If you want a quick, easy way to invest in the high-flying tech stocks found in the Nasdaq-100 index, one of the most popular ETFs you could buy is the Invesco QQQ Trust ETF (QQQ 0.24%).
The fund tracks the performance of the Nasdaq-100, which consists of the largest nonfinancial companies listed on the Nasdaq Stock Exchange. The vast majority of the most heavily weighted companies in the index are familiar tech names that have driven overall market returns for the past year and a half. Technology stocks account for nearly 60% of QQQ's holdings.
The strong track record for Invesco's QQQ Trust is undeniable. But investors just getting into the market may have several better opportunities. Here are three ETFs I'd buy before adding QQQ to my portfolio.
Image source: Getty Images.
1. Get a discount on QQQ with its sister ETF
Invesco launched QQQ in 1999. That's ancient in the world of ETFs. Back then, it didn't have much competition, so it could charge a relatively high price for its ETF.
But it's a different story today. Dozens of financial institutions offer ETFs these days. And as new competitors enter the market, it drives expense ratios lower as they compete for investors.
That's why Invesco launched a new ETF in 2020 called the Invesco Nasdaq 100 ETF (QQQM 0.23%). The ETF uses the same criteria and trading rules as its older sibling, but charges 5 fewer basis points to investors. Its expense ratio of 0.15% bests QQQ's 0.2% fee.
The newer ETF is designed for small, individual buy-and-hold investors. It lacks a lot of the liquidity offered by the older and bigger QQQ Trust, but those factors aren't nearly as important for someone that doesn't plan on trading in and out of their investment. Institutional investors who are making frequent trades in QQQ are more than willing to pay a few extra basis points for a lower spread on their trades. But small buy-and-hold investors shouldn't.
If you're sure you want to buy a Nasdaq-100 index fund, skip QQQ and go with its younger sibling. But there may be better opportunities in the market.
2. Avoid an overconcentrated portfolio with this simple ETF
The Nasdaq-100 isn't very diversified. For one, it only has 100 companies. Nearly 60% of the index is made up of tech stocks.
On top of that, it's market-cap weighted, which means the biggest companies are disproportionately represented in the portfolio. After the strong performance of the "Magnificent Seven," the top 10 companies in the index account for nearly half of the entire portfolio.
Investors can get much more exposure to a diversified portfolio by investing in an ETF that tracks an equal-weight index. The Invesco S&P 500 Equal Weight ETF (RSP 0.16%) tracks the S&P 500 Equal Weight Index. Unlike the S&P 500 or Nasdaq-100, which are cap-weighted indexes, the equal weight index spreads the portfolio evenly across every constituent of the index.
For example, Microsoft accounts for 8.8% of the QQQ Trust and 7.1% of the SPDR S&P 500 ETF. It accounts for just 0.2% of the equal-weight index. And even if it outperforms or underperforms this spring, Invesco will rebalance it back to 0.2% at the start of every quarter.
Giving more weight to smaller companies in the index creates an opportunity to outperform the standard index. While megacap stocks have driven overall S&P 500 performance in recent years, smaller companies have better historical returns over the very long run. The equal-weight index has generated annual returns nearly one percentage point better than the cap-weighted S&P 500 since 2003.
With an expense ratio of just 0.2%, you'll pay the same fees as QQQ. But you get a lot more diversification.
3. Tilt your portfolio with this segment that historically outperforms
If you're looking at the Invesco QQQ Trust ETF, you're probably attracted to the strong historic returns of the Nasdaq-100 index relative to the S&P 500. But the heavy concentration of large-cap growth stocks across the entire investible universe may push you to reconsider. Historically, small-cap and value stocks outperform in the long run. A small-cap value ETF may produce better returns going forward than the Invesco QQQ Trust.
The recent outperformance of large-cap stocks and the relatively poor performance of small-cap stocks has created a massive valuation gap between the two market segments. The Nasdaq-100 has a P/E ratio of 29.7x. Even if you look strictly at large-cap value stocks, they have a relatively high P/E. The Vanguard Value ETF, for example, has a P/E ratio of 19.3x.
By comparison, a small-cap value fund like the Avantis U.S. Small Cap Value ETF (AVUV -0.49%) has a P/E ratio of just 7.8x. That suggests there's a lot more upside potential than downside risk for small-cap value stocks right now.
There are reasons to think that gap will close in the future. First, we can typically rely on reversion to the mean. That's the phenomenon whereby the future typically looks more like the long-term past than the recent past. As a result, after several years of dramatic outperformance, it's not uncommon for a company, industry, or market segment to have a period of underperformance.
What's more, one of the biggest factors impacting small-cap stocks is interest rates. High interest rates can be a bigger challenge for smaller companies than bigger ones. The Federal Reserve quickly ramped up interest rates over the last two years. It's now considering when to lower rates. When rates start to come down, investors should see strong performance among small-cap stocks.
All this means that, amid the current market environment, small-cap value stocks look extremely attractive and may deserve your attention over the Invesco QQQ Trust ETF.
