Your ETFs don’t hold enough Nvidia and Amazon. It hurts them.

Sector-focused exchange-traded funds are designed to help investors capture profits in certain market segments, such as technology or telecommunications stocks. However, recently some of them have landed far from their target.

Several funds in the popular Select Sector SPDR ETF family have underperformed in their industries over the past year, according to a recent note from Ned Davis Research. The

Communication Services Select sector SPDR Fund

is the biggest laggard, returning 31% compared to 41% for this part of the market

S&P500,

according to Ned Davis, who took into account the 12 months to April. The technology fund lagged by 6.3 percentage points, while the consumer fund lagged by 4.6 points.

Perpetrator? Internal Revenue Service regulations that require mutual funds to meet certain diversification thresholds. One rule states that no single stock can account for more than 25% of the fund’s holdings, while another stipulates that positions in excess of 5% cannot collectively constitute more than 50% of the fund.

These rules impact the fund’s performance due to the increased nature of the stock market recently. A few names, like those of the Magnificent Seven, hold a huge share of market value, so limits on the number of shares a fund can hold could potentially negatively impact performance. In the relatively narrow industries targeted by Select Sector funds, the problem is more serious.

Result: While theoretically Nvidia should account for 17% of the tech-focused sector fund, it actually accounts for less than 5% of the holdings

Technology Select SPDR ETF Sector,

by Ned Davis. Other heavily underweight stocks in Select Sector ETFs include Alphabet
,

Amazon
.

com, PepsiCo and Exxon Mobil
.

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It’s important to note that diversification rules don’t always hurt investors – Ned Davis calls them a “double-edged sword.” In the 12 months to April, Energy Select Sector SPDR outperformed energy stocks by about 0.6 percentage points: Exxon lagged during this period.

SPDRs in the selected sectors did not immediately respond to requests for comment, but the ETF provider notes the issue in the FAQ section of its website. “Due to diversification requirements, some Select Sector SPDRs will not have the exact weighting of individual components of the broad S&P 500 Index,” it says.

Technically, the stock is performing in line with its benchmarks. A closer look at the funds’ records shows that the indexes they track are not simply sector spinoffs of the S&P 500. They have been specifically modified to conform to IRS diversification rules.

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When it comes to the issue of holding funds, investors may be right to fear that the stock market will have a high position in the market. In any case, the funds’ mismatched performance, whether government-mandated or not, makes them less convenient to use. As the Select Sector website notes, the purpose of sector ETFs is to provide “undiluted exposure to a particular sector or industry group.” This specific purpose is not served by limiting contact with the most valuable companies in the industry.

For this reason, many investors, especially those interested in technology and communications stocks, might be better served by owning individual stocks. Another option is to buy an S&P 500 index fund. As Ned Davis notes, Nvidia has a 5.3% share of the S&P 500 index, but only 4.6% of the Technology Select Sector SPDR.

Write to Ian Salisbury at [email protected]