The Case Against The Largest ETFs

December 23, 2010

The ETF world is driven by large-cap equity, for better or for worse.



While most of us writing about ETFs have talked a lot about niche products and how to play them, the flows data paint a far different picture: The money is in the big three.

The SPDR S&P 500 (NYSEArca: SPY), PowerShares QQQ (NYSEArca: QQQQ) and SPDR Dow Jones Industrial Average Trust (NYSEArca: DIA) ETFs have long been the bellwethers for all other funds in the marketplace.

They collectively make up $122 billion in assets under management and dominate the charts for creations and redemptions almost every day. They’re the titans of exchange-traded funds. There’s a good chance that you have a little bit of these funds in your own portfolio.

But you shouldn’t.

Even though these three funds are juggernauts, they’re far from perfect. What’s worse, they may not be providing what your portfolio needs.

DIA is designed to provide exposure to the top 30 securities on the Dow Jones Industrial Index—the oldest and possibly best-known indicator of market movement. To its credit, DIA generally does this well. But its index is itself flawed.

The Dow Jones Industrial Average Index is built as a modified price-weighted index. In simplest terms, it values securities that trade at a higher price more than those that trade lower, for no reason other than the share price in dollars.

Even worse, the index is built around 30 of the largest stocks in the marketplace. Thirty! Imagine applying this same line of thinking to your dinner options. What if you could only eat at the 30 largest restaurants? Your diet would quickly consist of Whoppers and McNuggets.

The Qs isn’t much better. Driven by the Nasdaq-100 Index, QQQQ is often used by investors who want exposure to the tech sector. It’s an assortment of domestic and foreign securities that explicitly leaves financial stocks out, so tech companies play a large role. But the unusual weighting scheme leaves me puzzling over why it’s so popular.

Billed as a “modified market-cap weighted index,” QQQQ’s weighting is as much a roulette wheel as it is a sound methodology. As I’ve explained before, an effort to cap the influence that Microsoft had on the index when it was created in the late 1990s dramatically skewed the weightings in the portfolio. Today, Apple makes up more than 20 percent of the index—five times as large a position as Microsoft, despite the fact that the two companies are roughly the same size.


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