There’s a good chance you’ve noticed that Apple has been sliding for the past three months.
If you hold a portfolio that is made entirely of index funds, you’re probably not worried about it.
If you’re not very familiar with the funds you hold, though, it’s possible that you should be worried. Not all index funds are equal. In fact, some equal-weighted tech-focused funds that do hold Apple were able to rise yesterday even as the iPhone maker’s stock was pummeled.
But first, a bit of background.
The benefit of most index funds is that they diversify away single-security risk by holding a broad basket of stocks, generally weighted by market cap, and instead isolate the “market” risk of the market that you’re trying to target.
That benefit lessens when you invest in an index with a narrow stock universe and concentrated positions in its top holdings.
The culprit here, of course, is the Nasdaq-100 (don’t get me started on the Dow—it’s just as bad, but doesn’t hold Apple and is thus irrelevant for the purposes of this blog).
The PowerShares QQQ Trust (NasdaqGM: QQQ) tracks the famed Nasdaq-100, used incorrectly by many as a barometer for the broad U.S. market.
It fails badly as a broad barometer, though, because it only holds nonfinancial companies listed on the Nasdaq. The Nasdaq has been historically biased toward technology companies, and indeed, so too is QQQ.
That means that if you’re holding QQQ, you have a 60 percent position in the U.S. tech sector, compared with 16 percent in the S&P 500 Index.
Worse, you currently have a 16 percent position in Apple alone.
So much for diversifying away single-security risk.
Over the past three months, Apple (NasdaqGS: AAPL) is down about 27 percent. The broader, more diversified S&P 500, as represented by the SPDR S&P 500 ETF (NYSEArca: SPY), has meanwhile returned about 7 percent over the same period.
QQQ is up about 3 percent—a significant difference considering both funds are ostensibly indexing the same market.
On the other hand, the First Trust Nasdaq-100 Equal Weighted ETF (NasdaqGM: QQEW) is up about 12 percent.
Equal-weighting schemes are great for reducing single-security risk—with 100 holdings, each of QQEW’s constituents makes up about 1 percent of its portfolio, drastically limiting the impact that any one security can have.
Indeed, QQEW actually appreciated yesterday, even with Apple plummeting 10 percent from the previous day’s close.
Of course, by equally weighting your portfolio, you’re trading single-security risk in for smaller-cap risk, and veering away from pure market exposure.
But if you like the Nasdaq-100’s selection universe and want to minimize single-security risk, QQEW or the newer, cheaper Direxion Nasdaq-100 Equal Weighted ETF (NYSEArca: QQQE) is the way to go. First Trust’s QQEW costs 0.60 percent a year, or $60 for each $10,000 invested, compared with 0.35 percent a year for Direxion’s QQQE.
So, pick your poison. Or look more closely at a broader market alternative.
At the time this article was written, the author had no positions in the securities mentioned. Contact Carolyn Hill at email@example.com.
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