Minding ETF Top Weightings Before Trading

Summary: When trading ETFs concentrated in a select group of names, you need to pay attention to the top holdings’ weightings and also their respective charts.

Recently I had a trader friend of mine comment on a wedge formation on the QQQs. He thought it was going to fail and was ready to place his bets accordingly by shorting the Qs with puts. He is a smart guy and a very instinctive trader, but I felt he needed a reality check. After looking into some things, I shared my feelings and he ultimately balked at the trade.

I’m a big believer in paying attention to macro forces out there and sentiment. Having worked for Fund managers and institutions, I always try to put myself in their shoes and think like them. I was the one to advise our analysts and portfolio managers to increase or reduce weightings in portfolio stocks based on their technical performance and underperformance.

It is clear to anyone that has been in the market for the last several years that there have been a select assortment of dominant companies comprising the bulk of the weighting in some of the most popular market-cap weighted indexes, particularly the Qs (NASDAQ 100), NASDAQ and the S&P 500). These have been popularized as the FAANG names (Facebook, Apple, Amazon, Netflix, and Google aka Alphabet). While FAANG represents just a few stocks, it is more of an analogy symbolic of how a select group of stocks have been responsible for the overwhelming majority of index gains in recent years (we have to keep in Microsoft and others that have hung in there and added incremental gains, too). These names have been the top performers that have driven the index higher. With some of them smaller in terms of shares outstanding than in the dotcom bubble with names such as Dell, Cisco, Microsoft and others leading the charge, there is a lot more money now chasing smaller capitalized stocks, thus with the increased money flow, they are being marked up more and more. According to Morningstar, as of 8/31/17, we can see, for example, how ultra-concentrated the Qs are with the said aforementioned names. Many of these are also top weighted contributors to the S&P 500 SPY ETF.

With the market doing well, fund inflows continue, and goliath institutions who are charged with competing and beating the market, naturally need to buy more of the most heavily weighted names in order to track the index and closet index to compete with it. They also need to show they are better, and generate alpha above and beyond the index (giving their investors the biggest bang for the buck). Remember that mutual fund complexes and money managers make money off of your assets under management (AUM) and for that, they charge their expense ratios. It is in their vested interest to keep your interest, by keeping you happy by beating the market over their peer institutions.

Getting back to FAANG, massive money flow into these names (or other future fancy acronymed groups of stocks – remember the nifty 50 and the dot coms?) promotes a self-perpetuating reality; investor fund inflows continue, the stocks continue to be bought, which pushes them higher, which increases their market cap weighting, which pressures institutions to buy even more shares to outperform the index to compete with other institutions.

And it goes on and on.  Institutions ride this wave until the party stops when it becomes evident and apparent to all by way of correction or crash, or until they “make a call” internally, to reduce their weightings. This move is always a double-edged sword for them because they risk reducing weightings while other competing institutions keep THEIR positions in force. They are in essence, making a market call. This in and out is one of the critical reasons that institutions and fund managers generally, over the long haul, do not beat the broader market’s performance, after fees, etc.

Getting back to my friend and given the above FAANG backdrop and using technical analysis and chart construction to make trading decisions, I had the following findings for my friend. See the slideshow below.

Facebook – The chart still looks great and is uptrending nicely. Roughly 6% weighting in the Qs as of this writing 8/1/17.

Amazon – Just completed a fairly substantial sideways correction in orderly fashion to the 200-day MA. Not bearish. Nearly 7% of the Qs.

Apple – Apple’s chart is kicking into high gear and the company is moving into a powerful upgrade cycle of its mobile devices. The chart is moving up just above every day. Silly to thing about shorting this, which you would, by shorting the Qs. A giant 12.5% of the Qs!

Netflix – NFLX’s chart looks great. It had a recent, large price and volume surge and has made a nice and orderly pullback to digest those gains. Looks just fine. Just over 1% of the index; not a big contributor or detractor, but symbolic of the broader FAANG trend.

Google/Alphabet – Resuming uptrend after a multi-month consolidation. Looks fine. Combined class A and B shares make up about 9% of the index.

Microsoft – MSFT is over 8% of the Qs and the chart is steady and powerful.

Construction of the Qs – 43% of the index’ constituent’s charts look fantastic. To short the Qs at this point means to run counter-trend, which is dangerous when the broader backdrop of the market is still very positive, politics aside. I advised my friend he should be long, not short.

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This post illustrates the power of technical analysis and the study and usage of charts to guide your trading decisions. Much of charting is subjective and in fact is designed to be so, as investor opinion and psychology are also subjective. Stock charts are the ultimate voting mechanism for investors who are casting their bets on the continued and future success of a company. Unlike other forms of investment analysis, TA is a tool that is visible and tangible for anyone to use, and they would be short-sighted to not take advantage of its benefits.

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