Invesco QQQ Trust (QQQ 0.02%) has risen 35% over the past year, easily surpassing the roughly 14% rise in the S&P 500 index. That might lead some investors to consider this exchange-traded fund (ETF) a superior investment option. Don’t buy it just yet; there are some important nuances you need to understand first.
The index is the key to the story
As with every index-based investment product, the one thing you need to make sure you understand with Invesco QQQ Trust is the index it tracks. In this case, the index is the Nasdaq-100. It is unlike most of the other major market indexes in a very important way. Specifically, human hands don’t touch the index. This is more important than you might think.
Inclusion in the S&P 500 Index and the Dow Jones Industrial Average are both overseen by human beings with the hope of replicating the broader economy. The key distinction between these two indexes boils down to how many stocks they own (roughly 500 versus 30) and the weighting approach (market cap weighting for the S&P 500 versus an odd share price approach that’s a relic of the Dow Jones’ long ago construction). But, in the end, the two indexes have actually tracked surprisingly closely over time.
As the chart above shows, however, the gains of the Nasdaq-100 have far surpassed those of the S&P and Dow. There are a couple of reasons for this. The Nasdaq-100, on which Invesco QQQ Trust is based, is simply the top 100 stocks on the Nasdaq Stock Exchange. The list is market-cap weighted, like the S&P 500. Given the large number of technology companies that choose to list on the Nasdaq, the Nasdaq-100 has ended up with a heavy weighting in the most important technology companies in the world. Those stocks are driving its performance and the performance of the broader market today.
This is not a technology index fund
Some investors might take the above paragraph to mean that Invesco QQQ Trust is a technology index exchange-traded fund. Not really. While technology makes up 57% of its assets and is currently the driving force behind the fund’s strong performance, that still leaves roughly 43% of assets that fall into other sectors. The list includes big contributions from consumer discretionary (nearly 19% of assets), healthcare (roughly 7%), telecom (around 5%), industrials (just under 5%), and consumer staples (about 4%). There are also fairly small contributions from the utilities, energy, real estate, and basic material sectors, all of which are about 1% or less of Invesco QQQ Trust’s assets.
While technology is important, the Nasdaq-100 is very specifically not a technology index. However, now you have to go back to the market-cap weighting of the index. Right now, technology companies are hot, leading them to make up most of the top 10 stocks. The list is filled with names you know, like Apple (AAPL -0.01%), Microsoft (MSFT -1.68%), and Amazon (AMZN 1.65%), which together make up a bit more than 25% of the ETF’s assets. What happens if, perhaps when, these stocks fall out of favor with investors?
There are two answers that really matter here. First, if the biggest technology names fall out of favor, the performance of Invesco QQQ Trust will likely be ugly, given the heavy weighting in these stocks. Second, and equally important, those stocks could end up being replaced by stocks that aren’t in the technology sector and materially shift the nature of the index. Given how the S&P and Dow are created, the impact of a tech downturn won’t likely be as pronounced on the performance or structure of ETFs tracking those indexes.
Know what you own
There’s nothing wrong with Invesco QQQ Trust. In fact, it achieves exactly what it sets out to do — track the Nasdaq-100. The issue that investors need to contend with is whether or not the Nasdaq-100 is the index that they want to invest in. For some, the inherent flexibility of the index to adjust and change, along with the makeup of the largest Nasdaq stocks, might be attractive. For others, the current reliance on a small number of large technology stocks might seem like a risky investment decision. At the end of the day, you simply need to understand what you are getting, or you risk getting something you didn’t expect.
John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Amazon, Apple, and Microsoft. The Motley Fool has a disclosure policy.