ARKK - QQQN: Playing The Next Generation Strategy

2023-04-26 03:07:28 ET

Summary

• QQQN is the first ETF to follow the Nasdaq Q-50.
• The Q-50 is a market capitalization-weighted index designed to capture the performance of those 50 securities that are next eligible for entrance into the vaulted Nasdaq-100 Index.
• Despite the concentration of innovative, high growth companies within its holdings, the QQQN has some issues.

For most investors, the ultimate dream is finding that future titan, that “next generation” growth company which --though still in its most incipient stage-- will go on to dominate its market.

We would like nothing more than to get in early on the next Microsoft ( MSFT ) in 1986 or scoop up Amazon ( AMZN ) up in 2002 for a $1.50. The challenge of course is trying to distinguish those future winners from their remarkably similar contemporaries –the Facebook from the Friendster-- and then select and hold those that will become durable winners. These are the choices that bring intergenerational wealth, that leave your grandchildren speaking of you in hushed tones of reverence.

Fortunately, the ETF industry is bringing a more systematic rules-based approach to finding that future juggernaut. That is essentially the mission statement of VictoryShares Nasdaq Next 50 ETF ( QQQN ). The ETF aligns with the innovation and growth focus behind the time-tested Nasdaq-100 Index, but with an emphasis on that “next generation” of market leadership which might well be tapped in the coming months or years for inclusion. It tracks the Nasdaq Q-50 Index.

What is the Q-50? It is a market capitalization-weighted index designed to mimic the performance of the 50 securities that are next eligible for entrance into the vaulted Nasdaq-100 Index. Consider it the ‘feeder index’ for the Nasdaq-100 Index. The foyer before “America’s Got Talent.”

What is its methodology? It starts with a universe of all companies, both domestic and foreign, that are listed on the Nasdaq Stock Exchange. It then culls all those companies classified as financials --banks aren’t allowed in the Nasdaq-100 and culling financials is a way to focus on companies with unimpeded revenue expansion and the kind of open “green space” market share growth that tech and retail sectors offer. It then selects the largest companies, based on market cap, that have yet to arrive in the QQQ.

Though the Q-50 index was launched in 2007, QQQN is the first ETF to follow the index. According to its prospectus, this is a cost-effective opportunity to invest in the next generation of innovators. Over the years, many companies have graduated from the Nasdaq Q-50 Index to become a part of the Nasdaq-100 Index. Some of notable companies on this graduation list are Facebook (META), Netflix (NFLX), Expedia (EXPE), Moderna (MRNA), Lululemon (LULU), Electronic Arts (EA), and Illumina (ILMN).

What isn’t mentioned in the prospectus? The so-called “membership effect.” The Nasdaq-100 has become a central index with US investors over the past 25 years. Invesco’s hugely popular QQQ has more than $172 billion AUM, and there are countless mutual funds and tracking strategies that also use the index.

Anytime a stock is tapped to join the Nasdaq-100, a flood of trader interest and money is poured on it. Academic research has found that index inclusion is associated with increased investor demand, elevated stock prices, and a lower cost of capital for those companies. Such are the perks of membership in the Western world’s most vaunted techs-to-buy list.

The Breakdown:

With an expense ratio of .18% and a P/E of 18.42, QQQN is not egregiously expensive. It is geographically centered in US firms (94.59%) with a smattering of Asian and European names.

Its holdings include 54 companies at present, with the Tech services (24.86%), Health Technology (19.27%), Electronic Technology (18.50%), and Consumer services (8.50%) making up the largest sectors.

QQQN's Largest Holdings

What is under the proverbial hood? Here is a quick description of four companies within the current top five:

ON Semiconductor Corporation ( ON ): ON provides sensors and image-sensing technology to the automotive field, among other sectors. ON's image-sensing technology is considered best-in-class, and such sensors are now a ubiquitous part of any car’s road safety features. The company reminds me of NXP, which I wrote about when it was still a $20 stock. ( SEE LINK )

Ulta Beauty ( ULTA ): Ulta Beauty is the largest beauty retailer in the U.S. “providing beauty lovers with cosmetics, hair care products, and salon services.” I used to think of them as a “Sephora for the burbs”, but Ulta stores really are more substantial. They offer a very comprehensive selection for beauty needs in suburban and exurban locations. Ulta is a destination retailer, like a Home Depot, where you might drive by a series of small main street retailers to find the far better selection (and competitive price) of the bigger venue.

The Trade Desk ( TTD ): A premier ad tech company, Trade Desk continues to grow faster than its larger peers and is even taking market share in advertising downturn. Election years make for good ad years and 2024 will probably be the biggest ever.

Tractor Supply Company ( TSCO ): The name of this company is a bit of a head fake, as TSCO is actually a “rural lifestyle retailer” with a focus on pets, livestock, and outside living in exurban/”far suburb” locations. It arguably capturing the growing affluence of the South and West, areas that have seen major economic buildouts over the past ten years. The company's profitability profile is fantastic; TSCO has been growing at over 5% consistently with 30 years of growth.

Performance:

As you can see in the following graph, these top holdings are successful companies that were quite resilient during 2022 downturn, though the same can’t be said for QQQN which is down -.74% since its inception in October 2020.

This is disappointing. QQQN went public on September 17, 2020 and had a strong first year before topping out with the rest of the Nasdaq in early November 2021. It is now back to where it was when it opened on its very first day.

This may explain why the ETF has thus far garnered only a $95.59 million AUM, but one important point should be made: the ETF went public when a decade-long tech boom was in its last innings.

A cursory look at a comparison chart of the Q-50 index and the Nasdaq-100 suggests that Q-50 operates at a different frequency than the Nasdaq-100. It seems to log better returns earlier in a cycle like it did in 2012 and 2013:

Competitors:

Its most direct competitor in the “Next Gen Nasdaq” space is Invesco Nasdaq Next Gen 100 ETF ( QQQJ ). It has a much larger in AUM ($728.75M) and tracks the 100 next largest Nasdaq companies (not the top 50) outside the Nasdaq-100 index.

What is interesting is that QQQN has fractionally outperformed this more direct competitor QQQJ over the past three years quite consistently, if not dramatically. QQQN is slightly more weighted in technology services, healthcare, and electronic technology –with its top ten holdings being the same names as the QQQJ but with a larger weighting. Both are essentially risk-on vehicles.

This apparently gives QQQN a bit more volatility (27.20% versus QQQJ’s 26.73%) due to its concentrated holdings. The smaller, last 50 in QQQJ appear to reduce its standard deviation fractionally but without any added alpha.

In terms of volatility, both QQQN and QQQJ pale in comparison to [[ARKK]], an active fund with a similar mandate. ARKK walloped both of them in 2021 but has underperformed over the most recent one-year period:

Risks:

I would not buy or add to QQQN at this juncture. The ETF seems to do best in the early stages of a bull run. If we are going into recession later this year, QQQN is an early risk-on “green shoots” play that might be best deployed later.

It may be very dependent on a few select tickers that are carrying the rest. While researching it, I became more interested in seeing what a Q-20 or Q-10 might look like, a more select group that can’t include names that have dropped out of the Nasdaq-100 and back into the “next gen” pool.

These are companies that have fallen from the QQQ typically due to a market cap decline. For instance, last December 9, 2022, though six names were added to the Index, seven companies were removed. One of them -- VeriSign, Inc. (VRSN) -- is now ninth in QQQN’s percentage of holdings. It is not clear whether these fallen angels provide ballast for the Next Gen index, or later swing back into the QQQ later, or whether they become a drag on the Q-50 index itself.

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