VictoryShares: ETF Targets Nasdaq-100’s Waiting Room

[This ETF industry perspective is sponsored by VictoryShares.]

Last year, VictoryShares rolled out an ETF that looks to surf the growth of the stocks most likely to join the Nasdaq-100 Index. The VictoryShares Nasdaq Next 50 ETF (QQQN) already has $140 million in assets. Here, Senior Investment Analyst Alex Chagoya and Senior Portfolio Manager Scott Kefer discuss the large/midcap sweet spot that the fund captures. You can find their website for more information here.

ETF.com: Would you start by providing an overview of QQQN?
Alex: The VictoryShares Nasdaq Next 50 ETF (QQQN) is one of our three thematic ETFs offered through the VictoryShares product suite. It tracks the performance of the 50 companies that are the next eligible for inclusion into the Nasdaq-100 Index.

As we were structuring this product, we were thinking to ourselves, how could we identify and capture the potential of high growth and high-profile innovative companies before they became household names?

So, this thematic innovation ETF seeks to invest in the next generation of those innovative companies, those with proven models, but presumably at an earlier stage in their life cycle, with still long runways of potential growth.

QQQN offers the ability to own companies destined for the Nasdaq-100 earlier in their life cycle. The product deploys the same methodology as the Nasdaq-100, but with a simpler weighting approach based purely on market capitalization.

It starts with all companies in that universe, both domestic and foreign, that are listed on the Nasdaq stock exchange, removes all companies classified as financials, and then based on market cap, selects the largest 50 companies that are currently not in the Nasdaq-100.

Tickers shown are representative securities of each index as of 12/31/2020. Individual stock performance was not considered when choosing the companies highlighted above. Nothing in this illustration should be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes.

ETF.com: Is the lack of financials a benefit of this fund, or just a neutral feature?
Alex: Looking at just the Nasdaq-100 performance over the longer term, it's been fairly extraordinary. It's one of the leading global indexes across the world. I don't think necessarily the inclusion of financials would have really had the potential to improve or detract from returns too much. Financials also typically provide exposure tilted to value. We really are targeting a growth bias that comes along with the holdings of QQQN.

ETF.com: Why should investors be excited about the companies that are just one tier below the Nasdaq-100?
Alex: Looking back at some of the previous constituents of the index the QQQN tracks, there have been some quite notable companies—such as Moderna, Expedia, Facebook, Netflix, Sandisk—that have all contributed to performance in the Nasdaq Q-50 index. So it's really owning those up-and-coming names before they become mega cap and large cap leaders in the 100.

ETF.com: Given they’re just below the top 100 nonfinancial stocks in the Nasdaq Composite, do the holdings in QQQN all qualify as large caps?
Alex: We would look at them as midcap growth stocks, not necessarily large or mega cap, in terms of Apple, Google, Tesla, that contribute those extreme weights to the Nasdaq-100.

If we look at some of the constituents of QQQN, even though it's market cap weighted, the distribution of weights is much more balanced, ranging from 1.5%, roughly, to upward of 4%. That spread between the weights is much more evenly distributed versus what you might find in the Nasdaq-100, where a single large cap weighting could be almost 13%, and smaller names might have a minuscule weighting allocation in the Nasdaq-100.

Scott: Most of these holdings are going to fall into the midcap space. A couple might be large caps. And obviously, it's similar to an arbitrary moving target.

Source: Nasdaq data analyzed by Victory Capital Management and sourced from FactSet; as of 12/31/2020. Not a recommendation to buy, sell or hold any security.

ETF.com: Is the midcap exposure part of the investment argument for QQQN?
Alex: I think so. That’s where we see QQQN able to provide complementary exposure to the Nasdaq-100. It offers diversification into forward-thinking, innovative and disruptive companies, earlier in their growth cycle, before they join the Nasdaq-100.

ETF.com: The portfolio includes names like Etsy and ViacomCBS. Can you talk a little more about QQQN’s holdings?
Alex: Over the last year, we saw quite a shift in business practices, seeking more innovative and nontraditional ways of operating as the COVID pandemic took over. There were many companies that benefited from that innovation, such as DocuSign, Moderna, Peloton. These are all names that QQQN was able to capture, and ultimately benefited from that type of innovation.

One of the benefits of the quarterly rebalance and reconstitution cycle of QQQN is that innovation is occurring quite rapidly, so things can change on a dime. With the quarterly rebalance cycle, it gives QQQN the opportunity to reallocate to those up-and-coming companies quarterly, and then on the same note, drop underperforming companies much more quickly than if it were on, let's say, an annual rebalance cycle.

Scott: That's the only difference in our methodology from the Nasdaq-100. We have the same methodology. It's a very simple process, where you have foreign and domestic companies listed on the Nasdaq exchange. Financials are removed, and the largest 100 forms the Nasdaq-100. The next 50 form our Q50 index. It's a pretty straightforward shared methodology, other than the fact that our index reconstitutes four times a year. The Nasdaq-100 only reconstitutes in December.

During the December rebalance, both indexes will simultaneously go through the process, but for the other three quarters of the year, the Q50 simply takes the largest 50 companies not already in the Nasdaq-100. That's where it can pick up IPOs or a company that may experience a rapid acceleration in growth.

Last year was a great illustration of it, when you had something as disruptive as what went on with the pandemic, and companies like DocuSign, like a Peloton, like a Moderna, can rise to that eligibility range of the next 50, inside of a year. Having those quarterly rebalances lets us get these new innovative companies in much quicker and remove underperforming names much more rapidly as well.

Netflix, Facebook, Tesla—these companies all spent time in the Q50 before they graduated into the Nasdaq-100. There are a lot of good story stocks you can pull from that deck of past, present and recent constituents of the Q50 index.

So we just reconstituted for our quarterly in March. Some cannabis stocks made the list, so now we have Canopy Growth. There's sort of this multithematic element to this strategy of always ending up with something active; representation to multiple different themes. We have a lot of next-generation internet companies, like Roku and Trade Desk. We have security companies and digital internet companies, like CrowdStrike.

Source: Nasdaq as of 12/31/20. Individual stock performance was not considered when choosing the companies highlighted above. Nothing in this illustration should be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes.

ETF.com: What happens when a company is dropping out of the Nasdaq-100? Does it fall into the 50 stocks in QQQN? How does that get handled?
Alex: The ETF was launched back in September of last year. However, the index that it tracks has been live since October 2007. With that longer track record, it gives us the opportunity to look at live returns and actual performance of how this would have performed in various market conditions and cycles.

And so looking back since inception of the index, 66 companies were demoted into the Q-50 from the Nasdaq-100. We looked at the average total return of those names that drop back into the Q-50, and there's really an interesting storyline that plays out. Some of those names were later promoted back into the Nasdaq-100. Some of those names still remain in the Q-50 index. And then some of those names dropped out from the bottom of the Q-50 entirely.

And as we look at the returns, it shapes out in a fairly positive story, with those that were promoted back to the Nasdaq-100 having an average total return of roughly 140%. Those that remain in the Q-50 had an average total return of about 53%. And those that were dropped out entirely from the Q-50, from the bottom, have average total return of only negative 8.5%.¹

The contribution of those that were placed back into the 50 from the 100 was far from negative.

Scott: Since this index's inception, there have been 110 stocks over this 13-year period that graduated up to the Nasdaq-100. On average, that’s about six stocks a year. In the 12 months leading up to their graduation, they're up 76%, on average. Once they graduate, the next year, they cool off. They're only up, on average, 18%.²

There's a real benefit to getting into these names earlier in their life cycle, before they become household names, before they graduate to the Nasdaq-100. With the six that are really on the cusp of graduating, it’s nice to have them in a portfolio like this, where they can be 3% and 4% positions, and benefit from that sort of hypergrowth stage that they make that transition from midcap into large cap.

^1. Source: Nasdaq data analyzed by Victory Capital Management and sourced from FactSet as of 12/31/2020; Index inceptions date is 10/10/2007. Performances stated are cumulative returns for each company based on the time they were in the Q-50 Index, considering that companies may have moved in and out of the index over time. Past performance is not indicative of future results. Not a recommendation to buy, sell or hold any security.

^2. Source: Nasdaq as of 12/31/2020;
Individual stock performance was not considered when choosing the companies highlighted above. Nothing in this illustration should be construed as a recommendation of individual holdings or
market sectors, but as an illustration of broader themes.

1. Constituent counts by year include some double counting; for example, Illumina was originally moved into the Nasdaq-100 in 2008, subsequently kicked back out to Q-50, then moved back in 2013. Of the 106 constituent “graduations,” there were 98 unique companies. In addition to Illumina, Ctrip.com International; Green Mountain Coffee Roasters; Hansen Natural; Hologic; J.B. Hunt Transport Services; Netflix; and NXP Semiconductors moved from the Q-50 into the Nasdaq-100 twice during the 2007-2019 period.
2. In the case of the 12-month statistics, names added in 2020 were excluded from averages.

Carefully consider a fund's investment objectives, risks, charges and expenses before investing. To obtain a prospectus or summary prospectus containing this and other important information, visit www.vcm.com/prospectus. Read it carefully before investing.

Investing involves risk, including the potential loss of principal. In addition to the normal risks associated with investing, investments in small- and midcap companies and narrowly focused investments typically exhibit higher volatility. International investing may involve risk of capital loss from unfavorable fluctuations in currency values, differences in generally accepted accounting principles, or economic or political instability. Technology companies are often subject to severe competition and product obsolescence.

The Fund has the same risks as the underlying securities traded on the exchange throughout the day. Redemptions are limited, and commissions are often charged on each trade. ETFs may trade at a premium or discount to their net asset value. The Fund is not actively managed and may be affected by a general decline in market segments related to the Index. The Fund invests in securities included in, or representative of securities included in the Index, regardless of their investment merits. The performance of the Fund may diverge from that of the Index.

The Nasdaq Q-50 Index is a market-capitalization-weighted index designed to track the performance of companies that are next eligible for inclusion into the Nasdaq-100 Index. The Index comprises 50 securities and reflects companies across major industry groups, except financial companies. Nothing in this illustration should be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes.

VictoryShares ETFs are distributed by Foreside Fund Services, LLC. Victory Capital Management Inc. is the adviser to the VictoryShares ETFs. Victory Capital is not affiliated with Foreside Fund Services, LLC. Nasdaq is a registered trademark of Nasdaq, Inc. and its affiliates (together, “Nasdaq”) and is licensed for use by Victory Capital. The product(s) are not issued, endorsed, sold, or promoted by Nasdaq. Nasdaq makes no warranties as to the legality or suitability of, and bears no liability for, the product(s).

©2021 Victory Capital Management Inc.
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