PowerShares QQQ (QQQ) has been racing ahead. During the past five years ending March, the ETF has returned 7 percent annually, outdoing the average large growth mutual fund by 4 percentage points, according to Morningstar. Investors have taken notice, and the ETF has $26.3 billion in assets. Should you join the crowd? Maybe not. The problem is that the ETF tracks the Nasdaq 100 index, a quirky benchmark. While it is supposed to represent 100 stocks, the index has 27 percent of assets in just three names, Apple, Microsoft, and Oracle. If one or two of those collapse, then the ETF would sink.
The QQQ fund is not the only ETF with an unusual structure. Other popular funds put heavy weights on a few stocks or use strange systems for picking holdings. These flawed funds make poor choices for clients who turn to ETFs for diversified exposures. Instead of taking oddly constructed ETFs, most investors should prefer funds that provide broad representation of important market segments.
Throughout its existence, the Nasdaq 100 has been strangely designed. The index aims to include 100 nonfinancial stocks that trade on the Nasdaq. With Nasdaq technology stocks soaring in the late 1990s, a developer sought to offer the first fund that would track the benchmark. But under SEC rules, no single stock could account for more than 24 percent of a fund portfolio's assets. This created problems for the new Nasdaq fund because Microsoft would have accounted for 25 percent of its assets.
To make it possible for the fund to meet SEC rules, the Nasdaq index agreed to rebalance according to a new set of rules. Under the policy, the assets of Microsoft would be lowered below 24 percent, and the weighting would be shifted to stocks with allocations of less than 1 percent. One of the tiny stocks that received more weighting was Apple. “It is a bizarre system for rebalancing,” says Dave Nadig, research director of IndexUniverse.com.
For 13 years, the index never rebalanced, and Apple mushroomed to account for more than 20 percent of assets. This year, the index managers again rebalanced, reducing Apple's allocation by 8 percentage points in a single day. When will the next rebalancing occur? That's hard to know, says Nadig. The rules allow the index managers plenty of discretion.
Instead of investing in the QQQ fund, investors should consider Rydex S&P 500 Pure Growth (RPG), says Michael Rawson, an ETF analyst for Morningstar. The S&P fund is broadly diversified and holds many of the high-octane stocks that are in the Nasdaq benchmark.
To place bets on industries, many investors rely on sector ETFs. Among the most popular are the nine Select Sector SPDR ETFs, which cover major areas of the S&P 500. But the Select Sector funds are not broadly diversified, warns Ron Rowland, president of Capital Cities Asset Management, a registered investment advisor in Austin, Texas. For example, Health Care Select Sector SPDR (XLV) has 32 percent of its assets in three stocks, Johnson & Johnson, Pfizer, and Merck. Instead of using the Select Sector funds, Rowland prefers funds that have more equal weightings. “If I can choose between two funds, I will usually take the one that has more diversification,” he says.
Rowland often uses SPDR industry funds, which cover narrower groups and weight the holdings more equally. He particularly likes SPDR S&P Biotech (XBI). The fund has about 40 stocks. Recently 25 of the holdings each had between 2 percent and 4 percent of assets.
Seeking to benefit from rapidly growing emerging markets, investors have been pouring into regional and country funds. But many of the most popular choices focus on one or two big stocks. These are often quasi-governmental businesses that export heavily to the developed world. Such multinationals don't necessarily provide good vehicles for investing in the growing consumer markets of the emerging markets.
Consider iShares MSCI Brazil (EWZ), one of the most popular emerging market ETFs with $12.7 billion in assets. The fund has 30 percent of its assets in two stocks, oil giant Petrobas, and Vale, a multinational mining company.
For a more diversified exposure to the growing domestic economies of the developing world, consider WisdomTree Emerging Markets SmallCap Dividend (DGS). The fund holds 450 dividend-paying stocks from 18 countries.
Lopsided Bond Funds
Most of the benchmarks used by equity ETFs are weighted by market capitalization. Under this system, stocks with large market caps count for more than small caps. The same system is used in the bond markets. Issuers with the most bonds outstanding account for the greatest weight. Critics of the approach argue that the system emphasizes issuers that are the most heavily indebted. “You are overweighting the riskiest issuers, and that is not what a rational investor might do,” says Nadig of IndexUniverse.com.
The weighting system can result in particularly shaky portfolios for funds that invest in high-yield bonds, which are rated below investment grade. The biggest holdings in the funds tend to include indebted financial and manufacturing companies. A standard high-yield fund is SPDR Barclays Capital High Yield Bond (JNK). Instead of relying on such a traditional fund, investors should consider funds that are weighted according to fundamental factors, says Michael Rawson of Morningstar. He likes PowerShares Fundamental High Yield Corporate Bond (PHB), which tracks the RAFI High Yield Bond Index.
The RAFI index was developed by Research Affiliates, the company headed by Rob Arnott, a longtime champion of fundamental indexing. In a RAFI bond index, issuers are ranked by four factors: book values, gross sales, gross dividends, and cash flow. Under the system, companies receive a heavier weighting if they pay more total dividends and record more sales. These bigger companies tend to be more stable, says Rawson of Morningstar. “The fundamental approach gives you a tilt toward higher-quality businesses,” he says.
The PowerShares fundamental high-yield fund has an average credit quality of BB, one step below investment grade. In contrast, the more traditional SPDR high-yield fund has a lower grade of B. It is too soon to know whether the PowerShares fund will outperform in the long term, but the fundamental system should appeal to investors who are looking for solid choices that can be used to build diversified portfolios.