Even investors who only keep casual tabs on the stock market probably know most of its recent gains have been driven by Nasdaq-listed stocks such as Microsoft and Nvidia. Indeed, all seven of the so-called "Magnificent Seven" stocks leading the charge throughout the past few years are Nasdaq names. This dynamic makes an exchange-traded fund (ETF) like the Invesco QQQ Trust (QQQ 0.21%) a compelling prospect, since it's built to mirror the Nasdaq-100 index, which means it holds a sizable stake in all seven of these market-beating tickers.
However, before diving into such a pick because it's overloaded with a particular exchange's hottest listings, consider an alternative that might make more sense to step into at this time. The Invesco S&P 500 Equal Weight ETF (RSP -0.38%) sidesteps almost all of the problems the Invesco QQQ Trust poses to investors right now.
The Invesco QQQ Trust's unique imbalance risk
An exchange-traded fund is simply a basket of stocks with at least one common characteristic.
In the case of the Invesco QQQ Trust, this common element is the fact that each of these names is a constituent of the Nasdaq-100 index. These are (for the most part) the Nasdaq Composite's biggest 100 companies as measured by market cap. It's an attractive investment option simply because these baskets make it easy for investors to achieve diversification with a single trade. As their name suggests, exchange-traded funds are bought and sold just like individual stocks.
There's an arguable built-in design flaw with ETFs meant to mirror an index, however. That's the ease with which an index or a corresponding fund can become poorly balanced when a small handful of its stocks reap the lion's share of the market's gains.
The Nasdaq-100 index and the Invesco QQQ Trust are certainly guilty of this problem right now. Because a small number of their underlying holdings -- like the aforementioned Microsoft and Nvidia -- have performed so incredibly well since the middle of 2020, these tickers are now overrepresented within the index. For perspective, Microsoft now accounts for nearly 9% of the index's total value, while Apple makes up 8%. Nvidia's 6.5% of the Nasdaq-100's and the QQQ Trust's value, while Amazon isn't far behind at a little more than 5%. All told, the Magnificent Seven stocks alone make up roughly one-third of the Nasdaq-100's total value. That's not exactly diversified. And that's after the Nasdaq-100 underwent a special rebalancing completed in the middle of last year specifically to address the problem of the Magnificent Seven's overheated performance.
It's a problem simply because these seven stocks tend to rise and fall together. As a group, they're now ripe for some serious profit-taking. This dynamic sets the stage for a degree of bearish pressure that may not be felt by most other stocks.
The Invesco S&P 500 Equal Weight ETF's advantage
The Invesco S&P 500 Equal Weight ETF is different in a couple of ways.
One of these ways is the deeper diversification it offers. Not only does it hold names beyond the Nasdaq's-100 biggest listings, but it's also got considerably more sector-based diversification. Indeed, its greatest sector exposure is to industrial stocks at 16% of its holdings, with financial being its second-biggest group at 14%.
The fund's most important nuance is, however, that it doesn't allow any single stock to ever become too much of its underlying portfolio. The index's and the ETF's managers rebalance these 500 holdings every quarter to bring them all back to just 0.2% of the fund's total value.
In some regards, this premise and strategy can be counterintuitive. Generally speaking, you want to let your very best winners run for as long as they're able to do so. Constantly rebalancing these holdings cuts off your exposure to the S&P 500's best-performing names.
On balance though, the underlying idea provides more long-term upside than not.
See, not only are equal-weighted funds less volatile than their cap-weighted counterparts -- making them easier to own -- they also often outperform their benchmark indexes simply because they hold more exposure to smaller companies. Although the market's mega-caps have become markedly bigger in recent years and outperformed smaller companies' stocks in the process, this is the exception to the norm rather than the norm. More often than not it's the smaller, nimbler players that are better positioned to capitalize on new opportunities.
An automated rebalancing approach also sidesteps another stumbling block associated with cap-weighted ETFs and indexes. That's momentum bias, or bullish interest in a particular stock solely because of its recently bullish performance. This bias can prove especially problematic in the latter stages of an expansion cycle when valuations are already stretched thin and headed into what will likely be a rough patch for the market. It's a particular problem for overextended, high-profile stocks though, which by that point are often over-owned by too many investors who aren't entirely committed to them.
When rebalancing has been taking place for the whole time leading up to that scenario, however, there is no such bias posing an undue risk.
It pays to be proactive rather than reactive
The biggest Nasdaq-listed names may well continue to outperform, keeping the Invesco QQQ Trust out in front of other ETFs. Smaller companies may continue underperforming, weighing on the Invesco S&P 500 Equal Weight ETF performance since it's more exposed to these tickers.
Just bear in mind that by the time it becomes obvious you should make such a strategic switch it's often too late to bother doing so.
Bottom line? If the idea that the Nasdaq's biggest names can't lead the way forever makes sense to you, the time to act is before it seems like you absolutely have to. This is one of those scenarios where it makes sense to be a little too early than even just a little bit too late, in fact. If that time isn't now, then it's certainly soon.
