There shouldn't be any question about the investment objective of VanEck Semiconductor ETF (SMH +1.53%). As its name clearly states, it invests in the semiconductor sector. So, by design, it isn't a particularly diversified exchange-traded fund (ETF), and that creates investment risk to factor into any buying decision.
But don't stop there -- there's one more diversification issue that you have to consider.
What does VanEck Semiconductor ETF do?
As already noted, VanEck Semiconductor ETF does exactly what its name implies and follows the semiconductor sector. The exchange-traded fund tracks the MVIS US Listed Semiconductor 25. According to thematic market indexer Market Vector, this index "tracks the performance of the 25 largest and most liquid US exchange-listed companies in the semiconductor industry. This is a modified market cap-weighted index, and only includes companies that generate at least 50% of their revenue from semiconductors or semiconductor equipment."
Image source: Getty Images.
In other words, VanEck Semiconductor ETF is designed to only own 25 stocks. All the stocks in the ETF predominantly generate revenue from semiconductors. They all also happen to be large, which indirectly suggests they are all popular stocks. There's one more important feature: a modified market cap weighting that caps the largest holdings at 20% of the ETF's assets. So not only are the stocks in the fund the largest semiconductor companies, but the largest of the largest are also given the heaviest weighting in the portfolio.
The ETF's expense ratio is 0.35%, which is elevated relative to a broad-based ETF like SPDR S&P 500 ETF Trust's 0.09% expense ratio but is in line with direct peer SPDR S&P Semiconductor ETF (XSD +1.81%). So the fund is cheap to own, but not as inexpensive as other, less-focused ETFs.
NASDAQ: SMH
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Diversification is the problem with VanEck Semiconductor ETF
To be fair, if you are buying VanEck Semiconductor ETF, you probably aren't looking for a highly diversified ETF. And you are probably willing to accept a slightly higher cost of ownership to have direct exposure to the semiconductor sector. But don't stop at the top level here; dig just a little deeper.
When you examine VanEck Semiconductor ETF's list of holdings, there are some concerning weightings. For starters, market darling Nvidia (NVDA +2.57%) currently accounts for a touch over 23% of the portfolio even though the cap is set at 20%. This is because the portfolio is only rebalanced quarterly. So, in between rebalancing dates, weightings can (and do) get out of balance. The next largest holding is Taiwan Semiconductor Manufacturing (TSM +1.40%) at a touch over 12%. This means that the ups and downs of Nvidia's shares will have a disproportionate impact on the ETF's performance.
That said, the top five stocks in the ETF (Nvidia, TSMC, Broadcom, Qualcomm, and Texas Instruments) account for just over 50% of assets. That's a huge weighting in a very small number of holdings. This is a fund that's concentrated in a single sector and then concentrated within that sector as well. As the chart above shows, four of the five top holdings have handily outperformed the S&P 500 index over the past year. But when the sector cools off, the downside could be pretty painful.
But the really big number from the chart of semiconductor stocks is Nvidia, which has gained an astounding 190% in a year! Wall Street seems to believe that Nvidia can defy gravity, but a quick look back at Cisco Systems during the dot-com bubble should be a sobering reminder that hot stocks usually come back down to earth. Indeed, Cisco's stock still hasn't regained all the ground it lost after its fall from grace. Given VanEck Semiconductor ETF's large Nvidia position, the ETF potentially exposes investors to a similar fate.
How much exposure do you really want?
Having exposure to hot stocks on the way up is exhilarating, but you have to understand the risks. Yes, VanEck Semiconductor ETF provides a little diversification within the semiconductor sector, but not a lot. This is the type of ETF that only more aggressive investors should own and then only if they have very strong feelings about semiconductor stocks (and, more specifically, Nvidia). Most would likely be better off with a more broadly diversified technology ETF.
