Why a $70 billion fund is likely to upgrade Nvidia stock, dump Apple this week

Key learning points

• The Technology Select Sector SPDR Fund (XLK) will likely be forced to buy billions of dollars worth of Nvidia stock – and dump a similar amount on Apple – when it rebalances this week.

• Nvidia’s weight in the ETF is expected to nearly quadruple after its float-adjusted market cap exceeded Apple’s late last week.

• Fund diversification rules have forced XLK to take a huge underweight position in Nvidia as the company’s value has more than doubled this year.

One of America’s largest tech-focused exchange-traded funds is expected to get a massive makeover this week.

The Technology Select Sector SPDR fund (XLK) will likely be forced to buy billions of dollars worth of Nvidia (NVDA) stocks, while drastically cutting back on Apple (AAPL) exposure, when it undergoes a quarterly rebalancing on Friday, a byproduct of both the chip giant’s meteoric rise this year and arcane fund diversification rules.

“The massive rebalancing is happening (I’m pretty sure),” James Seyffart, an ETF research analyst for Bloomberg Intelligence, said in an X-post on Friday. “The math means that $XLK will have to sell about $12.6 billion of $AAPL and buy about $10.9 billion of $NVDA at current prices. This transaction will take place on June 21. However, confirmation is needed of S&P/SPDR.”

Matthew Bartolini, head of SPDR America’s Research on State Street, which manages the XLK, agreed with Seyffart’s math in his commentary on CNBC. S&P Global declined to comment on possible index changes.

What’s going on with the XLK?

XLK tracks the Technology Select Sector Index, which is composed of the stocks of S&P 500 companies active in the information technology sector. There are 65 in total, including America’s three most valuable companies: Apple, Microsoft (MSFT) and Nvidia.

The fund is theoretically market capitalization weighted, meaning that the higher the market value of a company, the more influence it has on the fund’s value and share price. But the reality is more complex. Due to diversification rules, no single stock can represent more than 25% of the fund. S&P Global, the index manager, limits the weighting of each stock to 23% to give itself a cushion.

How Nvidia’s meteoric rise surpassed Apple

For a long time, Apple and Microsoft were the only companies in the index that came close to the 23% mark. But with Nvidia’s historic gains over the past year and a half, there are now three companies in the index worth more than $3 trillion each. Together they make up more than 60% of the index.

The story continues

At first glance, Nvidia’s rise solves the weighting problem. The weight has increased, reducing the weight of Apple and Microsoft to less than 23% each.

But there’s a catch: “The sum of companies with a weight of more than 4.8% may not exceed 50% of the total index weight.”

That’s why Apple, Microsoft and Nvidia have such drastically different weights in the index.

If all companies with a weight of more than 4.8% cumulatively exceed 50% of the index, they are ranked by market capitalization, and the weight of the smallest companies is reduced to a maximum of 4.5%.

The S&P Index is rebalanced quarterly, on the third Friday of March, June, September and December, based on each stock’s market capitalizations at the end of the previous week.

With Nvidia’s free float-adjusted market capitalization creeping past Apple’s after a close race at the close of trading on Friday, the index must now cut its exposure to the Cupertino-based tech giant by almost 80%.

“Any ETF that tracks this index will have to buy NVDA and sell AAPL to account for the cap difference,” George Smith, portfolio strategist at LPL Financial, said Friday.

What does this mean for the shares?

The stakes are high for the owners of each stock. While XLK is a large fund in its own right, it may not be the only fund that needs to course correct following index rebalancing. Even if so, changes in just the portfolio could have major implications for the biggest tech stocks.

Any fund that sells or buys billions of dollars worth of one stock over the course of a week is bound to put pressure on the share price. However, the boost that Nvidia’s stock could get from the rebalancing could be reduced by last week’s stock split. With ten times as many Nvidia shares on the market, buyers and sellers can demand more precision in the price at which their trades are executed.

In sharp contrast, a sudden surge of Apple stock sold by XLK could create a mismatch between supply and demand, causing the stock price to become temporarily weak.

Read the original article on Investopedia.