Don't Be Tempted by This ETF's Strong Performance

The fund tracks the market-cap-weighted NASDAQ 100 Index, which includes the largest 100 nonfinancial stocks listed on the Nasdaq exchange. The Nasdaq is a tech-heavy exchange. Consequently, this sector soaks up over half of the fund’s assets and has a strong impact on performance. However, a pure tech sector fund would offer more efficient exposure to the sector. Concentration risk extends beyond this heavy technology weighting. Its top 10 holdings represent about half of the portfolio, exposing investors to some firm-specific risk.

This strategy falls in the large-growth Morningstar Category, but its portfolio looks quite different from the category norm. Its exposure to the technology sector is more than twice as large as the Russell 1000 Growth Index’s, and it has less exposure to industrial, healthcare, and financial services stocks. In addition, because it limits its holdings to the largest nonfinancial stocks on the Nasdaq, it tends to have a larger market-cap orientation than the Russell benchmark.

While the fund’s technology orientation won’t always pay off, it has worked out well over the past decade, owing to its overweighting in the technology sector and more favorable stock exposure in that sector. However, its sector concentrations tend to make it more volatile than most of its large growth peers.

Fundamental View

The fund’s focus on the largest nonfinancial stocks on the Nasdaq gives it considerable exposure to multinational industry leaders, such as

Market-cap weighting further pulls the portfolio toward the largest names on the Nasdaq, promotes low turnover, and reflects the market’s assessment about their relative value. Market prices (which drive market capitalization) should incorporate all publicly available information, so market-cap weighting is a solid approach. That said, this weighting approach increases the fund’s exposure to stocks as they become larger and more expensive, and reduces its exposure to stocks as they become smaller and cheaper, which may have higher expected returns. It also allows the market to dictate the composition of the portfolio and can increase concentration. While the portfolio includes around 100 stocks, about half of its assets are concentrated in the top 10 holdings. Apple alone represents more than 10% of the portfolio, but this weighting is actually less than Apple’s market-cap weight. The index adjusts the market-cap weightings of its holdings to ensure that the portfolio complies with IRS rules. This means that cumulative weighting of holdings that exceed 4.5% of the portfolio can’t exceed 48% and no more than 24% of the portfolio can be held in any single security.

The fund’s fortunes are inexorably linked to those of the technology sector. Technology companies are usually less indebted than the broader equity market because they require less physical capital to operate. In addition, because the technology sector tends to evolve quickly, most technology companies reinvest most of their profits into research and development to fuel growth, rather than paying them out as dividends. Most of these firms trade at higher valuations than the broad market, reflecting their greater growth potential. However, if these firms fall short of the growth expectations embedded in their prices, they could underperform. There is no limit on the valuations the fund will pay for its holdings.

Consumer cyclical and healthcare stocks represent the fund’s next largest sector weightings at 17% and 11%, respectively, as of this writing. Consumer cyclical stocks tend to be more sensitive to market fluctuations (higher beta) than most, while healthcare stocks tend to be more defensive. In aggregate, the fund has tended to be more volatile and sensitive to market fluctuations than the Russell 1000 Growth Index over the trailing 10 years through March 2017.

Portfolio Construction Although it tracks a transparent index that weights its holdings by modified market capitalization (which keeps the portfolio compliant with IRS rules), the fund earns a Neutral Process Pillar rating. This is because it unnecessarily limits its holdings to the Nasdaq exchange and has large exposure to technology stocks that it doesn't explicitly target, which is a source of risk.

The fund fully replicates the Nasdaq 100 Index, which includes the 100 largest nonfinancial stocks listed on the Nasdaq by market capitalization. Both U.S. and international stocks listed on the exchange are eligible, provided that the latter have options listed in the United States. That said, U.S. stocks currently account for about 95% of the portfolio. The index is reconstituted once a year in December. To reduce unnecessary turnover, the index allows existing constituents to stay in the index if they rank in the top 125 stocks by market capitalization and were in the top 100 at the previous review. Consequently, the fund may hold slightly more than 100 stocks. This is a tech-heavy index, as companies in this sector usually represent more than half of the portfolio. This fund is structured as a unit investment trust, which means it can’t use derivatives to equitize cash, reinvest dividends, or engage in securities lending.

Fees The fund charges a 0.20% expense ratio, which is lower than most of its actively managed peers in the category, supporting the Positive Price Pillar rating. However, there are cheaper index alternatives. Over the trailing three years through March 2017, the fund lagged its index by 27 basis points annually, slightly more than the amount of its expense ratio, likely due to transaction costs. Full index replication has kept tracking error to a minimum.

Alternatives

A momentum fund, such as

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