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How To Buy And Hold Leveraged ETFs: The Top 7 Outperforming 3x ETFs Over The Past Year

Summary Leveraged ETFs can be dangerous buy-and-hold vehicles due to their extreme volatility and tendency for many to decay over time. However, leveraged ETFs offer the long-term trader an effective means to make a large investment in a particular sector without risking substantial capital, if the position is chosen properly. Leveraged ETFs that trade linearly with small daily intervals and few reversals tend to track their 1x ETF counterparts very well or even outperform on yearly timeframe. This Top-7 list highlights multiple sectors ranging from bonds and currencies to retail to commodities whose leveraged ETFs have outperformed the returns predicted based on their 1x counterparts. Conventional wisdom holds that the leveraged ETFs are the playthings of daytraders, that their volatility and underperformance versus their underlying indices and unleveraged ETFs makes them unsuitable for long-term investing. And there is certainly an element of truth to this – a large number of buy and holds of the 3x leveraged ETFs will end in disaster. However, these ETFs offer the longer-term trader an effective means to make a large investment in a particular sector without risking substantial capital, if the position is chosen properly. This article discusses the top 7 performing 3x leveraged ETFs Relative To Their Indices and corresponding 1x ETF over the last year. These are not necessarily the top overall percent-returning ETFs – a 3x leveraged ETF can double in a year, but if its underlying index was up 50%, that 100% return has to be pretty disappointing. These are the ETFs that best tracked three-times their underlying index, or even outperformed it. Before I go through the list of ETFs, it is first necessary to understand why a leveraged ETF outperforms or underperforms the index that it is designed to track. A leveraged ETF will underperform for three reasons (and therefore outperform when the opposite is true). First, leveraged ETFs that track commodities with a futures market that frequently trades in contango will underperform. These funds must sell near-term futures contracts prior to expiration and use funds from the sale to purchase more-expensive later-period contracts. Sectors that often trade in contango include natural gas and VIX futures where monthly contangos often range from 0.5% to about 3% on average. A 1x ETF such as UNG or VXX will see monthly losses equaling the contango, which can be unfortunate, but not devastating. But 3x ETFs such as UGAZ see losses equal to the contango multiplied by 3, meaning that some months may see as much as a 10% degradation in value of the fund and 40-50% over the course of a typical year. On the other hand, ETFs whose underlying futures trade with a nearly flat futures strip (or, rarely, in backwardation) will see minimal rollover losses on a monthly basis. Such funds include silver, gold, and occasionally oil. Secondly, leveraged ETFs that trade in a sine curve-like pattern with large rallies followed by large corrections tend to underperform versus their underlying index. On the other hand, leveraged ETFs that track indices that trade linearly with small moves in a single direction tend to outperform. The math behind this is complicated, so, I will illustrate this principle with two graphs. Figure 1 below shows a commodity or sector that moves up and down 5% each and everyday, oscillating between 95 and 100 for eternity. The red line shows the predicted movement of the corresponding 3x leveraged ETF while the green line shows what actually happens. After 28 days, the actual ETF is trading at a 20% discount than if the fund truly tracked the ETF on a longer-term 3:1 basis. (click to enlarge) Figure 1: Sample Underperforming Leveraged 3x ETF. Figure 2 on the other hand, shows another sector or 1x ETF that, for a 30-day period gains 1% per day each and every day. After 30 days, this fund is up 31% percent. The 3x ETF would be predicted to be up 93% if it tracked the index 3:1. However, we find that the leveraged ETF actually gains 122%. (click to enlarge) Figure 2: Sample Overperforming Leveraged 3x ETF. Finally, leveraged ETFs outperform their underlying indices and 1x ETFs when the latter suffers large losses. For example, if ETF XYZ loses 50%, the 3x ETF cannot lose 150% of its value and will probably be down 80-90%. This is sort of like winning the battle yet losing the war, so losing ETFs such as these will not be included in the list. With this in mind, onward to the top 7 outperforming 3x ETFs over the last 12 months. Again, these are not necessarily the top performing ETFs (although it sort of turns out that way), but those that best tracked or outperformed, their 1x ETF counterparts. # 7: Nasdaq: TQQQ and QQQ It was a banner year for the Nasdaq with the tech-heavy index up 13.4% and approaching 5000 for the first time since the dot-com bubble burst. The largest component of the 1x ETF PowerShares QQQ Trust (NASDAQ: QQQ ) – Apple (NASDAQ: AAPL ) which comprises 13.6% of the index – hit a new lifetime high in November and two of the other stalwarts in the top 4 – Microsoft (NASDAQ: MSFT ) and Oracle (NYSE: ORCL ) – hit their highest values since the dot-com bubble. Overall, QQQ is up 19.6% over the past year through January 23, 2015. The 3x ETF ProShares UltraPro QQQ (NASDAQ: TQQQ ), on the other hand, is up 58.6% vs. a predicted gain of 58.9% if it were to match QQQ 3:1. This represents almost perfect tracking with a end-of-period underperformance of just 0.3%. Its greatest underperformance during the year was 4% during the large October correction. Figure 3 below shows the performance of QQQ, the predicted performance of TQQQ, and the actual performance of TQQQ. (click to enlarge) Figure 3: 3x ETF TQQQ Actual Performance vs. Predicted Performance vs. 1x ETF QQQ #6: The US Dollar: UUPT and UUP Throughout 2014, the US dollar surged against foreign currencies, gaining nearly 20% versus the Euro, 10% versus the Pound, and about 15% against the Yen. As a result the PowerShares US Dollar Index (NYSEARCA: UUP ) gained 16.7% over the last 12 months. The 3x leveraged ETF PowerShares 3x Long US Dollar Index (NYSEARCA: UUPT ) gained 54.5% vs. a predicted gain of 50.3% during the same period. Thus, the leveraged ETF actually outperformed its underlying index by 3.8%. This outperformance can be explained by a generally linear trend, particularly during the second half of the year, and small mean daily movement and no major reversals with a mean daily change of a measly 0.9% vs. an average of 1.7% among all 62 eligible 3x ETFs. Figure 4 below shows the performance of UUPT vs. UUP vs. predicted performance. (click to enlarge) Figure 4: 3x ETF UUPT Actual Performance vs. Predicted Performance vs. 1x ETF UUP (Source: Yahoo Finance Historical Quotes) #5: Retail: RETL and XRT It was a banner year for retail as holiday sales increased 4% over 2013. The 1x SPDR S&P Retail ETF (NYSEARCA: XRT ) was up 16.6% over the last 12 months driven by all-time highs in major holding CarMax (NYSE: KMX ), and multi-year highs in The Pantry (NASDAQ: PTRY ) and Rite Aid (NYSE: RAD ). The corresponding 3x leveraged product Direxion Daily Retail Bull 3x (NYSEARCA: RETL ) was up 54.7% during the same period vs. a predicted gain of 49.5%, meaning that the leveraged fund outperformed by 5.2%. Figure 5 below shows RETL vs. XRT vs. RETL predicted performance. Of note, while both RETL and XRT are retail ETFs, they do not track the identical index. RETL tracks the Russell 1000 Retail Index while XRT tracks the S&P Retail Index, so it is possible that the two ETFs may vary unrelated to their degree of leverage. (click to enlarge) Figure 5: 3x ETF RETL Actual Performance vs. Predicted Performance vs. 1x ETF XRT (Source: Yahoo Finance Historical Quotes) #4: Healthcare: CURE and XLV The Healthcare Industry enjoyed yet another fantastic year in what is rapidly becoming a 21st century revolution in the medical and pharmaceutical industries. The 1x Health Care SPDR ETF (NYSEARCA: XLV ) has had three consecutive yearly gains of at least 15% and is up 120% since 2010. The ETF has gained 26.2% over the past 12 months bolstered by major holdings Johnson & Johnson (NYSE: JNJ ) and Gilead Sciences (NASDAQ: GILD ), which both hit all-time highs this past year. GILD is up 350% since 2010 on the heels of its blockbuster Hepatitis C drugs Sovaldi and Harvoni, in addition to its highly profitable HIV and Influenza product line. The leveraged Direxion Daily Healthcare 3X ETF (NYSEARCA: CURE ), on the other hand, is up 85.2% over the same period vs. a predicted gain of 78.9%. This equates to an outperformance of 6.3%. Since the leveraged ETF’s start date in mid-2011, the fund has returned a massive 593% vs. a predicted return of 306% for an outperformance of 287%. Figure 6 below shows the 1-year performance of CURE vs. XLV vs. predicted performance. (click to enlarge) Figure 6: 3x ETF CURE Actual Performance vs. Predicted Performance vs. 1x ETF XLV (Source: Yahoo Finance Historical Quotes) #3: 20-Year Bonds: TMF And TLT Thanks to nosediving yields in the face of the impending end of Quantitative Easing, US 20-year treasury bond ETFs have enjoyed their best year since 2008. The 1x iShares 20+ Yr Treasury Bond ETF (NYSEARCA: TLT ) gained 30.0% over the past 12 months. The 3x leveraged Direxion Daily 30-yr Treasury Bull ETF (NYSEARCA: TMF ), on the other hand, gained 108.7% vs. a predicted gain of just 89.8% for an impressive outperformance of 18.9%. Figure 7 below shows the 1-year performance of TMF vs. TLT vs. predicted performance. This is a textbook case of a leveraged ETF outperforming. TLT traded in a generally linear direction from the very start of the period. The leveraged fund had a small average 1.5% daily move which allowed the fund to trend steadily higher with fewer corrections that would eat up the leverage. Indeed, the fund traded higher on average 58.1% of the days over the past year, vs. an average of just 48.7% for all other ETFs. (click to enlarge) Figure 7: 3x ETF TMF Actual Performance vs. Predicted Performance vs. 1x ETF TLT (Source: Yahoo Finance Historical Quotes) #2: Real Estate: DRN and VNQ Boomtimes continued for REITs in 2014 with the 1x Vanguard REIT ETF (NYSEARCA: VNQ ) up 36.0% over the last 12 months. The fund was led by its largest holding Simon Property Group (NYSE: SPG ) – making up 8.3% of the fund – which was up 32% and hit an all-time high for the fourth consecutive year. On the other hand, the 3x leveraged ETF Direxion Daily Real Estate Bull 3x ETF (NYSEARCA: DRN ) gained 137.9% during the same period vs. a predicted gain of 108.2%, an impressive 29.7% outperformance. Figure 8 below shows this in chart form with the 1-year performance of DRN vs. VNQ vs. predicted DRN performance. You will note that for the first two-thirds of the period, VNQ traded slowly higher with only one real correction to note in September and October and therefore DRN tracked the 1x ETF very well 3:1. From October through January to-date, the sector caught fire and VNQ rocketed higher, gaining nearly 30% linearly. It was at this time that DRN really stretched its legs and the 3x leverage really began to work in its favor. (click to enlarge) Figure 8: 3x ETF DRN Actual Performance vs. Predicted Performance vs. 1x ETF VNQ (Source: Yahoo Finance Historical Quotes) #1: Oil: DWTI and USO The first six ETF pairs were all bullish funds. That is, for every 1% that the underlying index rose or fell, the 1x and 3x leveraged product would rise or fall (approximately) 1% and 3%, respectively. For our champion, we see the first inverse ETF on the list. The falling price of crude has been front-and-center news in both the financial and popular spheres over the last five months or so. After sitting near $100/barrel for the past few years, the price of oil has abruptly been slashed in half since June due to an oversupplied market thanks to US shale production and OPEC remaining steadfast on production quotas. As a result the 1x ETF United States Oil Fund (NYSEARCA: USO ) has tumbled 51.0% during the 12-month period ending January 23. On the other hand, the leveraged ETF VelocityShares 3x Inverse Crude product (NYSEARCA: DWTI ) – which is designed to track 3x the opposite of the price of oil – has surged. The ETF has rallied a massive 444.4% during the same period vs. a predicted performance of just 151.3%. This equates to a 293% outperformance. If you were to have sold short $3000 worth of USO last January, you would have profited $1530. On the other hand, if you were to have purchased just $1000 of DWTI, you would have made $4443 and change. Even if you chose a more apples-to-apples comparison using the United States Short Oil Fund (NYSEARCA: DNO ), which is designed to track 1x the inverse of the price of oil, DWTI still outperformed by 182% given that DNO rose just 86.9% during the 12-month period and predicted only a 260.1% rally in DWTI. Figure 9 below shows the 12-month performance of USO vs. actual performance of DWTI vs. predicted performance of DWTI. (click to enlarge) Figure 9: 3x ETF DWTI Actual Performance vs. Predicted Performance vs. 1x ETF USO (Source: Yahoo Finance Historical Quotes) Why did DWTI so dramatically outperform its commodity and USO? Due to minimal contango/backwardation in the absence of major price swings through June, DWTI tracked its predicted change based on USO very well, never underperforming by more than 10%. And then come September when oil really began to swandive, it did so quickly, relentlessly, and in large intervals which based on the discussion at the beginning of this article, includes all of the ingredients for a major outperformance of the leveraged ETFs. Table 1 Below shows a summarization of the Top 7 Outperforming ETFs discussed above. Table 1: Summary of top outperforming leveraged ETFs. In conclusion, this article is not intended necessarily to be a shopping list for outperforming leveraged ETFs as past performance does not equal future returns – even if several such as DRN, CURE, and TMF have a multi-year history of outperformance. Rather it is intended also to be a 7-part case study in how to invest in leveraged products without suffering the gradual decay seen in many of the 3x ETFs. I do not currently have a position in any of these positions currently, having closed out my DWTI a few weeks ago. I am considering opening a position in CURE on a pullback in the next couple of weeks. Stay tuned next week for a follow-up article discussing the Bottom 10 underperforming leveraged ETFs.

Equity CEFs: Global CEFs For A QE Europe

Summary After years of lagging the US markets, will Quantitative Easing by the European Central Bank inflate the European stock markets much like the Federal Reserve did for US markets? That seems to be the central question as the ECB begins its own QE bond buying program designed to help stimulate the Eurozone economies. And if the ECB is successful, then what global equity CEFs might benefit as well? If Quantitative Easing – Europe style helps European stocks much like Quantitative Easing – USA helped our equity markets, then it stands to reason that global equity based CEFs that have a high exposure to European stocks might benefit as well. Though I am not familiar with any equity CEFs that are pure European stock focused, i.e. follow an index that includes the largest and most popular European stocks like an S&P 500, you can certainly find equity CEFs that have a large percentage of their portfolios, typically around 25% to 35%, exposed to the large cap European stock markets. This is in contrast to the Asia/Pacific region in which there are quite a number of equity CEFs dedicated entirely to stocks in these markets, whether they be general equity CEFs, emerging market CEFs or more country specific CEFs. The theory, however, is that any QE – Europe would probably benefit the largest and most liquid European stock names and thus investors should focus on equity CEFs that include these securities as part of their overall portfolio. There are also several ETFs, such as the popular iShares Europe fund (NYSEARCA: IEV ) , that will give you a pure play on the largest and most popular European stocks as a non-managed index fund, but I personally like the global equity CEF approach since not only are many of these funds trading at wide discounts and are at the low end of their discount/premium range, but they also are diversified so that you don’t put all your eggs in one basket in case QE – Europe doesn’t have quite the same effect as QE – USA. Most of the global equity CEFs I follow are diversified among the US, Europe and Asia/Pacific markets and can also offer varying income strategies that help pay for their large yields, generally in the 7% to as high as 11%. For example, leveraged income global equity CEFs will often include fixed-income securities such as preferreds or corporate bonds to reduce volatility and provide further diversification to protect against any one sector underperforming. After all, we’re not looking for home runs in these funds but rather relative outperformance over their CEF and ETF counterparts. So if you want the pure play European stock approach, then IEV or some other European stock focused ETF is probably a better way to go. But as you’ll see, diversification has its merits and many of these global equity CEFs have outperformed, both at the NAV and market price levels – the most popular international ETFs such as IEV or the more broadly based iShares Morgan Stanley EAFE international index (NYSEARCA: EFA ) , which includes Europe, Asia and the Far East stock markets, hence the EAFE. Global Equity CEF 1-Year and 3-Year Performances The following two tables sorts the global equity CEFs I follow by their total return NAV performances over one-year and then three years (through January 23rd so a little longer than one-year and three-ye ar periods). All of these funds have roughly 25% – 35% large cap European stock exposure though most will still have a higher exposure to US markets and some may be more Asia/Pacific stock weighted than European stock weighted. What are not included in the tables are global equity CEFs that focus in emerging markets are country specific or sector specific funds such as global utilities or global REITs. In other words, I’m just including global equity CEFs that may be beneficiaries of any QE – Europe due to their large cap European stock exposure. Also included at the bottom of each table are the total return ETF performances of the most popular international ETFs, IEV and EFA , and from the US major market indices, the SPDR S&P 500 (NYSEARCA: SPY ) , the Powershares NASDAQ-100 (NASDAQ: QQQ ) , the SPDR Dow Jones 30 Industrials (NYSEARCA: DIA ) . 1-Year Total Return Performance 3-Year Total Return Performance Recommended Global Equity CEFs For QE – Europe Using the tables above and other proprietary information regarding relative valuations and historic NAV performance, these are the global equity based CEFs with European stock exposure that I would recommend. First is the Eaton Vance Tax-Advantaged Global Dividend Income fund (NYSE: ETG ) , $16.15 market price, $17.71 NAV, -8.8% discount, 7.7% current market yield . ETG , along with (NYSE: ETO ) , are Eaton Vance’s two global leveraged equity based CEFs that also include about 20% of their portfolios in fixed-income preferred securities. Both of these funds, along with (NYSE: EVT ) , which is Eaton Vance’s leveraged US based CEF, are higher risk, higher reward CEFs due to their use of leverage but all have been fantastic performers over the past few years both at the NAV and market price level. ETG used to have the highest valuation of all of the Eaton Vance leveraged CEFs but currently trades at a -8.8% discount, at the low end of its Premium/Discount range as shown in this 3-year Premium/Discount chart. (click to enlarge) ETG includes about 32% of its portfolio in large cap European stocks, 7% exposure in Asia/Pacific and the rest mostly in US based large-cap stocks. ETG’s overall portfolio is 82% equities and 18% preferred securities. I have followed ETG for years and I often used it as a short hedge against my long CEF positions as the fund would often spike up to trade close to a premium valuation for short periods only to drop back to a wider discount. For investors who think that CEFs don’t stray much from their premium/discount valuations over time, ETG is a good example of a fund that does. Eaton Vance’s other leveraged global equity CEF, ETO is similar to ETG but trades at a much narrower and even historically narrow -1.2% discount due to recent distribution increases and very large capital gain distributions over the last couple years. Frankly though, both of these funds have knocked the cover off the ball the last few years even with their global stock exposure and have far outperformed IEV or EFA at both the NAV and market price levels. Referring to the tables above, ETG has returned 62.4% to investors at its market price in a little over three years while ETO has returned a whopping 81.6% . Have The Alpine CEFs Finally Turned The Corner? Well, I never thought I would say this but the second group of global equity CEFs I would recommend to take advantage of a European market turnaround are the Alpine Total Dynamic Dividend fund (NYSE: AOD ) , $8.66 market price, $10.02 NAV, -13.6% discount, 7.8% current market yield and the Alpine Global Dynamic Dividend fund (NYSE: AGD ) , $9.99 market price, $11.25 NAV, -11.2% discount, 7.7% current market yield . For those of you who have followed my articles over the years, you know that I had been one of Alpine’s biggest bears ever since I started writing on Seeking Alpha due to the two fund’s ineffective dividend harvest income strategy that dramatically eroded the fund’s NAVs over the years while overpaying their distributions. Alpine finally got the message a couple years ago and brought in new portfolio managers who first took steps to minimize the use of their dividend harvest strategy while significantly reducing the distributions to a more reasonable NAV yield. Then just a year ago, Alpine implemented a reverse split (not their first) for the two funds to boost up their depressed NAV prices. Though this was tough medicine to take and the funds still reflect some of the worst NAV and market price performances of any equity CEFs since their inceptions in 2006 and 2007, it’s safe to say that the funds have finally turned it around and are seeing a resurgence in their NAV performances. Though AGD is considered the global of the two funds, the fact is both funds have similar portfolios and similar exposure to European equities, with AGD showing 32% of its portfolio in European stocks, 55% in US stocks and about 11% in Asia/Pacific while AOD’s portfolio breakdown is 29% in European stocks, 58% in US stocks and 11% in Asia/Pacific (as of 10/31/2014). Though the funds rely less on a dividend capture income strategy now and have much more achievable NAV yields of about 6.8% instead of the 12%+ NAV yields they use to have, there still seems to be hesitation by investors as to whether the funds have actually turned the corner. This is reflected in the fund’s wide discounts with AGD at a current -11.2% discount and AOD at one of the widest discounts of all equity CEFs at -13.6%. But this is where the opportunities lie because investors were wrong in their zeal for AGD and AOD several years ago (as I pointed out in many articles) when investors drove the fund’s valuations up to market price premiums as high as 50% in early 2010 and I believe they are wrong now as the fund’s drop to double digit discounts just at a time when their improved income and growth strategies could really start to pay off. A Global Equity CEF With The Highest European Exposure The last global equity CEF I am recommending is also one I used to pan because of its high valuation and lackluster NAV performance, but it also has one of the highest exposures to large cap European stocks if you believe the time is now for this region to outperform. The Voya International High Dividend Equity Income fund (NYSE: IID ) , $7.94 market price, $8.44 NAV, -5.9% discount, 10.4% current market yield targets 50% of its portfolio to be invested in European stocks, 40% in the Asia/Pacific region and only about 9% in US stocks. This minimal exposure to the US markets has resulted in IID’s severe NAV and market price underperformance over the last few years though the fund has continued to maintain a high NAV yield and offer an extremely generous market price yield, currently 10.4% paid monthly, even in the face of this underperformance. Some might argue that this is still too generous as the fund’s NAV yield of 9.8% will not be easy to achieve for an option-income CEF that targets a fairly low 20% – 50% of its portfolio to write options against. In other words, IID will need a lot more portfolio appreciation going forward if it wants to continue to pay out that high of an NAV yield. Because the alternative is continued NAV erosion and a diminishing asset base, which makes it that much more difficult to sustain the current distribution. I personally would feel even better about IID’s turnaround prospects if Voya cut the distribution to a more attainable 7% – 8% NAV yield because if the QE – Europe effect doesn’t play out, then Voya will probably have to take that step. IID , like ETG , is another fund that can vary widely in its valuation, going from a market price premium to a market price discount in a matter of weeks as seen in this three-y ear Premium/Discount graph. (click to enlarge) As you can see, IID’s current -5.9% discount is at the bottom of its range for a fund that typically can trade at a market price premium. Though IID is certainly not the most undervalued global equity CEF even at the bottom of its discount range, one reason why it trades at such a high relative valuation is because of its appreciation potential. Because if the international markets like Europe start to play catch up with the US markets, then IID is one of the best high risk/high reward equity CEFs to take advantage of that. Conclusion All of these fund’s portfolios can be seen at their fund sponsor’s websites and this analysis does not take into account a fund’s actual stock holdings though there tends to be a lot of overlap in the large-cap international stocks these funds own. In addition, most of these global equity CEFs use hedging strategies to reduce currency risk and the effectiveness of these strategies is also not taken into consideration. But if you believe that QE – Europe has the potential to do for large-cap European stocks what QE – USA did for our markets, then these global equity CEFs, offering low valuations and high yields, could be an excellent way to play off that effect.

A Low-Tech Index Offering Exposure To The High-Tech Sector

By Robert Goldsborough Investors craving a big helping of large-cap growth stocks with a strong tilt toward the technology sector can consider PowerShares QQQ ETF (NASDAQ: QQQ ) . A perennial favorite among U.S. large-cap growth investors, QQQ is the sixth most actively traded U.S. exchange-traded fund and has the sixth-most assets of any U.S. ETF. QQQ also offers exposure to leading Nasdaq-listed consumer discretionary firms (18% of assets) and biotech firms (15% of assets) and tracks the cap-weighted Nasdaq-100 Index, which includes the 100 largest nonfinancial stocks in the Nasdaq Composite Index. Given its narrow sector focus, this ETF would work best as a satellite holding in a diversified portfolio. This is a high-quality portfolio with a mega-cap tilt, with more than 87% of assets invested in large-cap companies and more than 93% of assets invested in companies with Morningstar Economic Moat Ratings, those that Morningstar’s equity analysts deem as having sustainable competitive advantages. However, given this fund’s sector tilts, it is more volatile than a broad portfolio of large-cap stocks. For example, over the past 10 years, it has had a volatility of return of 18.0% compared with 14.6% for the S&P 500. When considering whether to invest, investors should take note of the fact that stocks in this fund make up almost the entire 20% tech component of the S&P 500. Despite the relatively low overlap, QQQ has a high correlation in performance with the S&P 500 (90% over the past 10 years) and an even higher correlation with the large technology ETF Technology Select Sector SPDR (NYSEARCA: XLK ) (98% over the past 10 years). Fundamental View The U.S. technology sector dominates QQQ and accounts for fully 58% of its assets, and large-cap tech firms’ performance determines its fortunes. The single largest dynamic affecting the tech sector right now is the shift to mobile computing and growth in cloud computing. Mobile and cloud computing are truly disruptive forces in the tech sector. As users shift to mobile devices, PC sales continue to fall. Global PC shipments dropped by 10% in 2013 and were flat to slightly down in 2014, with developed markets stabilizing but emerging markets seeing declines, as users shift to tablets. Despite sluggishness in PC sales, the total number of devices sold is expected to rise meaningfully in the years to come, as consumers and businesses adapt to smartphones and tablets. Our analysts project that some 2.6 billion-plus computing devices will ship in 2017–more than twice the total number of devices that shipped in 2012. Across the tech sector, firms are reshaping their portfolios for this ongoing transition. Microsoft (NASDAQ: MSFT ) in 2013 acquired Nokia’s (NYSE: NOK ) handset business and has developed the Windows Phone operating system, while Intel (NASDAQ: INTC ) has invested heavily in producing microprocessors optimized for mobile devices. Apple (NASDAQ: AAPL ) leads the marketplace with its iPhone and iPad, continually gaining share from struggling competitors. And Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ) long has had a dominant position in Internet search and has aggressively invested in its Android operating system for smartphones and tablets, providing it free of any license fees. Having Google software on the device helps to ensure that when users search, they use Google. Enterprise hardware suppliers also are reshaping their businesses. Broadly, we are confident in tech firms’ positioning for growth in the medium term. Tech firms generally are procyclical in their performance, and with continued economic strength, tech firms generally should do well. The Gartner Group estimates that tech spending grew 3.2% in 2014, measured in constant currency, to $3.8 trillion and forecasts a growth rate of 3.2% in 2015. As large tech firms manage and reshape their businesses to adapt to secular declines in PC demand, we expect that they will continue to find ways to benefit from smartphone and tablet growth. To be sure, not all technology players will win in a world dominated by mobile computing and cloud computing. For instance, we view cloud computing as a moderate threat to all IT infrastructure suppliers, as cloud service providers are technically savvy customers. So as enterprises migrate their infrastructure to these service providers, infrastructure suppliers’ pricing power likely will decrease. Apple makes up 13% of the assets of QQQ and is far and away this ETF’s largest holding. Apple surged in 2014 after a turbulent 2013. The company benefited from strong earnings reports and guidance that beat expectations, driven by solid iPhone unit sales in both developed markets and in China. Although iPad sales have continued to lag, investors have been enthused by the launches of two larger-screen iPhones, Apple Pay, and Apple Watch and what it means for Apple’s continued ability to innovate. We expect Apple to remain a leader in the premium smartphone and tablet markets for years to come. Portfolio Construction Known as the Cubes or the Qubes, this ETF tracks the Nasdaq-100 Index, which was created in 1985 to represent the Nasdaq Composite Index’s 100 largest nonfinancial stocks by market capitalization. The top 10 holdings account for a significant 47% of the portfolio. While Apple has a narrow moat, this ETF’s next-largest eight holdings all have wide moats. The average market cap of this fund’s holdings is about $96.6 billion. The Nasdaq-100 index rebalances once a year, although it has on occasion conducted special index rebalances in order to prevent any one company from having an outsize impact on the index (the index caps any one company’s weighting at 24%). The last special index rebalance took place in 2011 and was driven by the continued overweighting of Apple. Fees This ETF is relatively inexpensive, with an annual expense ratio of 0.20%. Its estimated holding cost is slightly higher, at 0.25%. Estimated holding costs are primarily composed of the expense ratio but also include transaction costs, sampling error, and share-lending revenue. One alternative is Fidelity Nasdaq Composite (NASDAQ: ONEQ ) , which tracks the broader Nasdaq Composite Index. ONEQ contains 1,920 stocks listed on the Nasdaq, making it a much broader portfolio than QQQ’s. Given its broader holdings, ONEQ is less top-heavy, with the top-10 names accounting for about 31.5% of total assets. ONEQ also includes Nasdaq-listed financial stocks, which make up about 6.5% of its portfolio. The average market cap of ONEQ’s holdings (about $31.5 billion) is considerably less than that of the holdings in the Cubes (about $97.0 billion). This can be attributed in part to ONEQ’s 17% exposure to small-cap stocks. ONEQ charges 0.21%, with an estimated holding cost of 0.12%. A cheaper and less volatile large-cap growth fund is Vanguard Growth ETF (NYSEARCA: VUG ) , which has an expense ratio of 0.09%. The performance of QQQ is highly correlated with the performance of VUG (96% over the past five years). Similarly, another large-growth option is iShares Russell 1000 Growth (NYSEARCA: IWF ) , which charges 0.20%. With just more than one third the holdings of ONEQ, IWF is more concentrated than the Fidelity offering. At the same time, it’s far more diverse than QQQ. Even so, QQQ’s performance is highly correlated with the performance of IWF (96% over the past five years). Those seeking more-concentrated exposure to tech names can consider Technology Select Sector SPDR ( XLK ) , which carries a 0.16% expense ratio and holds 71 companies, all of which are information technology and related services, software, telecommunications equipment and services, Internet, and semiconductors. A less-liquid alternative is Vanguard Information Technology ETF (NYSEARCA: VGT ) , which holds 393 companies and charges just 0.12%. Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.