When it comes to exchange-traded funds (ETFs) that track the technology sector, there are a lot of options to choose from. Two of the most popular ETFs are the Invesco’s QQQ and the State Street’s XLK. Both are popular amongst investors who wish to track technology stocks, but are they really the best to track the technology sector? I was actually surprised by what I found and I think you would be too.
QQQ vs XLK: A quick summary
Here are some of my surprising findings about the two ETFs and why I think neither is the best fund to track the technology sector:
- QQQ tracks the Nasdaq-100 index which contains many non-tech companies such as Pepsi, Costco, Dollar Tree, etc.
- XLK tracks the S&P 500’s IT sector only, which causes a couple of issues. Nearly half the fund is invested in Apple and Microsoft. XLK also does not include companies such as Alphabet or Amazon.
- QQQ also has small weights in Chinese companies like JD, Baidu, and Pinduoduo, but does not have any exposure to larger companies like Alibaba or Tencent.
- Despite having exposure to the Utilities and Consumer Staples sector, QQQ actually underperformed the XLK in a falling market, which is very odd.
- The dividend yield of both funds is low: XLK is 1.07% vs QQQ’s 0.74%.
- I do not have any concerns about their fees, market liquidity, or fund size.
Due to the artificial constraints imposed by their indices, I feel that neither fund provides optimal exposure to the tech industry.
If you are curious to know which ETFs are, in my opinion, better for tech exposure, then dive straight to the bottom of this article! Otherwise read on to learn more about the two indices and also examine the differences between QQQ and XLK.
Mandate and Underlying Index
The Invesco QQQ is an exchange-traded fund that tracks the Nasdaq-100 Index. The companies in the Nasdaq-100 include approximately 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market. The index is market capitalization weighted. The index has exposure to primarily technology companies.
State Street’s XLK is an ETF which tracks companies that are in the S&P 500 and classified in the Information Technology sector. There are 11 sector indices and this Technology Select Sector Index is one of them. The Index includes companies from the following industries: technology hardware, storage, and peripherals; software; communications equipment; semiconductors and semiconductor equipment; IT services; and electronic equipment, instruments and components.
Holdings
Let’s dissect the holdings in a couple of different manners. This will help us get the best idea of what’s going on under the hood.
Sector Allocation
I had a preconception that as QQQ has the name “Nasdaq” attached to it, it is a tech-only ETF. Surprisingly, this is not accurate! Let’s look at the holdings first classified by sector to understand this further:
As you can see, the QQQ does have a substantial allocation to the IT sector – nearly 50% of the fund is in it. Once you include some other companies that we typically would consider to be tech but that are classified under other sectors, such as Alphabet/Google or Meta/Facebook (Communication Services) and Amazon or Tesla (Consumer Discretionary), the actual tech-oriented weight does increase.
Based on my assessment, around 74% of the fund is invested in technology-related companies. However QQQ misses out on many important companies like Salesforce, Oracle, ServiceNow, AMD, Mastercard, Visa, etc. The balance 26% is invested in a variety of non-tech companies such as Pepsi, Costco, Dollar Tree, etc. Even utilities like American Electric Power Co and Exelon make the cut.
The XLK is solely focused on the Information Technology sector, with 100% allocation to it. While at first glance this may seem positive for those that want purely tech exposure, I believe this fund misses the mark for the opposite reasons as the QQQ.
As I discussed above, the major companies like Alphabet (Google), Amazon, Meta (Facebook), Netflix, Activision Blizzard, Tesla, etc. are not classified within the Information Technology sector. By excluding these other sectors, or at least the tech-focused companies in those sector, you are really missing out many of the largest and best names in the space! Not very desireable.
Top 10 Holdings
Let’s look at the top-10 holdings in each of the funds.
A few observations:
- XLK is heavily invested in Apple and Microsoft, with the combined position at approximately 45%, which is nearly half the fund! QQQ also has the same companies in its top 2, but the weight is only 26%
- QQQ is better diversified amongst companies, with holdings 3 to 10 accounting for 27% of the weight, compared to only 22% in XLK.
- Top-10 holdings account for 50% of QQQ’s holdings but this climbs to 67% for XLK.
- As outlined earlier, QQQ also holds companies like Pepsi and Costco, and these two in fact make it to the top-10 list.
Geographic Breakdown
The geographic allocation for QQQ is somewhat bizarre to me. As the table below shows it has nearly 98% of the weight allocated to US companies, but with a few stubs in other countries. The holdings in China consist of the Nasdaq-listed ADRs of companies like Pinduoduo, JD, and Baidu. However, companies like Alibaba and Tencent are missing as they’re not listed on the Nasdaq.
I’ve said this before but I find ETFs with artificial constraints result in a sub-optimal product. Any time your focus shifts from having a portfolio composed of the best stocks for your goal, to include other constraints, your portfolio construction and returns will be sub-optimal. In this case, the artificial constraints include being listed on the Nasdaq only (QQQ) or strictly classified in the IT sector only (XLK). Other examples of artificial constraints including prioritizing dividends, at the expense of total returns, such as in the SPYD.
We see these artificial constraints manifesting themselves repeatedly in different forms with both the QQQ and the XLK.
Performance
The multi-year performance data for both funds is quite illuminating. Their returns are nowhere close to each other and the QQQ has underperformed across all time horizons.
Even when looking at fund returns on a year-to-date (YTD) basis, the QQQ has underperformed the XLK in 2022: QQQ delivered -32.40% compared to -31.24% for the XLK. Now the difference might seem small, but given the QQQ’s exposure to non-tech sectors, I would have expected it to better in a falling market.
There are two main factors that drive the difference in the returns, specifically XLK’s outperformance so far:
- XLK’s significantly higher exposure to Microsoft and Apple.
- XLK’s lack of exposure to sectors such as consumer staples, utilities, etc.
To fully appreciate how big of a driver both MSFT and APPL have been to XLK’s returns, let’s take a look at this chart from Bloomberg. This chart shows the total performance of Apple (top line), Microsoft (second line), XLK (third line), and QQQ (bottom). The table shows the total return figures in cumulative and annualized terms. It doesn’t take much effort to figure out that any fund with greater exposure to the two stocks will perform better!
Let’s look at the price charts (click for larger images).
Even when comparing the two charts, it’s obvious that the QQQ has underperformed the XLK by quite a margin. In the run up to the correction of 2022, the XLK’s outperformance does not surprise me as it is not bogged down by exposure to other sectors such as consumer staples and utilities. However I am surprised that even in a down year like 2022 the QQQ has underperformed the XLK, where you would expect those same sectors to serve as a buffer.
Over the last 5 years, the QQQ has underperformed in both up and down markets – as an investor I would find that very troubling.
Dividend Yield
Neither fund is a big dividend payer. XLK’s dividend yield (30-day SEC yield) is 1.07% whereas for the QQQ it is 0.74%.
My recommendation to investors is to always focus on the total returns of their investment, which includes both price performance and dividend returns. While there might be legitimate reasons for prioritizing other factors, such as high dividend yield, you may end up sacrificing your total returns. For a graphic example of how much impact this can have, take a look at my comparison of the SPY vs SPYD.
Expense Ratios
Both the XLK and QQQ have very low fees and the difference between the two is negligible. The QQQ charges 0.2% and the XLK charges 0.1%. This difference of 0.1% amounts to $1 on each $1000 invested in the funds. For that reason, I do not think this should be a deciding factor in which fund to choose. The ETF price volatility is higher than that and you’re more likely to make or lose more than that based on what time of day you trade these funds.
Fund Size & Liquidity
While both funds are quite large and liquid, there’s a notable difference between the two on these factors:
- Size: QQQ has $148 billion in AUM compared to $36 billion for the XLK
- Trading liquidity: Both funds are very liquid: QQQ trades an average of 56.7 million shares daily compared to the XLK’s 6.9 million.
Unless you’re a BIG fish with hundreds of millions of dollars to invest in either of these ETFs, it’s unlikely that you will move the market. Neither fund size or trading liquidity is therefore a material factor for us.
Looking Ahead
In investing, the future matters much more than the past. We’ve had a big market correction in 2022, so now it’s important to understand what can happen in the future. There are two ways to think about this question: 1) QQQ vs XLK relative performance the future 2) What is the outlook for technology stocks in general?
QQQ vs XLK: Relative Performance in the Future
As we have seen, there are appreciable differences between XLK and QQQ in terms of holdings, sector allocations, and even geographic allocation (although this is relatively minor source of difference). It is for these reasons that QQQ and XLK’s performance has not really been convergent in the past and I expect both to continue to perform differently in the future.
Based on typical stock and sector performance (see image below), one would expect the QQQ to outperform in poor markets like what we are experience now as it holds stocks in the Utilities and Consumer Staples sectors. However we have clearly seen that is not the case. Now according to the same historical data points, I would also expect XLK to outperform when the markets and the economy do recover as it does not have exposure to those two sectors.
Looking at all the data points, I would hazard a guess that the XLK will continue to outperform in the future. Obviously the heavy concentration of the fund in Apple and Microsoft would be the overwhelming factor that decides the direction of this fund.
Outlook for Technology Stocks
In general I believe the long-term (10+ years) outlook for technology stocks continues to be very solid. As a consequence of low interest rates, a lot retail money, and even highly bullish institutional investors, these stocks had increased in value dramatically. As you may know, any highly valued stock is highly susceptible to even small bits of negative information.
As these stocks were priced for perfection, any less than perfect news can hammer the stocks. When you overlay the macro environment which we have now – high inflation, war in Europe, high and rising interest rates, concerns about consequent recessions – you are looking at a very negative environment. Any high-flying stock will get killed in such an environment.
Nevertheless, I do not believe we are in for a wholesale repeat of the 2000/01 dot-com crash and burn. Almost all the big names in tech are profitable now, generate a great deal of cash flow, and typically have a low debt burden. Equally importantly, they all are solid product offerings and our lives continue to become even more tech-heavy with each passing year. I expect all those companies to survive through any recession and thrive in the growing economy on the other side. Their stocks will behave in a similar fashion and for that reason should do well in the long run.
However where history will rhyme is for companies that:
- are highly levered, or
- do not generate any cash,
- or simply have a business model that is dependent on buying users by giving them free money.
Most of these businesses will likely go under. In the charitable case, some of these companies might get acquired at cheap valuations by the larger successful companies. Stocks of these unprofitable companies will most likely not recover.
By virtue of the indices that they follow, both QQQ and XLK are composed of companies that are profitable. For that reason, I expect the ETFs to recover over the long run. The current valuations are quite gloomy and imply a great deal of negativity. Just like the market was too optimistic in 2021, we are probably in a negative overshoot now. Yes the stock market can still decline (even if the war in Europe does not expand), however it will likely go higher from here.
Which ETF is better QQQ or XLK?
If we judge solely on historical total returns, XLK has handily outperformed the QQQ. The fact that QQQ has underperformed in both up and down markets is very concerning to me. However it is important to remember that XLK’s performance is mostly the result of Apple and Microsoft. This is where I feel XLK’s lack of diversification is a hindrance. As the saying goes, past performance does not guarantee future returns! If however you are okay with having the high exposure to MSFT and AAPL, then the XLK is the best fund to pick.
What are alternatives to QQQ and XLK?
If your goal is to get exposure to the broader technology sector, then it seems to me that neither ETF is particularly well-suited. QQQ gets close, but it then brings in exposure to completely unrelated companies in the consumer staples, healthcare, and utilities sectors. XLK has the opposite problem and is too laser focused on just companies in the IT sector, while excluding the major tech names like Alphabet and Amazon that are bucketed in other sectors.
Instead, I feel that there are better options to explore where there are no artificial constraints such as only including companies that listed on the Nasdaq (QQQ) or only including companies in the IT sector (XLK). These options include many I have discussed in my mega article on best ETFs to buy in the 2022 correction.
If however you don’t really care about the concentrated exposure to only two stocks, then the XLK is a good fit. If you prefer a more distributed portfolio, then you can go with my recommendations above. Finally, if you want to be somewhere in between, you can just add some Microsoft and Apple stock to the above recommendations at a level where the weight is properly balanced. This would give you the best of all worlds!
Before You Go…
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