ETFs
Nvidia and Microsoft will account for over 40% of this popular ETF. Here’s why this alternative ETF might be a better option.
There is one ETF that might be a better option for investors interested in the Technology Select Sector SPDR Fund ETF.
The three largest technology companies today (as measured by market capitalization) are 1. Nvidia (NVDA -3.22%), 2. Microsoft (MSFT 0.92%), and 3. Apple (AAPL -1.04%), each being valued relatively close to the other, and all three being valued at over $3.25 trillion. Not surprisingly, these stocks make up the top three holdings in the popular market. State Street Technology Selected Sector SPDR Fund (XLK -0.17%), which follows the S&P Technology Sector Selection hint.
The fund’s holdings are rebalanced each quarter to account for changing valuations, which has created a situation. Oddly, the two main stocks in this sector exchange-traded fund (ETF) (Microsoft and Apple) now represent the bulk of its portfolio, far surpassing its third holding (Nvidia). The reason is that the index has a rule that caps holdings with an allocation above 5% so that the top two cannot exceed 50% of the combined index portfolio. There is another rule in effect that once the 50% allocation is exceeded, no other stock in the portfolio (including #3) can exceed 4.5% of the index. This seems complicated because these investment rules often are. Suffice it to say that the rules exist for a useful reason, but they create an unforeseen situation due to the exceptionally strong performance of these three titles.
These rules mean that Microsoft and Apple each represent more than 20% of the index at the moment, while holding number 3 (Nvidia) represents less than 6%. However, Nvidia’s market capitalization surpassed Apple’s on the day chosen to determine the next quarterly rebalancing of the index. The chipmaker will therefore rise to account for more than 20% of the index when the rebalancing takes place while Apple’s weighting is expected to fall to around 4.5%.
This will cause the $71 billion ETF to buy a lot of Nvidia stock (at high prices), while then dumping a bunch of Apple stock (also at high prices). This isn’t necessarily a wise investment decision to make right now, but rules are rules.
Is it time to buy another ETF?
An ETF dominated by Microsoft and Nvidia, two of the companies that benefit the most from artificial intelligence (AI)doesn’t seem like a bad idea at first glance.
Nvidia has been the biggest AI winner so far with its graphics processing units (GPUs) being the choice of infrastructure necessary for training AI models and inference. The company is not the only GPU producer, but programmers have long been trained on Nvidia’s Cuda software platform, which has led it to become the de facto GPU leader in the field, with a wide ditch. As a result, its first-quarter revenue jumped 262% to $26 billion.
Microsoft, on the other hand, was an early adopter of AI thanks to its significant investment and partnership with OpenAI. So far, the company’s Azure cloud computing business has been the biggest beneficiary as customers build their own AI solutions using its Azure platform. Microsoft has also benefited from AI in other areas, notably with the adoption of its AI assistant Copilot. Its GitHub developer platform grew revenue 45% year-over-year last quarter, with more companies adopting its GitHub Copilot. And Microsoft 365 saw revenue increase 14%, thanks to the early success of Copilot on that platform.
As Nvidia and Microsoft stocks perform, so will the ETF given the heavy weighting of these names.
However, the drastic change in weighting between Nvidia and Apple shows the risk associated with the ETF. It also missed out on some of Nvidia’s earlier gains due to its allocation rules. Meanwhile, a poor quarterly performance from Nvidia could significantly reduce its weighting. It appears that these rules that are supposed to benefit shareholders may actually harm them.
Image source: Getty Images
A better alternative?
Given these issues, I think there is a better alternative for investors who like the idea of an ETF with very large positions in Nvidia and Microsoft. It might be a better long-term choice than the State Street Technology Select Sector SPDR Fund ETF.
A great option for investors is the Vanguard Information Technology ETF (VGT -0.52%). Like the Technology Select Sector SPDR Fund ETF, it holds significant positions in Nvidia and Microsoft. But its first three positions are more balanced.
At the end of May, Microsoft held its largest position at 16.7%, followed by Apple at 15.9% and Nvidia at 14%. Given Nvidia’s strong performance in June so far, this could very well be its top position currently.
Other stocks have much lower weightings, including Broadcom at 4.2%, Advanced microsystems at 1.9%, and Qualcomm at 1.6%.
The Vanguard ETF has performed strongly, with an average annual return of 20.3% over the past decade. Its average return is comparable to that of the State Street fund. And because the Vanguard ETF doesn’t have the same rebalancing quirk, I think it’s the best option for investors looking for nice tech exposure with a heavy weighting toward AI leaders Nvidia and Microsoft without certain buying and selling rules that force some questionable stock trades.
Geoffrey Seiler has no position in any of the stocks mentioned. The Motley Fool holds positions and recommends Advanced Micro Devices, Apple, Microsoft, Nvidia and Qualcomm. The Motley Fool recommends Broadcom and recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Mad Motley has a disclosure policy.