A while back I pointed out that due to Apple's (AAPL) market capitalization, a large number of ETF's were massively over-weight the technology giant. In some cases, Apple represented more than 5%, 7% or even 10% of the total value of the ETF based on how many holdings the fund actually owns.
I recently came across an ETF that is not only overweight Apple by a massive amount, with maker of the iPhone representing more than 13%, but its top 5 companies (6 holdings since Google (GOOG)(GOOGL) has two stock classes) represent more than 37% of the fund, of which might I add has over 100 holdings. Furthermore though, what makes this so interesting is that the ETF I am talking about tracks a major index, which simply adds to the myth that the fund is helping investors diversify and is a safer way to invest.
The Specific ETF I am discussing is PowerShares QQQ ETF (QQQ) which attempts to track the Nasdaq 100. Let me be clear first before I go any further; in most cases I do believe indexing, or simply investing in large indexes is the best way to invest for individual investors. The large indexes such as the S&P 500, Russel 1,000 or 2,000 do offer diversity in the market; limit the larger capitalization stocks to much smaller percentages of the total portfolio, offer very responsible expense ratios while offering an easy one-stop shop for their long-term investing.
But, my grip is with the smaller indexes, smaller as in a lower number of holdings, not dollar value of the fund, such as the Nasdaq 100 and even the Dow Jones Industrial Average (^DJI).
My issue was highlighted just this week, on Tuesday, July 21 when we saw the Dow fall by more than 200 points or roughly 1%, of which though 100 points of that decline came simply from two stocks, IBM (IBM) and United Technologies (UTX) as those stocks fell 6% and 7% respectively during the day.
Looking at this issue over a longer period of time, the Nasdaq 100 has risen more than 5.5% since the start of July. But the indexes top 5 stocks have gained 14.8% compared to the rest of the indexes measly 0.6% gain. When we break down those top 5 companies performance, Google has jumped 27.4%, Facebook (FB) has gained 14.2%, Amazon.com (AMZN) has increased by 12.4%, Microsoft (MSFT) has risen 6.3% and Apple has gained 5.3%.
While these five companies have certainly helped Nasdaq 100 investors since the start of July, those five companies can also hurt investors when they aren’t performing well. For example during 2014, the Nasdaq 100 rose 18.31%. The five companies mentioned above combined returned 18% during 2014 while the other 95 companies return a combined 22.9%. In this situation, the larger companies hurt investors by bringing down the indexes return.
So what's the Point?
By pointing out how a few stocks can dramatically change the overall return of a particular index, ETF, or fund, I am not trying to say that investors they are better off going it alone and attempting to cherry pick individual stocks or picking industry specific funds. While I do believe that strategy can work for some, the majority of investors will be better suited by simply buying index funds and holding them for very long periods of time. The other options take dramatically more time and commitment from the investor in order to reap the same rewards, in addition to in most cases more stress.
The main reason I point out how imbalanced these indexes are though, is to help investors understand that just because they are buying a "large" fund with 10's or even 100's of stocks in them, they can and most likely will still be affected by just a handful of the largest holdings within those funds. Knowing this information can help investors better understand why their fund is performing in a certain way and help them truly better diversify themselves overall portfolio's.
Of the two reasons, the latter is the more important of the two since most investors; even those indexing, don’t typically just buy one fund. In most cases, they buy a few different funds, or a few funds and a hand full of different stocks. So if they don’t pay attention to the fine print associated with the ETF or fund they are buying, they may think they own an even amount of a specific company, when in reality they own a massive amount of a few stocks and very little of their portfolio owns smaller capitalization companies, meaning they aren’t nearly as diversified as they think.
Matt Thalman
INO.com Contributor - ETFs
Follow me on Twitter @mthalman5513
Disclosure: This contributor held long positions in Apple, Google, Facebook, Amazon.com and Microsoft at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.
