Tracking an Index with ETF QQQ Can Be Frightening

Do you know your exposure to the technology heavy NASDAQ? You should.

This week has been a glaring reminder that many ETFs and mutual funds have similar behaviors. If a fund manager tracks the S&P 500, the Dow Jones Industrial Average, or the NASDAQ, then their fund is likely to preform like the index they track. An index is usually cap-weighted. This is certainly true of ETF QQQ (Invesco QQQ ETF). Here is a comparison of several popular indexes for just the last 30 days.

S&P 500, Dow Jones Industrial Average, NASDAQ, Small Caps, and Mid-Cap Stock Indexes

A cap-weighted index fund will have a substantial portion of the total invested dollars in the top ten investments in the index. When the top ten are doing well, the gains can be very appealing. However, the rapidly falling prices of the top ten can help an investor see that the fall can be hard. Index funds are not equal and you should know why they are different. It pays to look at the top ten investments in any mutual fund you are buying. This week the NASDAQ index fell over 7.5%. Any ETF or mutual fund that tracks the NASDAQ likely did the same. If you had $100,000 in a fund, you lost over $7,000 in one week. Why does this happen? Let’s look at one darling: Netflix.

Investopedia does a nice job providing information for free.

ETFs and Netflix (NFLX)

On Friday NFLX fell over $100 per share. This was almost a 22% drop in one day. In November 2021 NFLX was trading for $690 per share. Friday the shares closed at $397.50. In just the last month, NFLX has fallen 34.3%. If you are a buy-and-hold investor, you got hammered. Do you buy more, sell, or abandon ship? I don’t know what to tell you, but I certainly wouldn’t be buying more. NFLX has a P/E ratio that doesn’t seem to make sense, at least to me. It will have to grow much faster than it is to justify paying $400 per share.

There are many ETFs and mutual funds that own shares of NFLX. ETFs with the most NFLX shares include QQQ, SPY, IVV, VOO, and VTI. (Source: ETF.COM)

Comparing Two ETFs: QQQ and DIA

While QQQ has about 100 NASDAQ investments and many of them are technology companies, ETF DIA has far fewer investments: thirty-two. That is because DIA tracks the Dow Jones Industrial Average (DJIA). The top ten investments in DIA make up over 54% of the fund, because it too is cap-weighted. The biggest companies in the DJIA make up the lion’s share of the total value of the fund but the top ten are not tech-focused. The top ten are: UnitedHealth Group, Home Depot, Goldman Sachs, Microsoft (MSFT), McDonald’s, Salesforce.com, Amgen, Visa, Honeywell International, and Caterpillar.

These companies have one thing going for them that many NASDAQ companies often don’t have: dividends and growing dividends. However, MSFT is a part of the NASDAQ, so it isn’t fair to say the advantage of the DJIA is a focus on NYSE stocks. Rather, the focus is on a more diverse type of business and that focus tends to provide growing dividend income.

DIA has a five-year dividend growth rate of 5.15%, a reasonable payout ratio, and it pays the dividend monthly. Retirees like monthly income. QQQ has a better dividend growth rate of 6.25% but that is offset by a puny 0.48% yield and a dividend that is only paid quarterly.

DIA is not a high growth investment. However, it makes up for it with monthly, growing dividends.

Why do Investors like QQQ and some like DIA?

QQQ is great for growth when the market is going up. When it is going down, not so much.

To be fair, QQQ has shown better returns than DIA in the last ten years. However, as more workers leave the workforce, they don’t like rollercoaster results and they cannot live on stock price appreciation. They want income. So, they have to sell investments if they don’t have cash coming from dividends or other sources. Sadly, they might have retired at the end of 2021 only to see their total retirement account drop significantly. If they don’t have a cash reserve, they might have to sell some investments at a price that is far less than the value of the investment when they retired.

I believe more investors will be shifting to dividend growth investments that have a rational yield. DIA’s yield is 3.5 times greater than QQQ’s.

You should recognize the companies in the DJIA. Note that the DJIA is also cap-weighted!

Key Take Away

Investors must always be aware of the top ten investments in all of their ETF and mutual fund investments. This includes investors who pick their own investments, and those who rely on an “expert” to pick investments for them. I have seen far too many portfolios where there is too much invested in a very small number of big companies due to fund overlap.

Recommendation

I like DIA, and I wouldn’t be buying QQQ. But both of them are lacking in diversification. Therefore, as I often have, I still recommend a mix of DGRO, SCHD, and VYM. VOO and IVV are also worthy contestants.