Nvidia and Microsoft Will Make Up Over 40% of This Popular ETF. Here's Why This Alternative ETF Could Be a Better Option.

The three largest tech companies right now (as measured by market cap) are 1. Nvidia (NASDAQ: NVDA), 2. Microsoft (NASDAQ: MSFT), and 3. (NASDAQ: AAPL), with each valued relatively close to the other, and all three valued over $3.25 trillion. Not surprisingly, these stocks are the top three holdings of the popular State Street Technology Select Sector SPDR Fund (NYSEMKT: XLK), which tracks the S Technology Select Sector index.

The holdings in the fund are rebalanced quarterly to account for changing valuations, and that has created a situation. In an unusual quirk, the top two holdings in this exchange-traded fund (ETF) (Microsoft and Apple) now account for the bulk of its portfolio, far outstripping its third-largest holding (Nvidia). The reason why is that the index has a rule that caps holdings with over 5% allocations so that the top two cannot exceed 50% of the index's combined portfolio. There is another rule in effect saying that once the 50% allocation is breached, no other stock in the portfolio (including No. 3) can exceed 4.5% of the index. It sounds complicated because these investing rules often are. Suffice it to say the rules exist for some useful reason, but they are creating an unforeseen situation because of some unusually strong stock performance by these three stocks.

These rules have resulted in Microsoft and Apple each representing over 20% of the index at the moment, while the No. 3 holding (Nvidia) represents less than 6%. However, Nvidia's market cap exceeded Apple's on the day chosen to determine the index's next quarterly rebalancing, So the chipmaker will jump up to represent over 20% of the index when the rebalancing happens while Apple's weighting is expected to drop to around 4.5%.

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Source Fool.com