion in market value) have just a 15.8% share of QQEW's NAV; the figure goes up to over 63% in the case of QQQ.
Consequently, considering a higher share of cyclicals and smaller-size companies, we should not be surprised that QQEW's exposure to the value factor is larger if compared to QQQ.
Using the data downloaded from the screener, I have created two charts that illustrate what tilts both funds actually have. The first one contains the data on the shares of holdings having high ratings (B- or better):
QQQ, QQEW factor exposure; Created by the author using data from Seeking Alpha, Invesco, First Trust
Though both funds have rather small allocations to value stocks (a Value rating of at least B-), QQEW is slightly ahead, with a 15% vs. QQQ's 10%. However, it seems it had to sacrifice its investments in growth players: almost 47% of the Invesco ETF have pronounced growth characteristics, the First Trust ETF has just 37%. Its Momentum and EPS Revisions also lag, and drastically. In terms of profitability (hence, quality), it is also behind, with 93% of the net assets parked in stocks of highly efficient companies vs. QQQ's over 98%.
The second chart tells precisely the same story: 
QQQ, QQEW factor exposure; Created by the author using data from Seeking Alpha, Invesco, First Trust
Here, I analyze the share of stocks that have lackluster scores (D- or lower). It appears that QQQ has a 78% allocation to grossly overvalued companies, while only just ~26% are laggards incapable of delivering growth above the sector medians. In the case of the equally-weighted ETF, loiterers have 32% weight. Invesco also deployed only 4.5% to stocks that have poor momentum vs. First Trust's 13%.
Turning to returns
Now we understand that the equal-weight scheme engenders higher allocation to value plays and smaller exposure to the growth/momentum factors. But does it improve safety or bolster returns? Mostly not. And QQEW's hefty expenses (0.58%) are to blame, among other things.
Anecdotal evidence suggests that a lighter top makes a fund less sensitive to sharp valuation resets and probably to market-wide meltdowns. So let us look at the max drawdowns.
Since QQEW has a deeper 3-year max drawdown, it seems it suffered slightly more during the coronavirus sell-off last spring, which means the equally-weighted portfolio does not necessarily mean higher safety.
QQQ does have a substantially deeper all-time drawdown, but, please, take notice that QQEW was incepted in 2006, while QQQ has been in the market since 1999. So the 80% max drawdown reflects the price slump from the dot-com zenith straight to nadir, and QQEW simply did not exist in the dot com bubble era.
Now, returns. And expectedly, now alpha (mostly). The equal-weight ETF did outperform QQQ in 2009, 2010 (marginally), and 2013; still, in 2008, it slipped much deeper amid the Great Recession sell-off, losing ~43.6% in value vs. the Invesco ETF's negative ~41.7% return. During the post-shock recovery of the tech equities in 2020, QQQ outperformed QQEW by a solid margin. And it's ahead year-to-date. After all, investors who parked $10 thousand in QQQ in May 2006 are not sitting at $104.9 thousand while the QQEW investors have just $64.9 thousand.
QQQ, QQEW annual returns; source: Portfolio Visualizer
Final thoughts
To conclude, QQEW is an expensive smart-beta version of the prominent QQQ fund. Its advantages are questionable.
It does have larger exposure to value coupled with lighter top and smaller exposure to mega-caps. But all these are not necessarily a tailwind.
Despite the smart-beta strategy (though requiring only minimal adjustments to its parent index) that should give it an edge over QQQ, QQEW scores rather weakly. Its large counterpart is ahead in almost every possible sense, with better Momentum, Dividends, Expenses, and Asset Flows, except for Risk that is elevated given top-heaviness, large short interest, and high volatility. QQEW can boast a B- Risk Grade, while the Invesco ETF’s rating is D-, almost the worst possible. Anyway, it has a higher turnover of 28% vs. QQQ’s 7.7%.
QQQ, QQEW Seeking Alpha ETF grades comparison; source: Seeking Alpha
Although I am confident that tech, a close to 50% allocation of QQQ, will remain dominant, some fatigue has also been observable of late. In sum, I give both funds a neutral rating, assuming the current prices.
This article was written by
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