In 2024, technology stocks are once again the best. Why these ETFs don’t tell the same story.

The S&P 500 has hit several all-time highs this year, thanks in large part to strong gains from technology companies. U.S. stocks seem to be going up all the time. But some of the most popular ETFs that follow those stock sectors haven’t kept up, leaving big gaps between their returns and the returns of the indexes they’re supposed to follow.

If you look at the 11 sectors that make up the S&P 500, the communication services sector XX:SP500.50 has done the best so far in 2024. However, the Communication Services Select Sector SPDR Fund XLC has underperformed by 6.6 percentage points, according to data from FactSet.

In the same way, the Technology Select Sector SPDR Fund XLK has done about 5% worse this year than the S&P 500 information-technology sector XX:SP500.45. FactSet data shows that the Consumer Discretionary Select Sector SPDR Fund XLY has lagged its tracked index XX:SP500.25 by almost 3 percentage points during the same time period.

FactSet data (see table below) shows that the Utilities Select Sector SPDR Fund XLU has done better than all the other SPDR sector ETFs in 2024. This is because it has been in line with the remarkable recovery of its sector index in recent months.

What happened

Most of the time, there isn’t much difference between the performance of the S&P 500 SPX sector index and that of ETFs that track it. But this year, some of the Select Sector SPDR ETFs have not accurately tracked the movement of the market.

There’s no way that State Street missed the mark—their ETFs did exactly what they were meant to do and did a great job of tracking their benchmarks. Market strategist at Grindstone Intelligence Austin Harrison said, “Their benchmarks aren’t what most people think they are. That’s the problem.”

Cap-weighted S&P 500 sector indexes are not investable. In these indexes, the weight of each company is based on its market capitalization. Some passively managed sector ETFs use what is known as a modified market-cap weighting instead.

For the most part, “modified” means that fund managers limit the power of the biggest companies by limiting the weight of each constituent.

That keeps a fund from breaking the asset diversification rules for U.S. regulated investment companies by making sure that no single constituent has a weight greater than 25%. Also, Matthew Bartolini, managing director at State Street Global Advisors and head of SPDR Americas Research, said that the sum of the companies with weights over 5% shouldn’t claim a combined allocation greater than 50%.

It is planned that the caps will leave some room below the 5% limit.

The Class A GOOGL, +0.97% and Class C GOOG, +0.89% shares of Alphabet Inc. make up only 26% of XLC but about 46% of the market capitalization of the S&P 500 communication-services sector. Statista says that Meta Platforms META, -1.73% shares make up only 22% of the ETF, but they make up about 26% of the market value of the sector index.

Because of these big cuts, the combined weighting of the two “Magnificent Seven” stocks dropped from 72% to 48%. This meant that no other company in XLC could get more than a 5% weighting without breaking the 50%-cap rule.

“The tracking difference] hasn’t been as much of a problem in recent years because the stock market wasn’t as concentrated as it is now,” Harrison told MarketWatch by phone on Wednesday. He also said that the changed market-cap weighting is now a real problem for funds because they are starting to underweight some of the best-performing stocks in the sector.

Bartolini said that the rules are in place from a regulatory point of view to make sure that a lot of ETFs are diversified.

“Investing in sector ETFs is the way to go if investors want to own a certain stock sector without having to buy every single stock themselves, trading it and keeping that exposure, which would be expensive and take a lot of time,” he told MarketWatch on the phone on Thursday, adding that it has been “beneficial” for investors for a long time.

Utility stocks offer a different tale

Yes, megacap tech company stocks have started to give way to other stocks that are going up. This is seen by some investors as a sign of a healthier market that isn’t so reliant on the performance of a few big names. The rise that started in tech is now spreading to utilities, industrials, and even small-cap stocks in 2024.

Since the beginning of the year, the Utilities Select Sector SPDR Fund has gone up almost 15%. This is a big change from 2023. Brian Mulberry, client portfolio manager at Zacks Investment Management, says that the traditional defensive corner of the market is now appealing because the Federal Reserve expects interest rates to go down and artificial intelligence is using more electricity.

It’s interesting that three of the five best-performing S&P 500 stocks so far this year are in the utilities sector. FactSet data shows that Vistra Corp. VST, -3.89%, an electric utility company, has done better than Nvidia Corp. NVDA, -0.29%, which has gained 92% this year, going up 150%.

FactSet data shows that Constellation Energy Corp. CEG, -3.12%, the biggest nuclear power company in the U.S., has gained almost 91% so far in 2024. Only 6.5% of the Utilities Select Sector SPDR Fund is made up of Constellation.

Mulberry told MarketWatch on Wednesday, “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.”

“It’s [the utility sector] a very stable way to make money. Even though demand for electricity from AI-related data centers is falling, demand is still rising for electric vehicles and many other places, so power generation will be used wherever it comes from,” he said.

U.S. stocks lost early gains Thursday and ended the day down after major indexes hit new highs the day before. In the morning, the Dow Jones Industrial Average (DJIA) briefly traded above 40,000 for the first time ever. However, it lost 0.1% by the end of the day. The Nasdaq Composite COMP went down 0.3% and the S&P 500 went down 0.2%.

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