Why it Pays to Dig Deep Before Buying an ETF

When buying exchange-traded funds (ETFs), it pays to know what’s inside.

Here’s a great example. Wall Street’s marketing machine tends to treat the technology sector as a single entity and often recommends buying the sector via single investment vehicles such as the fabled Invesco QQQ Trust (QQQ).

In some cases, this is justified. On the other hand, when investing in technology ETFs, it behooves investors to see what’s inside before buying.

The Big Picture

The justification for lumping all tech stocks into one conceptual basket is the notion that all tech companies are related to one another because they are in the same business. As a result, because of the industrial and conceptual ties that bind them together, when one of them rises, the rest of them are likely to follow.

To some degree this is true. Yet, Wall Street erroneously applies this rationale quite often when it targets investors to buy ETFs, such as the Invesco QQQ Trust.

To be sure, investors who choose this ETF have access to a diversified portfolio of 100 large cap stocks which make up the Nasdaq 100 Index (NDX). Moreover, the advantage to owning QQQ is that money in this stock basket catches the general trend of the technology sector as well as the overall stock market during most rallies.

So, it’s great when the market is in an uptrend. But it does not guarantee that you’re getting a tech exclusive investment. More on that below.

The tech-related rallies in QQQ are an especially useful marketing tool when a big buzz generating trend develops, such as the recent artificial intelligence (AI) craze. During the early to middle stages of these story driven price trends, many stocks in the affected sector, in this case technology, move up in tandem and the ETF rises in price, often impressively. These are the good times for instruments such as QQQ, which are heavily weighted toward big cap tech stocks.

Currently, the ETF is in a consolidation pattern after a nifty run-up earlier in the year driven by AI. QQQ has a lot of room to maneuver here, because it has excellent price support all the way down to $355. That means that patient investors are likely to have opportunities to build positions in QQQ during this consolidation pattern.

Under the Hood

A major reason for the bullish action in QQQ over the last six months is the price action in AI bellwether Nvidia Corp. (NSDQ: NVDA). A close review of the price chart for NVDA reveals that its price pattern is nearly identical to that of QQQ.

That’s not a coincidence.

A stock price’s influence on the overall price action of an index is based on the capitalization weighting of the stock in the index. The larger the stock’s capitalization, the greater its influence on the price of the index.

When big stocks go up or down, their weighting can distort the price action of the index.

For example, NVDA has a nearly 5% weighting in NDX, which means that its price action is a significant contributor to the overall price of the index and QQQ.

By comparison, only Apple (NSDQ: AAPL), Microsoft (NSDQ: MSFT) and Amazon.com (NSDQ: AMZN) have higher weightings on NDX than NVDA. These three stocks account for nearly 21% of the index’s capitalization weighting. When you throw in the roughly 3.5% of the index that both Meta Platforms (NSDQ: META) and Alphabet (NSDQ: GOOGL) individually contribute to the index, you can see that these seven stocks (the above plus NVDA) account for nearly a third of the index’s market cap.

Given that these seven stocks often move in tandem, their price trends can often hide the true value of the portfolio which is QQQ. Here is an overview of the NDX components and their weightings on the index.

Nvidia is a hot stock for sure, but Apple accounts for 10% of the weighting in QQQ. As a result, the stock is a major influence on the price for the ETF. It’s a fair assessment that as Apple goes, so goes QQQ.

Apple’s recent weakness has been a negative for the overall price of QQQ. Reports that China may restrict iPhone usage by its government workers as well as a less than impressive reveal by the company of its new line of iPhones and related hardware are pressuring shares.

Another QQQ stock which is often in the news is Tesla (NSDQ: TSLA). But this highly volatile bellwether for the electric vehicle (EV) market only accounts for 3% of the weight in NDX. As a result, it is less influential than the more heavily weighted stocks described above when setting the price for the whole QQQ basket. You can see that TSLA is on the verge of a potential price breakout but QQQ is still sluggish because Apple’s weakness is more influential than Tesla’s strength in the current market.

An even starker sample of how cap weighting affects the overall price of an index is illustrated by another component of QQQ, Texas Instruments (NSDQ: TXN). This stock is trading near its 52-week lows. Yet, its less than 1% weight on the index doesn’t have a major influence in the overall price for QQQ. In other words, if TXN had Apple’s weighting in QQQ, the ETF’s price chart would likely look much different.

It Pays to Dig Deeper

A deeper dive into QQQ shows that aside from tech stocks, it also holds shares in many non-tech companies such as wholesale warehouse Costco (NSDQ: COST), biotech giant Amgen (NSDQ: AMGN), coffee kingpin Starbucks (NSDQ: SBUX), as well as auto parts retailer O’Reilly Automotive (NSDQ: ORLY) and freight and logistics company Old Dominion Freight (NSDQ: ODFL).

Certainly, these and other non-tech companies in QQQ are credible corporate entities. But they’re not tech stocks, which means that when you buy QQQ, you’re not getting a tech exclusive portfolio. This can be a big negative during markets when the technology sector is moving higher while the rest of the market is not. That’s because in that case, the capitalization weightings of the other 70% of the NDX/QQQ index’s components may be enough to pull down any gains in the big cap tech stocks.

QQQ Is an Excellent Trend Trading Vehicle

Wall Street is very adept at marketing its products and its message can be misleading. A great example is the commonly held notion fostered in part by Wall Street and the media that QQQ is a technology ETF.

The truth is that QQQ is heavily weighted toward large cap technology stocks because of the large capitalization of a small group of stocks which it holds in its portfolio. This characteristic can be useful during market trends which favor large cap technology stocks, but can be harmful when these stocks are out of favor.

A more accurate way of describing QQQ is that it is a great instrument for trading long lasting trends in the stock market which are favorable to a specific group of stocks such as Nvidia, Apple, and Microsoft because it is heavily weighted toward this particular group of stocks which in turn attract large amounts of professional trader capital.

I am certainly not recommending that investors shun QQQ. This is a great ETF, especially for investors who trade the general trend of the stock market for periods of weeks to months when these periods emerge.

But I do suggest that before anyone invests in QQQ, they should be aware of the effects on the ETF’s price from Apple, Microsoft, Amazon, Nvidia, Alphabet, and Meta as these five stocks exert an overweight influence on the ETF’s price.

The smart way to make money on Wall Street is to trade with the trend and to stick with it for as long as it lasts. On the other hand, it’s always best to be fully informed before putting any money to work in the stock market.

I own shares in AMZN as of this writing.