A new kind of sector ETF concentrates even more of your money in the top stocks such as Nvidia
By Jason Zweig
Do you have too much money in too few stocks -- or not enough?
For years now, investors have been fretting that the U.S. stock market is overconcentrated in a handful or two of such giant winners as Nvidia, Apple and Microsoft. Could you be underexposed to them instead?
That's the pitch behind a batch of new exchange-traded funds with supersize holdings of the biggest stocks in U.S. industry sectors. Whether you should buy one of these ETFs depends much less on how they're built than on how you're built.
And most investors should approach all sector funds with caution -- especially these new extra-strength versions.
Sector funds can become a devil's workshop where otherwise patient investors chase the demonically bouncing ball of short-term return. Extra-strength sector funds might make that temptation even more dangerous.
As index funds tracking the broad stock market have boomed in recent decades, so have index ETFs that track only a single segment: healthcare or financial or technology or energy stocks, for instance. So far this year, $42 billion has poured into technology index ETFs alone, according to Morningstar.
Sector funds, though, are Exhibit A in why investing in index funds isn't always as simple as people think.
Securities regulations and federal tax rules limit how much money an ETF or mutual fund can have in its top holdings. In general, a fund can't have more than 25% of its assets in a single company, and the sum of individual holdings that exceed 5% of assets can't be greater than half the fund's total value. Those limits can be breached only temporarily.
And, of course, the biggest stocks have become behemoths. In early 2024, Apple and Microsoft each hit roughly 22% of S&P Dow Jones' information-technology index. S&P had to cap Nvidia's weight at an artificially low level of about 5% to keep the three companies combined from exceeding the 50% maximum permissible concentration.
Then, that June, Nvidia surpassed Apple in market value, just in time for the index's quarterly rebalancing. Nvidia's weight in the tech index promptly shot up to about 21%, Microsoft remained about the same and Apple fell to less than 5%.
S&P Dow Jones has since tweaked its index design to make such changes less disruptive.
Still, the top five stocks -- Nvidia, Apple, Microsoft, Broadcom and Micron Technology -- make up 66% of the total market value of the S&P 500's technology sector. At State Street's Technology Select Sector SPDR ETF, popularly known by its ticker XLK, those same five stocks constitute 50% of the fund's $126 billion in assets.
Several firms have recently introduced ETFs that seek to mitigate these quirks by hopping through a regulatory loophole. Putting much of their money into another ETF -- which doesn't count toward the limits on concentrated positions -- lets them crank up exposure to the biggest companies.
State Street S&P 500 Technology Market Sector SPDR, which launched earlier this month, has 66% of its assets in State Street's giant XLK fund.
The new fund, with the ticker XLKM, has only three single-stock positions greater than 5%: Nvidia at 10.3%, Apple at 9.8% and Microsoft at 7.8%. That's well below the 50% maximum on holdings that exceed 5% each.
Remember, though: XLKM has 66% of its assets in State Street's Technology Select Sector ETF. This week the older, bigger fund had 14.9% in Nvidia, 14.3% in Apple and 11.3% in Microsoft.
Look through to those positions, and the new fund effectively has 55% in the top three stocks. Besides its own direct 10.3% in Nvidia, XLKM's 66% position in its older sibling gives it another 9.9% in Nvidia indirectly -- and so on for each of its top holdings.
That enables the new, uncapped fund to reflect the relative size of technology stocks within the S&P 500 more accurately and makes it less subject to the rigid changes that regulations impose on traditional sector funds, says Matthew Bartolini, global head of research strategists at State Street Investment Management.
In August of last year, VanEck started rolling out its TruSector ETFs, which now cover all 11 industry sectors of the S&P 500. (So far, State Street offers four uncapped sector index funds.) VanEck's TruSector funds may increase their exposure to top holdings by owning large positions in index ETFs, including State Street's, within their respective sectors.
The VanEck Energy TruSector ETF has 23% of its assets in State Street's Energy Select Sector SPDR fund -- indirectly pumping up its positions in such giants as ExxonMobil and Chevron. Although they're technically active funds, the VanEck TruSector ETFs seek to capture the return of each sector's index as closely as possible.
New sector ETFs from other firms also zoom in on an industry's top holdings, but use different approaches.
What all these funds have in common is that they take an already heavy dose and make it extra-strength.
Funds like these will tend to do best in a rising market, and worst in a downturn, if a sector's returns are dominated by a handful of the biggest stocks that move in sync.
Recently, as jitters have spread about the future payoffs from artificial intelligence, such titans as Nvidia have faltered -- and some uncapped tech-sector funds are lagging behind the traditional variety.
"These are definitely not a single-portfolio-holding solution for anyone," says Michael Cohick, director of product management at VanEck Funds.
That's been true all the way back to the run-up to the Crash of 1929. Back then, when utility funds boomed and then busted, money had poured into sector funds when returns were hot, then sloshed back out when performance went cold, locking in severe losses.
Investors might do better buying sector funds in unpopular industries. At the beginning of this year, the overwhelming consensus was that AI's future was limitless. In fact, energy stocks have outperformed tech by 25 percentage points so far this year.
The new turbocharged sector funds are a more powerful tool for focusing on the biggest winners in an industry. That could make you more money if you're right about which sector will boom.
The hard part is the word "if."