Do You Know What’s In the QQQ’s?

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Do you like Apple (AAPL)? Do you think they’ll continue their stellar climb or have we hit that quintessential “moment of peak optimism” investors are told to watch for? Are you prepared to stake 20% of your portfolio on that bet? If you own the PowerShares QQQ (QQQQ), that’s exactly what you’re doing.

Apple made big news on May 26th when it surpassed Microsoft (MSFT) in market capitalization. (Market cap is the number of shares outstanding multiplied by the share price.) But lurking behind the scenes is an even bigger takeover, and one that makes the market cap win look meek by comparison. Apple now accounts for 20% of the NASDAQ-100 index. In fact, Apple’s weight in the index is equal to the combined weights of Google (GOOG), Qualcomm (QCOM), Oracle (ORCL), Cisco (CSCO) and Intel (INTC). What gives?

The PowerShares QQQ, also known simply as “the Qs,” is an ETF that tracks the NASDAQ-100 index. In other words, it’s designed to invest in the same companies, at the same proportion, tracked in the NASDAQ-100. Since investors can’t actually invest in an index, the idea is to match the performance of the underlying index giving investors a chance to, as closely as possible, emulate the performance of the index with a tracking stock.

Most investors make the assumption that the NASDAQ-100, and by extension the Qs, is a market-cap weighted index. This is not actually the case. As Kathleen Pender of the San Francisco Chronicle points out in her article today, NASDAQ was forced to re-think its index back in 1998 when, ironically enough, Microsoft dominated the weighting. “To preserve its tax status, a mutual fund can’t have more than 25 percent in one company,” she writes. “So Nasdaq modified the index to shrink Microsoft and other big companies and beef up small-company weightings.”

Exactly how NASDAQ decides to weigh stocks in its index is a little unclear. According to NASDAQ, “The NASDAQ-100 Index is calculated under a modified capitalization-weighted methodology.” They review the composition on a quarterly basis and “adjust the weightings of Index components using a proprietary algorithm.”

Back in 1998 Apple’s weight in the index was a paltry 0.9%. As Apple grew and Microsoft shares fell, their relative share of the index adjusted accordingly. NASDAQ’s “proprietary algorithm” worked its magic and, since 1998, their absolute share of the index has changed dramatically. Today Apple sits at just over 20% of the index while Microsoft represents only 4.3 percent of the index.

This weighting difference can have dramatic effect on the performance of the index and the tracking stock. To wit: as of about midday today the markets were experiencing a sell-off thanks to some negative news about consumer spending – news that can directly impact a consumer product company like Apple. While the broader S&P 500 index is down 2.67%, the Qs are down 3.16%.

That may not sounds like much, but it’s actually a 20% difference in relative performance. While shares of Google, Intel and Cisco are all trading down today, none of them are off as much as Apple, which is currently off 4.3% on the day – and dragging the Qs along with it.

Morningstar offers a great tool, which we recommend, called the “portfolio x-ray.” The tool gives you the ability to analyze the actual underlying holdings in your mutual funds and ETFs to get a better sense for what you actually own. In addition to understanding the expenses you’re paying, the tool allows you to “understand the basic characteristics of your portfolio including its asset allocation, exposure to different investment styles, geographic regions, and sectors.”

When you run the Qs through the portfolio X-Ray tool, the relative lack of diversification becomes clear. Fully 67% of the Q’s holdings fall into the “information” sector. This compares with 25% in the broader S&P 500. Of the holdings in the Qs, 24% are considered “cyclical” and 43% fall into the “aggressive growth” category, compared with 16% in the S&P 500.

The lesson for investors? The Qs are not as diversified and investment as they may sound. And today, as goes Apple, so goes the Qs. This risk applies to any investment in a cap-weighted index. “Because,” says Pender, “they tend to become dominated by whatever is hot.”

This doesn’t mean that the Qs are a bad investment. It just means they need to be considered in context Before you before you buy the Qs with a “set-it-and-forget-it” mentality, make sure you have a handle on how this particular holding will affect your entire portfolio’s diversification strategy.