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ETF Of The Week: The Weirdest Fund Turns 20

Lara Crigger

How do you explain a fund like the Invesco QQQ Trust (QQQ)?

The sixth-largest ETF by assets, and the second-most-actively traded, QQQ (sometimes called "the Q’s") defies easy explanation. Is it a tech market proxy? A large-cap growth fund? A thematic, "innovation" ETF?

It's none of these, says FactSet's Director of Research Elisabeth Kashner: "It's a Rorschach test."

QQQ is many things to many different people, she explains. With over $67 billion in assets under management, QQQ is one of the largest ETFs in existence; in fact, the fund is so popular, it accounts for $1 of every $50 invested in U.S. ETFs. But pinning down exactly what investors use QQQ for is no easy task.

"The Q’s are such a mystery to me that I don't quite know what investors think they're getting when they put money into the fund," Kashner added.

Tech Fund That Wasn't

QQQ's benchmark is the Nasdaq-100 Index, which tracks the top 100 stocks by market cap listed on the Nasdaq Stock Exchange, excluding financials.

Once upon a time, that meant tech stocks: In 2000, one year after QQQ launched, a full 78% of the index (and QQQ) was allocated to the tech sector (right during the worst of the dot-com crash). Indeed, for years afterward, QQQ was dominated by its significant allocation to Microsoft (MSFT) and, later, to Apple (AAPL).

Today however, tech stocks comprise only 60% of QQQ. Most of that is in the handful of "FAANG" stocks: Facebook (FB) (5%), Amazon (AMZA) (9%), Apple (10%), Netflix (NFLX) (2%), Alphabet (GOOGL) (10%) and Microsoft (10%). Meanwhile, another 21% of QQQ is in consumer cyclical stocks, like Pepsi (PEP) and Costco (COST), while another 9% is in health care stocks.

Yet traders still use QQQ as a proxy for the tech industry, and when tech swings, so too do flows in and out of QQQ. For example, since tech stocks began to droop back in October, QQQ has seen net outflows of $2.6 billion.

For his part, John Frank, QQQ's equity product strategist for Invesco, resists the description of QQQ as a tech fund.

"I don't think QQQ is necessarily about technology, but about technology-enabled companies. It's about innovation," he said. "These are today's companies which are changing the economy for the better and growing well. It's almost sector-agnostic."

Good Growth, Better Long-Term Performance

Frank argues that QQQ is better understood as a large-cap growth fund, citing the above-average R&D budgets and investment by Nasdaq-100 companies, as compared to S&P 500 companies.

The idea of QQQ as a large-cap growth ETF makes some sense. For example, the fund's price-to-earnings ratio is roughly 24, placing it solidly at market average, while its price-to-book ratio is relatively high at 5.6.

Yet comparable—or better—metrics are available from other dedicated large-cap growth funds, such as the $42 billion iShares Russell 1000 Growth ETF (IWF), which has a P/E ratio of 25 and a P/B ratio of 7.0.

However, what QQQ offers is fairly strong risk-adjusted returns, especially over the long term. Over the past 10 years, the fund has returned 21%, compared to the SPDR S&P 500 ETF Trust (SPY)'s 16% and IWF's 18%.

 

Source: StockCharts.com; data range 3/14/16 - 3/14/19

‘Marketing Triumph’

The Nasdaq-100 Index on which QQQ is based is itself a strange beast, says Kashner, who explains that the index was first developed in 1985 as a way to promote the then-up-and-coming Nasdaq exchange, boosting its liquidity and popularity compared with its competitors, the NYSE and AMEX.

"It's a marketing triumph; there's no question about that," she added.

As a modified market-cap-weighted benchmark, the Nasdaq-100 blends equal and market-cap weighting through an unusual weighting and rebalancing mechanism.

According to QQQ's prospectus, the benchmark limits the weight of individual securities to 24% and the top five stocks' combined weight at 40%. Furthermore, the aggregate of stocks with weights higher than 4.5% is limited to 48%.

Unusual Rebalancing Scheme

Should these limits be exceeded, a cascading rebalance is triggered.

First, if the biggest stock weighting exceeds 24%, at the next quarterly rebalance (or at Nasdaq's discretion), the weight of that stock is brought down to 20%. Meanwhile, if the aggregate of stocks with weights higher than 4.5% exceeds 48%, then all those stocks' weights are reduced at once, until the aggregate hits 40%.

That freed-up weighting is then distributed, stock by stock, to holdings below 1%; meaning, if a stock has a weight of 0.99%, it is pushed up to 1%, then the next stock that's at 0.98% gets pushed up to 1%, and so on, until all the excess weight is distributed.

On an annual basis (or, again, at Nasdaq's discretion), the index is checked to ensure the top five stocks' collective weight doesn't exceed 40%. If they do, they are together scaled down in weight until the combined weight hits 38.5%. Whatever weight is left over is redistributed to the rest of the securities—until they hit a 4.5% cap, at which point the remaining weight is redistributed to those securities that haven't hit 4.5%.

Have you gone cross-eyed yet?

"At the core, it's nonsensical," said Dave Nadig, managing director of ETF.com (read: "The Worst Index In The World"). "The rebalancing mechanism leaves you with a tortured mash-up of cap-weighting and equal-weighting, while the universe has no grounding in any core investment thesis. It's almost literally a random collection of stocks."

Invesco’s Frank acknowledges the quirks of the index, but adds that, "These are just the index rules that Nasdaq implemented so that the index doesn't get too concentrated."

Quirks In The UIT Structure

Intriguingly, QQQ is a holdover from the early days of ETFs, some of which launched under the now-mostly-obsolete unit investment trust (UIT) structure. SPY is another example of a UIT, as is the SPDR Dow Jones Industrial Average ETF Trust (DIA).

As a UIT, QQQ possesses a few structural quirks. For example, the fund has a life span: According to the prospectus, QQQ must close by either March 4, 2124 or "the date 20 years after the death of the last survivor of fifteen persons named in the Trust Agreement, the oldest of whom was born in 1986 and the youngest of whom was born in 1996."

"Tying the longevity of your product to the health and well-being of the trustees is, to say the least, unusual" said Nadig.

Secondly, UITs may not reinvest their dividends; instead, the trust must hold them as cash and periodically redistribute them to shareholders. That introduces some cash drag into the fund.

Given that QQQ's current distribution yield is just 0.79%, it won't be much cash drag. But it can make a difference over the long haul, especially in rising markets.

Through-The-Roof Volume

Traders don't seem overly bothered by QQQ's unusual index or structure, however. QQQ remains the second-most-actively traded ETF in the U.S., behind only SPY. On a daily basis, the Q’s trade an eye-popping $5.2 billion in average volume, with almost 31 million shares trading hands at sub-pennywide spreads.

"Knowing that there is liquidity out there puts people's minds at ease," said Frank. "There are hedge funds and institutions that need to change their beta on a dime. So they'll use QQQ to do that."

"QQQ has done an extraordinary job as a trading tool,” noted Kashner. “It's obviously beloved."

But the fund still leaves her with a lot of questions.

"I have to wonder," she added, "if we'd never had the Q’s and this fund launched today, would it get this kind of reception?"

Contact Lara Crigger at lcrigger@etf.com

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