On first glance the performance of the Dow Diamonds (DIA), S&P 500 SPDR (SPY) and Nasdaq QQQ (QQQ) seems to be closely correlated. This first glance assessment, however, couldn’t be farther from the truth. Here’s what separates the indexes from each other and why it’s important.
Index investing or ETF index investing is a popular and low-cost way to put your dollars to work, it’s like putting your portfolio on cruise control.
But driving on cruise control isn’t always the best way to get from A to B and doesn’t mean you won’t get into an accident. It merely means that you delegate speed control to your car.
Your level of commitment to your own portfolio ultimately dictates your style of investing: buy and hold via indexes or ETFs, buy and hold via actively managed mutual funds, or a more active approach to buying and selling.
Regardless of what type of investor you are, you need to be familiar with your investment vehicle(s) of choice, just like a driver needs to know the difference between automatic and stick shift.
Look Under the Hood
The S&P 500, Dow Jones, and Nasdaq are the most popular U.S. indexes and if you are an investor, odds are some of your money is invested in one or more of those three indexes.
Equity indexes are often described as a basket of stocks. Retirees or near retirees are familiar with the term nest egg and the comforting picture of many golden eggs nested up to provide a comfortable retirement.
But what if the basket of eggs is made up of one or two giant ostrich eggs that limit the space for other eggs? That wouldn’t be well diversified and one knock against the basket could scramble most of the retirement.
Hidden Ostrich Eggs
Financial ostrich eggs among major U.S. indexes are more common than you think.
IBM accounts for nearly 12% of the Dow Jones Industrial Average (DJIA or Dow Jones). Technically speaking, the DJIA is an average not an index. The DJIA is price weighted, in other words only the price of a stock matters, nothing else.
IBM is the most expensive stock of the DJIA and moves the index (or average) 20x more than Bank of America (BAC) even though IBM has only about twice the market capitalization (the price per share multiplied by the amount of outstanding shares) of BAC.
The ETF that best represents the DJIA is the SPDR Dow Jones Industrial Average ETF. Its ticker is DIA, that’s why it has the nickname Dow Diamonds ETF.
The Nasdaq-100 and the PowerShares Nasdaq QQQ ETF (QQQ) hide another “ostrich egg,” – Apple. Apple accounts for a whopping 20% of the Nasdaq-100 Index. If you already own Apple or don’t believe Apple is the way to play technology, you may not want to own QQQ.
The S&P 500 Index – represented by the S&P 500 SPDR (SPY) – provides more balanced diversification than the DJIA or Nasdaq-100. Apple, still the biggest player of the S&P 500, accounts for less than 5%. IBM has a weight of only 1.8%.
Considering the different composition of the three indexes, it’s remarkable how closely their day-to-day moves correlate.
The chart below provides a visual of the long-term correlation between the Dow Diamonds (DIA), S&P SPDR (SPY), and QQQs. Illustrated is the percentage change since April 1999 (when the QQQs began trading) to provide an apples to apples comparison of the three indexes.
The SPY and QQQ delivered a near identical return (+38%). The DIA is up 68% since April 1999. Of course the picture looks much different if you start measuring the return from the 2000 highs.
All three indexes and index ETFs share the commonality of having had very sizeable swings ranging from -60% to +60%. The Profit Radar Report advocates an investment approach that capitalizes on larger up moves and turns neutral or short during major down moves.
This approach can significantly enhance your return and reduce your exposure to risk.