Nvidia is shaking up a big tech ETF. Here’s what this means for investors

The usual rebalancing of the S&P 500 Index and the exchange-traded funds surrounding it is a quarterly event that occurs on Friday. Most of the time it gets little or no attention. This time around — thanks to Nvidia’s relentless rise, up nearly 45% this quarter alone — things are different. NVDA YTD Mountains Nvidia’s Performance in 2024 Gap Between an Index and the ETF That Tracks It The S&P 500 has 500 large-cap stocks weighted by market cap. It is rebalanced quarterly to reflect additions, deletions, and changes in the number of shares due to repurchases. Some ETFs track the broad market benchmark and others track S&P 500 sector indexes, including technology. These sector ETFs also rebalance quarterly. But there is a difference. The S&P 500 indices are pure indices. They impose no limits on the concentration of individual stocks. Nvidia could become 99% of the S&P 500 in terms of market cap, and that would be reflected in the index. This is not the case for ETFs. These are investment funds. There are federal rules they must follow, dating back to the 1930s. Under these rules, no stock can account for more than 25% of a fund’s exposure, and the combined weighting of all stocks greater than 5 % cannot exceed 50% of the fund’s assets. Normally this is not a problem, because almost no company experiences this type of concentration. But things have changed a bit because three companies – Microsoft, Nvidia and Apple – have a market capitalization of around $3 trillion. This trio dominates the S&P 500 Technology Index. When the Technology Select Sector SPDR Fund (XLK), the ETF that seeks to track the S&P Technology Index, was last rebalanced three months ago, the weightings were very different from those of today: SPDR Technology ETF (XLK) (current index weighting) Microsoft 22.1% Apple 21.9% Nvidia 6.0% Broadcom 5.4% Here is the current weighting of the four largest S&P Technology Index values, as of last Friday: S&P Technology Index (index weighting) Microsoft 22.0% Nvidia 21.8% Apple 20.6% Broadcom 5.1% Source: S&P Dow Jones Indices There’s a problem here: the combined weight of the top three names exceeds 64%. So, according to the rules, there must be a rebalancing. The rules say you have to cap the last stock that breaks the 50% barrier. That would be Apple. So Apple’s weighting will be reduced so that the combined weighting of any stock above 5% will be less than 50% of the combined weight, and Nvidia will increase. The new weightings look like this: SPDR Technology ETF (XLK) (new index weighting) Microsoft 21.9% Nvidia 21.6% Apple 4.5% Broadcom 4.5% Source: SPDR Americas Together, top three values ​​have a weighting of 48%. The goal isn’t to reach exactly 50 percent, Matthew Bartolini, head of SPDR Americas Research, told me. In this way, the cumulative weight of shares representing at least 5% of the fund is kept below the 50% threshold. This can lead to unusual situations. Due to concentration rules, it is possible for an ETF that tracks the S&P Technology Index to deviate slightly from the index it seeks to track. This has not been a major problem in the past, but it could become one if concentration increases further in the future. It’s a little confusing to understand the numbers, but it makes sense when you consider that many investors were burned by mutual funds during the Great Depression. Regulators have sought to limit concentration to protect investors. Still, a move to a company like Nvidia is rare. “It’s an anomaly,” Bartolini told me. “We’ve never had three companies in the same industry with over $3 trillion in a single industry. That’s a byproduct of concentration.”

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