Why I Choose VGT ETF Over Its Top Holdings Or QQQ (NYSEARCA:VGT)

The Vanguard Information Technology Index Fund ETF (NYSEARCA:VGT) focuses on US Information Technology companies. Vanguard describes its fund as targeting companies involved with electronics, computers, or cutting-edge science.

VGT sticks to a strict definition of Information Technology. For example, it doesn’t invest in Amazon (AMZN), viewing it as a retail company, nor in Google (GOOGL) or META (META), which it categorizes as Communications companies.

While VGT’s 0.10% expense ratio is double that of the average Vanguard ETF, it’s still significantly lower than the 0.99% average for similar technology-focused funds, according to Vanguard.

VGT: A Focused Bet On Tech

Tech stocks have been major players in the stock market’s success over the last ten, fifteen years. If, like me, you’re big on tech and believe it will continue to outperform, VGT is one of the best choices you can make.

The VGT ETF offers wide exposure to US tech companies, focusing solely on tech. This is unlike the Invesco QQQ Trust ETF (QQQ), which follows the Nasdaq 100 and includes non-tech companies like PepsiCo and Starbucks. It is therefore a preferable options if you are a believer in the tech sector.

Investing in the VGT ETF is also preferable to investing directly in individual stocks, like its own top holdings Microsoft (MSFT) or Apple (AAPL). That’s because VGT offers a broader selection of tech stocks that in the past has allowed this fund to perform better than the average Venture Capital firm. I’ll delve into more details in the following sections.

VGT Is Very Concentrated – But It Doesn’t Matter

The most common misconception about VGT is that you could simply own its top holdings and be better off without having to pay the ETF’s 0.10% fee. For example, a January Seeking Alpha article suggested exactly that you should buy AAPL and MSFT rather than VGT, but it hasn’t held up. From January to April, MSFT and AAPL fell from 42% to 34% of VGT’s composition. The reason? The stellar rise of NVIDIA (NVDA).

If you chose to invest in MSFT and AAPL over VGT in January, you would have missed out on NVIDIA’s gains, and your returns would have lagged behind the S&P 500. In contrast, VGT has slightly outperformed the S&P 500 during this time. This shows that VGT can benefit from the rise of all companies in its portfolio, even if it is a very “top heavy” ETF.

Conventional financial wisdom often says to “let your winners run.” This means if a stock in your portfolio is doing well, you shouldn’t rush to rebalance. Instead, let it continue to perform, potentially increasing your returns further. Unlike other conventional advice, there is a decent amount of financial literature suggesting how this is a key strategy for generating higher returns in a portfolio. These include the Coffee Can Portfolio by Robert G. Kirby and a 2014 study conducted by JP Morgan.

For VGT, this means that If a new company within the ETF experiences significant growth, it will naturally become one of the fund’s top holdings. Again, that’s exactly what happened in the past 6 months with NVIDIA. This dynamic allows VGT to adapt and benefit from emerging success stories in the tech sector.

This dynamic is not unique to VGT; it also applies to other ETFs like QQQ and the Vanguard S&P 500 ETF (VOO). These funds are currently “top heavy,” meaning a few large companies make up a significant portion of their value. While this is less pronounced than in VGT, it’s a common feature of many non-sector neutral ETFs. The concentration of holdings in itself isn’t a concern.

If VGT Was A Venture Capital, It Would Be Regarded As A Highly Successful One

How many VCs have beaten the market in the past 5, 10, 15 years? According to a 2020 research paper, about half of US private equity and venture capital firms manage to outperform the market. The CFA institute notes that since the tech bubble burst in the early 2000s, the performance of US venture capitals has generally matched that of the Nasdaq Composite.

In comparison, the VGT ETF has consistently outperformed the QQQ ETF, which tracks the Nasdaq 100, over the past 5 and 10 years. If VGT were a venture capital firm, it would likely be ranked at least in the 50th percentile, and possibly even in the top quarter of venture capitals, given that surpassing the Nasdaq 100 is a notable accomplishment on its own.

I believe investors in ETFs tend to prefer diversified portfolios, which might make some hesitant about the VGT ETF due to its concentration in a few key stocks. However, concentration should not be viewed as a limitation but as a feature of the VGT ETF. While this concentration does introduce a risk-meaning that if the top holdings underperform, the ETF will likely suffer (as I will mention in the risk section) -it’s also the very feature that has enabled the ETF to achieve impressive results in the past. This concentration can be a double-edged sword, but it has historically been a significant factor in the ETF’s strong performance.

Past performance is not indicative of future results, but I see no reason to expect the VGT ETF to suddenly start underperforming compared to ETFs that are not exclusively focused on Tech. This confidence stems from my belief that the tech sector will continue to deliver outstanding returns for the foreseeable future.

Seeking Alpha Quant Rating For The VGT ETF Is Excellent

I wouldn’t advise choosing an investment solely based on its quant rating. Particularly with ETFs or mutual funds, it’s crucial that their strategy aligns with the objectives of your portfolio. However, it’s worth mentioning that the VGT ETF currently holds a “Buy” Quant Rating from Seeking Alpha, with an overall score of 4.38 out of 5. It scores an A or A+ in categories like Momentum, Liquidity, and Expenses, while Dividends and Risk are rated B-. This comprehensive evaluation can offer valuable insights, especially when aligned with your investment goals.

Risks – What I Do Not Like About VGT

AMZN, GOOGL and META are missing

The absence of major tech companies Amazon, Google, and Meta in the VGT ETF means it falls just short of being a fully diversified investment in the technology sector. Should these significant tech players excel in the future, VGT would likely underperform compared to ETFs that include these stocks. This limitation is arguably the most substantial risk facing investors in VGT today, making it a crucial consideration, especially when evaluating it alongside ETFs like QQQ. It is however a risk that can be easily managed, by simply holding these stocks separately from the VGO ETF.

Concentration is a double-edged sword

As illustrated previously, I believe that concentration should not be considered a problem of the VGT ETF, but a feature of this fund. However, given that currently 44% of VGT is represented by 3 companies, there is a concentration risk that is worth mentioning. Should Apple, Microsoft or NVIDIA suffer in the future, the VGT ETF will most likely underperform when compared to QQQ or the S&P 500.

Tech might be overbought and overpriced

At the time of writing, valuations of tech companies are near their all-time highs, which presents the most apparent risk of investing in the VGT ETF in absolute terms. If tech stocks were to undergo a correction and adjust their valuations downward, the ETF could underperform.

This article isn’t focused on evaluating current tech valuations; instead, it highlights the VGT ETF as a useful tool for gaining exposure to the tech sector. If you’re cautious about tech or think it’s too pricey right now, the QQQ ETF might be a better fit. It includes about 45% of non-tech companies like PepsiCo and Starbucks, giving you a more balanced mix.

Conclusion: Having VGT In Your Portfolio Is A No-Brainer If You Are Bullish On Tech

The scope of this article is not to discuss Tech valuations and whether it might be wise to enter in Tech now. If you do not believe in Tech or prefer to avoid it, then this ETF is not for you.

However, if you are bullish on tech, the VGT ETF is an excellent choice for adding tech exposure to your portfolio. Its exclusive focus on Information Technology companies makes it similar to a venture capital investment but with the added benefit of a low 0.10% fee. This gives it an edge over ETFs like QQQ, which includes companies from various sectors and is not solely tech-focused. Moreover, investing in VGT is preferable to handpicking individual tech stocks because it provides broader exposure to the sector and the potential to benefit from emerging tech leaders.

I recently started a small position in the VGT ETF with 20 shares. I plan to gradually increase this investment, as I see it as a beneficial addition to my larger stake in the QQQ ETF, which currently makes up 25% of my main portfolio. This strategy aims to balance my tech exposure with broader market coverage.