Martin Barraud
Investment Thesis
I believe the recent adjustments in The Technology Select Sector SPDR® Fund ETF (NYSEARCA:XLK) have increased Nvidia Corporation's (NVDA) weighting to a level that has led to heightened concentration risk, the antithesis of what many investors look for when investing in an ETF. As of the June rebalance, Nvidia's share in the XLK ETF surged to approximately 21%, which overshadowed other major components like Apple (AAPL) and Microsoft (MSFT). This follows a rise in Nvidia's stock price based on their performance selling GPUs to help fuel the artificial intelligence race.
I strongly believe such a high concentration in one stock poses considerable risks, in my opinion, particularly in the event of a market correction. Nvidia's disproportionate representation means that any notable fluctuation in their stock price (like what we have seen in their stock over the last week) will have an impact on the ETF's overall performance. It mirrors the broader tech sector's vulnerability, where a handful of stocks disproportionately influence market movements.
I view market corrections as inherently unpredictable, and the tech sector is no stranger to volatility. The heightened concentration risk in XLK due to Nvidia's large weighting could amplify losses during downturns. Investors could face more pronounced draw-downs, and the ETF's recovery might be sluggish if Nvidia's stock does not rebound swiftly. This risk is compounded by other major tech stocks like Apple that have seen reduced weightings, which historically acted as a buffer against sector-wide declines.
Adding to this, the announcement of recent changes have sparked notable trading, with substantial volumes of Nvidia shares being bought to adjust to the new weightings (some estimates note this to be about $10 billion in shares). I believe this created a short-term demand surge, potentially inflating Nvidia's stock price further heading into the weighting and exacerbating the ETF's vulnerability to future correction.
In the event of a market correction or any negative news specific to Nvidia, I expect that the impact on XLK could be severe, given the competitive pressures and high costs associated with Nvidia's chips, as I highlighted in one of my other recent reports. Nvidia's reliance on high-priced AI chips, which may not deliver the expected return on investment for many customers, adds uncertainty.
Given this, I believe a sell position on XLK is prudent unless the ETF's composition can be adjusted to reduce Nvidia's weighting. A diversified portfolio (or ETF) should not hinge on the fortunes of a single company that has had such a run-up, no matter how influential.
Background
XLK’s most recent rebalancing earlier this month, and was driven by Nvidia's sharp rise in market value that has outpaced even tech giants like Apple. Nvidia's market performance and dominance in the AI market has led to their heavy weighting within the XLK ETF. Specifically, Nvidia’s allocation in XLK has surged from around 5% previously to more than 21%, while Apple's allocation has dropped from approximately 21% to 5%. This is due to how the ETF is designed. It is supposed to weigh larger market cap companies more disproportionately.
The rebalancing is expected to trigger a substantial trading volume, which involves an estimated $8-$10 billion purchase of Nvidia shares and an $11 billion sale of Apple shares. While this transaction positions XLK to capitalize on what has been Nvidia's exponential growth, it also heightens the ETF's exposure to the volatility and risks associated with a single stock. This concentration risk is particularly concerning for investors seeking diversified exposure to the tech sector, as it undermines the primary objective of an ETF.
For a brief period this past week, Nvidia became the largest publicly traded company in the world, surpassing giants like Microsoft and Apple. The company's rapid ascent, driven by their dominant position in the AI chip market, has drawn parallels to the dot-com bubble of the late 1990s and early 2000s, and the market cap rivalry between Microsoft and Cisco during that era.
This year, Nvidia's market cap has surged to (at one point) over $3.34 trillion after investor enthusiasm for AI technologies has accelerated. During the dot-com boom, Cisco Systems (CSCO) also briefly became the most valuable company in the world by riding the wave of internet infrastructure investment. However, when the bubble burst, the company’s stock plummeted by over 80%, which showed the risks of overvaluation and speculative investments. Companies can grow rapidly just to see future growth expectations evaporate and their stock price drop. I am concerned XLK could get caught up in this.
For me, Nvidia's recent performance has prompted similar concerns. The company’s current price-to-earnings ratio is exceptionally high, which suggests that their stock price is driven more by future expectations than by current earnings. I believe they are uniquely
The ETF Ranks Poorly For Diversification
XLK has outperformed the SPDR S&P 500 ETF Trust (SPY) this year due to the concentration of big tech stocks within their portfolio. As of the time of this writing, XLK's year-to-date return stands at 18.08%, compared to SPY's 15.36%.
XLK’s heavy reliance on a few major tech companies, however, introduces notable risks. The ETF’s lack of diversification, or its current asset concentration, earned it a "D+" rating.
Historically, XLK's modified market cap-weighted index approach aims to prevent over-concentration by capping individual stock weights, but, in my view, the recent tech rally has challenged these limits. The ETF's structure, designed to mitigate such risks, has been uniquely tested by the unprecedented rise in Nvidia's valuation, which questions the balance between growth and maintaining diversification.
Investors are essentially paying a premium for XLK at a time when Nvidia has already experienced gains. If Nvidia's stock were to correct, the impact on XLK could be severe, given their outsized influence on the ETF’s overall performance. In my opinion, while XLK has outperformed due to the tech rally, the heavy reliance on a high-flying stock like Nvidia at peak valuations poses a heavy risk.
Performance & Valuation
While I am not attempting to place a specific fair value on XLK, multiple quantitative grades underlying the ETF are cause for concern. For instance, the annualized volatility of XLK stands at 17.52%, which is higher than the median volatility of all ETFs at 12.75%. This represents a 37.41% difference from the median, earning the ETF a volatility grade of D+. High volatility is generally undesirable in many ETFs, since it contradicts the fundamental purpose of diversification, which is to reduce risk.
In addition, XLK suffers from a tracking error (the standard deviation of the difference between the returns of an investment and their benchmark) over one year at 7.75%, over three years is 11.70%, and over five years is 10.40%. In comparison, the median tracking errors for all ETFs over the same periods are 7.19%, 8.84%, and 9.37%, respectively. This places XLK's tracking error in the C range, which indicates that the ETF has struggled to consistently match their benchmark's performance over time.
I believe this should be a cause of concern for investors, given the recent rebalancing that increased Nvidia's weighting in the fund to over 20%. With Nvidia's stock already clocking strong gains this year, there is a heightened risk that any downturn in the company could disproportionately affect XLK's performance (the ETF did not enjoy as much of the run-up while it could enjoy much of the drawdown).
Quantified: What Is The Downside Risk?
Singling out Nvidia in particular, I believe the stock could see around 45% downside from here given my previous estimate of what the fair value of the stock is (and the subsequent run up which has made the stock drift farther away from what I think the fair value is).
If we see Nvidia’s shares drop 45%, this would cause an effective 9% drawdown in the XLK ETF given Nvidia’s approx. 20% rating.
Bull Thesis
In my opinion, investors in XLK are placing a huge bet on Nvidia's capability to sustain their exceptional growth and performance in a highly competitive market. It’s impossible to deny Nvidia's stock has experienced an extraordinary run-up this year, driven by the booming demand for AI-related technologies.
Nvidia's upcoming Blackwell chips, set to be released later this year, are also expected to perform well in the market, continuing the company's strong track record in AI innovation and GPU technology. As industries continue to invest heavily in AI, Nvidia currently stands to benefit and potentially drive further growth in their stock price. The increase in Nvidia's weighting means that for XLK, it is now heavily dependent on Nvidia's continued performance and market dynamics.
This doesn’t mean for the next leg of the AI revolution, Nvidia will be the only player in town, however. The challenge for Nvidia is the increasing competition from Intel and Advanced Micro Devices (AMD), both of which are making huge advances in AI and GPU technology. Intel, for example, is ramping up their efforts to capture more market share in the AI chip market, and AMD's MI300 chips are gaining traction for their performance in AI inference tasks.
Likewise, Taiwan Semiconductor Manufacturing Company (TSM), Nvidia's key supplier, has announced plans to raise prices for their manufacturing services (compressing margins). TSMC's CEO, CC Wei, hinted at price hikes due to the increased costs associated with geopolitical tensions and the need to diversify production outside of Taiwan.
Takeaway
The rebalancing in XLK has made Nvidia the largest component of the ETF, overshadowing other major tech stocks Microsoft and Apple that have slower, more stable run-ups in their shares and are both valued on what I believe to be more sustainable earnings. Nvidia's rapid rise in market value because of their dominance in the AI and semiconductor sectors has influenced such a high concentration of the company within XLK.
I like the premise of a diversified tech fund, but this is not well diversified, as indicated by Seeking Alpha concentration ratings. It ranks poorly, in my opinion, for diversity. For investors seeking broad tech exposure, I believe it is crucial to remember that the original intent behind investing in a sector ETF like XLK was to spread risk across various companies. However, the current structure contradicts this principle by heavily concentrating risk instead.
Therefore, I believe a sell on XLK is prudent unless the ETF's composition can be adjusted to reduce Nvidia's weighting. One stock with such a violent run-up does not seem to be sustainable.
