You Need to Know What's in Your ETF

NEW YORK (TheStreet) -- Earlier this week I looked at Amazon.com's (AMZN) weighting in certain tech-related exchange-traded funds and its omission from others.

The Internet-themed ETFs such as First Trust DJ Internet Index Fund ( FDN) own Amazon, while broad technology-sector funds such as the Technology Select Sector SPDR ( XLK) do not.

This year FDN is up 39% compared to just 10% for XLK. XLK has also lagged far behind the S&P 500's 17% gain this year.

The difference between the two is likely less attributable to Amazon and its 22% gain this year so much as XLK's inclusion of Apple ( AAPL), which makes up 14% of the fund and is down 9% this year.

In late 2006, ETF provider Rydex, which was subsequently acquired by Guggenheim, created a suite of funds that took the sectors of the S&P 500 and weighted the holdings equally. So while Apple has a 14% weighting in XLK, it has only a 1.6% weighting in the Guggenheim S&P 500 Equal Weight Technology ETF ( RYT).

RYT is up 26% in 2013, more than double XLK's gain this year.

Over the years we have consistently discussed the importance of looking under the hood of any ETF to understand the makeup of the portfolio. An investor should have some understanding of an individual holding that takes up a disproportionately large position in a fund.

Apple has gone from an undeniable can't-miss stock to one with many questions now unanswered. The decision to avoid a company is much simpler than the decision to buy one. One does not need to be a Wall Street analyst to have realized that the story at Apple started to change a year ago and become more uncertain. Faced with this, an investor who invests at the sector level could have switched from XLK or any of the other broad, market cap-weighted tech ETFs into RYT.

This effect has happened with other sector funds in the past. General Electric ( GE) is the largest holding in the Industrial Select Sector SPDR ( XLI), with an 11% weighting. Going into the financial crisis, it had more than a 20% weighting in XLI vs. a sub-2% weighting in Guggenheim S&P 500 Equal Weight Industrials ETF ( RGI).

During the darkest days of the financial crisis, GE declined by 75%, contributing to a 54% drop in XLI, but RGI went down by only 38% in the same period. RGI was able to recover to its precrisis high in May 2011, whereas XLI got back to its high in March of this year.

The risks in GE because of its large exposure to the financial sector were well known before the crisis, as I wrote in 2006, and the decision to avoid the one stock made a meaningful impact on returns.

A large weighting in a single stock is not necessarily a bad thing. In the year leading up to Apple's high in September 2012, XLK was up 30% compared to 19% for RYT.

Many investors may not realize that this sort of specific portfolio strategy can be had investing in ETFs, and of course, it is not a prerequisite to successful implementation of an ETF portfolio.

But investors willing to commit the time to look under the hood at the holdings, sector weightings, country weightings or the weightings of any other characteristic in a given fund gives themselves an opportunity for a better long term result.

At the time of publication, Nusbaum had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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