Exchange traded funds provide investors with broad market exposure, but investors should still look under the hood or risk finding unwelcome surprises.
For instance, the Technology Select Sector SPDR (NYSEArca: XLK) is up 10% this year, whereas the First Trust DJ Internet Index Fund (NYSEArca: FDN) has gained nearly four times that.
FDN’s outperformance is attributed, in part, to its allocation to Amazon (NasdaqGS: AMZN), which is up 22% this year, and its lack of exposure to Apple (NasdaqGS: AAPL), which is down 8.0% year-to-date. XLK, on the other hand, has a 14% allocation toward AAPL. FDN has also gotten a boost from Facebook (NasdaqGS: FB) and Google (NasdaqGS: GOOG), among other Internet heavyweights.
If an investor is more comfortable with holding an all inclusive technology ETF but is concerned about heavy stock allocations, the Guggenheim S&P 500 Equal Weight Technology ETF (NYSEArca: RYT) equally weights holdings, so AAPL makes up about 1.6% of the fund. RYT has gained 26% so far this year. [What an Equal-Weight S&P 500 ETF Brings to the Table]
Investors should understand that most capitalization-weighted ETFs overweight exposure in stocks based on the firm’s market capitalization, so larger companies get a larger weighting. [Understanding ETF Portfolio Indexing]
The overweight characteristic is not limited to tech ETFs. For example, General Electric (NYSE: GE) is the largest holding in the Industrial Select Sector SPDR (NYSEArca: XLI), with an 11% weighting. On the other hand, investors can use an equal weight methodology to reduce large allocations to one stock, such as the Guggenheim S&P 500 Equal Weight Industrials ETF (NYSEArcac: RGI), which allocates less than 2% to GE.
However, investors should also know that a large single stock holding is not necessarily bad since it could help lift an ETF in good years. In the year leading up to September 2012, Apple rallied to its all-time high, which helped XLK rise 30% in, compared to RYT’s 19% gain.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.