NEW YORK (TheStreet) -- Most exchange-traded stock funds favor companies with big market caps over smaller ones, a process known as cap weighting.
For example, cap-weighted S&P 500 funds will feature Apple (AAPL) as their largest holding, because Apple has the largest market cap in the world. A cap-weighted energy ETF will hold ExxonMobil (XOM) as its largest constituent because it's the largest U.S. oil company.
But cap weighting isn't always a good idea. In fact, sector ETFs that are cap weighted expose investors to excessive single-stock risk.
Remember back in 2012 when Apple tanked? That was problematic for sector funds like the Technology Select Sector SPDR (XLK), an ETF that now devotes a whopping 18% of its weight to Apple, nearly double the weight of its second-largest holding. Cap-weighted energy funds are similarly flawed as many allocate anywhere from 28% to 33% of their combined weight to ExxonMobil and Chevron (CVX).
If you want to avoid that kind of scenario, there are ETFs that attempt to give equal weight to every stock they hold. For example, a hypothetical equal-weight ETF with 100 stocks would allocate 1% to each.
Some equal-weight ETFs have outperformed their cap-weighted counterparts. The Guggenheim S&P 500 Equal Weight Technology ETF (RYT), for example, is only 1.54% Apple stock. The fund is up 4.1% so far this year, but has soared 92% over the past three years.
The cap-weighted version of the fund, which holds more Apple stock, has had a bigger gain this year, but is up 63% over three years, an impressive gain but still below the equal-weight fund.
"The composition of the nine S&P 500 sector indices can differ significantly when you compare the cap-weight version to the equal weight version," said Guggenheim Managing Director William Belden. "Some of the cap-weight indices are heavily overweighted to the mega-cap stocks in their sector."