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National Bank Financial’s Daniel Straus says market-weighted ETFs offer investors a low-risk way to get exposure to emerging sectors, such as cannabis. THE CANADIAN PRESS/Sean Kilpatrick

Sean Kilpatrick/The Canadian Press

If you bought the Invesco QQQ Trust (QQQ-Q) exchange-traded fund (ETF), which tracks the Nasdaq-100 Index, in the wake of the dot-com meltdown in 2000, you were invested in the technology heavyweights of the day such as Palm Inc., Red Hat Inc., JDS Uniphase Corp. and Canada’s Research In Motion Ltd.

If you held that same ETF to 2019, those companies had long faded from the upper ranks of the correlating index to make way for the now popular “FAANG” stocks of Facebook Inc., Apple Inc., Amazon.com Inc., Netflix Inc. and Alphabet Inc.’s Google.

Oh, and your investment quadrupled in value.

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Such is the way for market-weighted ETFs. The rebalancing formula might vary from one fund to the next, but holdings are based on their market capitalization. If a stock in the underlying index gains in value, it takes a bigger stake in the index and consequently, the ETF. If it declines, the stock moves down the ranks and possibly out of the index. In other words, the cream rises to the top and the weak wither and die.

“Every time the prices change inside that index – and they’re changing continuously throughout the day – it’s automatically self-rebalancing,” says Daniel Straus, vice-president, ETFs and financial products research, at National Bank Financial Inc. in Toronto.

As a result of that automatic self-rebalancing, market-weighted ETFs might be late to the party with rags-to-riches stocks such as Apple, but they do trim the stocks that are declining well before they hit bottom. They also provide an opening for the FAANGs of tomorrow – whatever they may be.

Although the Nasdaq is often considered a technology index, only 60 per cent of its components are actually technology stocks. Mr. Straus says there are many pure technology and technology subsector ETFs, such as biotech and genomics, that are better suited to advance the big names of tomorrow.

“There’s been a huge proliferation of what we call thematic investing,” he says. “With this bull market we’ve been in, technology thematic ETFs have been selling like gangbusters; every category from robotics and automation to pharmaceuticals, biotech and medical devices.”

Mr. Straus says market-weighted ETFs can also offer a low-risk way for investors to get exposure to other emerging sectors, such as cannabis. For example, Canopy Growth Corp. recently became the first cannabis producer to join the S&P/TSX 60 Index, which is tracked by iShares S&P/TSX 60 Index ETF (XIU-TSX).

“In the TSX 60, those 60 stocks have very low turnover. Canopy just entered the [index]. That’s a major example of a new company coming in, but there will often be many years when the TSX 60 simply does not change” he says. “If you want to future-proof an investment, the soundest idea is to let the efficiency of the capital markets decide and get as broad an exposure as you possibly can.”

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The key to determining just how future-ready a market-weighted ETF is to establish how often holdings in the underlying index change – or the turnover rate, Mr. Straus says. Regulators require fund managers to file periodic documentation disclosing how holdings change, but the numbers can be skewed by other variables.

“If you look up the turnover rate for any ETF or mutual fund, you will see a line called turnover. The problem with that number is that it’s calculated according to a regulatory definition related to the amount of cash buying and selling the manager is doing,” he says. “That will include the internal turnover happening inside the fund, but it also includes what we think shouldn’t be included: New cash coming into the fund from creations or fund redemptions.”

All factors considered, the two-way turnover rate for the QQQ, according to Invesco Ltd., was 3.8 per cent last year, which was slightly lower than historical standards. Nasdaq Inc. data show the turnover of the Nasdaq-100 Index between 1999 and 2018 averaged 13 securities a year.

That number includes periodic changes due to mergers and acquisitions, and delistings, but it gives a good idea of how stocks in the index can be flushed out over several years. As an example, about half of the companies currently in the Nasdaq-100 Index were not in the index 10 years ago.

Howard Silverblatt, senior index analyst at S&P Dow Jones Indices in New York, says the same challenges exist for determining turnover in other major market-weighted indexes such as the S&P 500.

“We all understand the Dow. It’s nice and simple; you add the [number of stocks] up and divide. That’s the Dow Jones Industrial Average. The S&P 500 average is market weighted. It’s a lot more complicated,” he says.

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According to S&P Dow Jones Indices, the S&P 500 experienced a typical 4.8-per-cent turnover in 2018, but the change has been as high as 9.5 per cent going back to 1998.

“The [stocks] could change very quickly, especially when you add in buybacks. Apple spent an enormous amount of money on buybacks. This quarter, they did US$23 billion. That means they took US$23 billion out of the marketplace. That’s a lot. If you go by market value, Apple is actually reducing its importance in the index” Mr. Silverblatt says.

Investors looking for a steadier flow of new blood should consider market-weighted ETFs tied to indexes that track smaller companies such as the S&P MidCap 400 Index and the S&P SmallCap 600 Index, he says.

“When you move over to the mid-cap and small-cap indexes, you get much bigger, double-digit numbers,” he says. “Mid-cap had a 20-per-cent turnover last year and small-cap had almost 22 per cent.”

However, Mr. Silverblatt points out the smaller indexes also have more variables at work beyond pure market weighting, including more active merger and acquisition activity.

“Very often, it’s the big guys taking over the smaller companies” he says.

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