By Isabel Wang
Some Select Sector SPDR ETFs have failed to reflect the stock-market's movement this year
U.S. stocks are on a seemingly relentless upward trajectory with robust gains from megacap technology companies propelling the S&P 500 to multiple all-time highs this year. Some of the most popular ETFs that track those stock sectors haven't kept pace, leading to significant gaps between their returns and the indexes they are designed to mirror.
While the S&P 500 communication-services sector XX:SP500.50 was the top performer among the 11 sectors of the large-cap benchmark index so far in 2024, the Communication Services Select Sector SPDR Fund XLC has lagged behind the index it tracks by 7.1 percentage points, according to FactSet data.
Similarly, the Technology Select Sector SPDR Fund XLK has underperformed the S&P 500 information-technology sector XX:SP500.45 by 4.7 percentage points this year. The Consumer Discretionary Select Sector SPDR Fund XLY has fallen behind its tracked index XX:SP500.25 by 2.7 percentage points over the same period, according to FactSet data.
As a result, the Utilities Select Sector SPDR Fund XLU, aligned with its sector index's remarkable resurgence in recent months, has outperformed all the other SPDR sector ETFs in 2024, according to FactSet data (see table below).
S&P 500 Sector Sector Index Performance Select Sector SPDR ETF Performance YTD Difference Communication Services 20.8 13.7 7.1 Information Technology 14.7 10.0 4.7 Utilities 13.6 14.2 -0.6 Financials 12.5 13.0 -0.5 Energy 12.8 13.3 -0.5 Industrials 9.8 9.9 -0.1 Consumer Staples 9.5 8.6 0.9 Materials 7.4 7.7 -0.3 Healthcare 7.1 7.3 -0.2 Consumer Discretionary 2.6 -0.1 2.7 Real Estate -3.5 -3.2 -0.3 Source: FactSet data through Friday, May 17.
What happened
Typically, there's little difference between the S&P 500 SPX sector index performance and the ETFs tracking these benchmarks. However, this year, some of the Select Sector SPDR ETFs have failed to accurately reflect the market's movement.
"It's not that State Street dropped the ball - their ETFs did exactly what they are designed to do and they've tracked their benchmarks admirably. The problem is that their benchmarks aren't what most people think they are," said Austin Harrison, market strategist at Grindstone Intelligence.
Different from the uninvestible cap-weighted S&P 500 sector indexes in which each company is weighted according to the size of its market capitalization, some of the passively managed sector ETFs use what's called a modified market-cap weighting.
What "modified" means, in effect, is that fund managers cap the weight of individual constituents, limiting the influence of the largest companies.
That prevents a fund from breaching the U.S. regulated investment company's asset diversification requirements by ensuring no single constituent has a weight exceeding 25%, while the sum of the companies with weights over 5% should not claim a combined allocation greater than 50%, said Matthew Bartolini, managing director at State Street Global Advisors and head of SPDR Americas Research.
The caps are set to allow for a buffer below the 5% limit.
Alphabet Inc.'s Class A (GOOGL) and Class C (GOOG) shares currently constitute about 46% of the market capitalization of the S&P 500 communication-services sector, yet they account for only 26% of XLC. Shares of Meta Platforms (META) make up about 26% of the sector index's market cap, but they account for only 22% of the ETF, according to FactSet data.
As a result, the sizable reductions saw the combined weighting of the two "Magnificent Seven" stocks chopped to 48% from 72%, while leaving little room for any other company in XLC to exceed a 5% weighting without violating the 50%-cap rule.
"It [the tracking difference] hasn't been as prevalent of a problem in recent years because there wasn't as much concentration in the stock market as there is over the last 18 months," Harrison told MarketWatch via phone on Wednesday, adding that the modified market-cap weighting has become an actual problem for funds because they are starting to underweight some of the best performing stocks in the sector.
See: Why S&P 500's consumer-discretionary sector is 'left behind' in U.S. stock market
Bartolini said the rules are in place from a regulatory standpoint to ensure diversification for a swath of ETFs.
"If investors want to own a specific stock sector without having to individually buy every single stock themselves, maintaining that exposure and trading it, which would be costly and time-consuming, this [investing in sector ETFs] is the way you need to do it," he told MarketWatch via phone on Thursday, adding that it has been "beneficial" to investors over a long period.
Utility stocks offer a different tale
To be sure, shares of megacap tech companies have started to make room for other stocks on their way up, which some investors think is a sign of a healthier market that's less dependent on the performance of a few big names. The rally in tech sectors is now expanding into areas like utilities, industrials and even small-cap stocks in 2024.
The Utilities Select Sector SPDR Fund was up over 14% year to date in a big reversal from 2023. The Federal Reserve's lower interest-rate outlook and increased demand for electricity from artificial intelligence has made the traditional defensive corner of the market attractive, according to Brian Mulberry, client portfolio manager at Zacks Investment Management.
Remarkably, three of the five best-performing names in the S&P 500 this year to date are from the utilities sector. One of the newest members to the S&P 500 index, electric utility firm Vistra Corp.(VST), has outperformed Nvidia Corp.'s (NVDA) 87% gain this year, up 144%, according to FactSet data.
Constellation Energy Corp. (CEG), the biggest nuclear-power operator in the U.S., has advanced over 82% so far in 2024, according to FactSet data. Constellation accounts for only 6.5% of the Utilities Select Sector SPDR Fund.
"I think investors are seeing utilities as a way that they can invest in AI at a price-to-earnings ratio [P/E] of around 17 and get a 3-4% dividend yield...without having to buy Nvidia at an over 70 P/E ratio," Mulberry told MarketWatch on Wednesday.
"It's [utility sector] a very durable source of earnings, even though the electricity demand softens from (AI-related) data centers, it is still growing for electric vehicles and lots of other places, so the power generation will be used wherever it comes from," he added.
U.S. stocks finished mostly higher on Friday with the Dow Jones Industrial Average DJIA ending above the 40,000 threshold for the first time ever. The S&P 500 and the Nasdaq Composite COMP notched their fourth straight week of gains, up 1.5% and 2.1%, respectively, according to FactSet data.
-Isabel Wang
This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
05-20-24 0854ET
Copyright (c) 2024 Dow Jones & Company, Inc.
