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Investment Thesis

The Nasdaq 100 has been one of the U.S. equity market’s best-performing indices over the past several years as mega-cap tech names continue to roar. If you’re looking to add some of the “bubbling under” companies to your portfolio that could be next in line to gain membership into the high profile index, the new Invesco Nasdaq Next Gen 100 ETF (QQQJ) should be on your radar.

Overview

Ever since emerging from the depths of the financial crisis, the subsequent bull market in equities has been driven by the tech sector. The rally’s best performer hasn’t been small-cap tech (PSCT) as you might expect, although that group has beaten the S&P 500 (SPY) since then. It’s been driven by large-cap tech.

Over the past decade, the tech sector has easily outdistanced the broader market and, in the process, making it one of the most popular targets for investors.

Data by YCharts

While the Technology Select Sector SPDR ETF (XLK) may be one of the better proxies for tech sector exposure, many target the Nasdaq 100. Or more specifically, the Invesco QQQ ETF (QQQ), which replicates the index. While it does eliminate financials, it’s only about 2/3 composed of tech and communication services stocks, which makes it less than ideal for pure tech exposure.

But whether QQQ is the right ETF for tech is besides the point for the argument I’ll make here today.

With so many investors gravitating towards QQQ over the past few years, many might be interested in trying to invest in the next companies to qualify for the index. The up-and-comers. The rising stars. The bubbling under companies ready to take the next step.

If you want to consider adding these companies to your portfolio, the new Invesco Nasdaq Next Gen 100 ETF should be on your radar.

Fund Overview

QQQJ tracks the Nasdaq Next Generation 100 Index, which will target the largest 100 non-financial Nasdaq-listed companies outside of the Nasdaq 100 Index. Selection criteria for QQQJ is essentially the same as those for the Nasdaq 100. It’s simply grabbing the 2nd 100 companies from the exchange. As Invesco says in its sales pitch for the fund…

It provides diversified exposure to mid-cap companies that are at the forefront of innovation and have strong historical growth rates as well as robust fundamentals.

One of the first questions that came up when I first profiled this fund is what it looked like in comparison to QQQ. QQQJ does have a significant tech presence just like its “parent” ETF, but there are some noticeable differences.

source: Invesco

A couple of things stand out when looking at the fund.

  • Overweight to healthcare – QQQ has only a minor allocation to the healthcare sector, but it’s nearly 20% of the QQQJ portfolio. Not surprisingly, the healthcare is heavily tilted towards pharmaceutical and biotech names.
  • Overweight to cyclicals – QQQ has a 1% allocation to the industrial sector and that’s it as far as cyclicals are concerned. QQQJ has an 11% weighting to cyclicals through a combination of (mostly) industrials, materials and energy.
  • Underweight to communication services – 19% of QQQ belongs to this sector (mostly Facebook (FB), Alphabet (GOOG) (GOOGL) and Netflix (NFLX)), but QQQJ has only about half of that. Think more along the lines of Roku (ROKU), Zynga (ZNGA) and Yandex (YNDX).

You can see these differences in the following illustration.

source: etfrc.com

QQQJ is underweight in communication services, consumer discretionary and consumer staples relative to QQQ, and is overweight healthcare and industrials. Both funds have a 45-50% allocation to the tech sector, but QQQJ appears to be much more diversified beyond that group. QQQJ will be heavily influenced by tech, but it will likely behave more like the broader market than QQQ would be expected to.

On its website, Invesco does a nice job of profiling what the Next Generation 100 Index looks like from a fundamental standpoint and where the biggest opportunities lie. While the index hasn’t, historically, kept up with the earnings growth rate of the S&P 400, it’s delivered consistently higher revenue growth compared to its mid-cap peers.

source: Invesco

Also worth noting is the fact that these names have also produced a higher dividend growth rate. Most investors won’t typically look to the Nasdaq for yield, but a historical 14%+ dividend growth rate should appeal to income seekers as well as those looking for above average growth potential from their portfolios.

Invesco also emphasizes the commitment to innovation and research within the index’s components. That can be seen through their research spend as a percentage of revenue.

source: Invesco

The R&D spend of those companies within QQQJ is more than twice that of the broader mid-cap stock universe and well ahead of even just the growth segment of it. This kind of reinvestment back into the business will be key in seeing these companies turn into large-cap growth names over time.

Speaking of which…

QQQJ is advertised as a portfolio of companies that would be the next in line to join the Nasdaq 100. So what are the odds that this will indeed happen? How many companies have “graduated” into the big index historically? Turns out the rate is pretty good.

source: Invesco

Companies in the Next Generation 100 Index have roughly a 1-in-3 chance of moving up to the Nasdaq 100. Moving into the bigger index has benefits beyond just the confirmation that they’re becoming one of the more influential names on the Nasdaq. Stocks that move into the Nasdaq 100 also need to be added to any ETFs that are tied to the index.

When a company gets added to the S&P 500, for example, we usually see the stock price jump because hundreds of billions of dollars are tied to funds linked to the index and they’ll need to add positions in order to reflect the updated index. The same thing applies to the components of QQQJ (although probably not to the same degree). Upon announcement, QQQJ members should see a bounce in the stock’s price before officially moving over, adding another modest degree of share price growth potential.

Conclusion

I see no reason why this fund couldn’t get very popular quickly. The one-month old fund already has $165 million in assets showing that investors are catching on to it pretty fast. The fund’s expense ratio of 0.15% will also be an attractive factor.

For investors looking to add some more capital growth potential to their portfolios, I think QQQJ makes a lot of sense. It is a little tech-heavy, obviously, making it more of a sector bet, but it’s fairly well-diversified beyond that and in a different way than you’ll find in many large-cap and mid-cap indices.

The idea of “getting ahead of” the next big Nasdaq winners is appealing and I see no reason why investors shouldn’t at least have this ETF on their radars.

Disclosure: I am/we are long QQQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.