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. Apple (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&P 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%.

This will cause the $71 billion ETF to buy a lot of Nvidia shares (at elevated prices) while subsequently dumping a bunch of Apple shares (also at elevated prices). That's not necessarily a smart investing move to make right now, but rules are rules.

Is it time to buy a different ETF?

An ETF dominated by Microsoft and Nvidia, two of the companies most benefiting from artificial intelligence (AI), doesn't seem like a bad idea on the surface.

Nvidia has been the biggest AI winner thus far with its graphic processing units (GPUs) being the choice for the infrastructure needed for AI model training and inference. The company isn't the only producer of GPUs, but programmers have long been trained on Nvidia's Cuda software platform, which has led it to become the de facto GPU leader in the space, with a wide moat. As a result, its first-quarter revenue surged 262% to $26 billion.

Microsoft, meanwhile, has been an early adopter of AI through its large investment and partnership with OpenAI. The company's Azure cloud computing business has been the biggest beneficiary so far, as customers build their own AI solutions using its Azure platform. Microsoft has also benefited from AI in other areas, including the adoption of its AI assistant Copilot. Its developer platform GitHub grew revenue by 45% year over year last quarter with more companies embracing its GitHub Copilot. And Microsoft 365 saw revenue jump 14% helped by the early success of Copilot in that platform.

As Nvidia and Microsoft stocks perform, so will the ETF given the large weighting in these names.

However, the dramatic weighting shift between Nvidia and Apple shows the risk associated with the ETF. It also missed out on some of Nvidia's earlier gains because of its allocation rules. Meanwhile, one poor quarterly showing from Nvidia could dramatically knock down its weighting. It seems these rules intended to benefit shareholders might actually be hurting them.

Artist rendering of AI chip.

A better alternative?

Given these issues, I think there is a better alternative for investors who like the idea of an ETF with very large positions in Nvidia and Microsoft. It could be a better choice in the long run than the State Street Technology Select Sector SPDR Fund ETF.

One great option for investors is the Vanguard Information Technology ETF (NYSEMKT: VGT). Like the Technology Select Sector SPDR Fund ETF, it has large positions in Nvidia and Microsoft. But its top three positions are more balanced.

At the end of May, Microsoft was its largest position at 16.7%, followed by Apple at 15.9%, and Nvidia at 14%. Given Nvidia's strong June performance so far, it could very well be its top position currently.

Other holdings have much smaller weightings, including Broadcom at 4.2%, Advanced Micro Devices at 1.9%, and Qualcomm at 1.6%.

The Vanguard ETF has been a strong performer, averaging a 20.3% annual return over the past decade. It has a comparable average return to the State Street fund. And because the Vanguard ETF does not have the same rebalancing quirk, I think it is the better option for investors looking for some nice tech exposure with heavy weightings toward AI leaders Nvidia and Microsoft without certain buying and selling rules that force some questionable stock transactions.

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Geoffrey Seiler has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Advanced Micro Devices, Apple, Microsoft, Nvidia, and Qualcomm. The Motley Fool recommends Broadcom and recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.