Imagine owning a single ETF that holds 10,010 different stocks. It sounds almost as unrealistic as Taylor Swift getting married at MSG on the weekend of the United State’s 250th anniversary. And yet, both are completely real.
The ETF in question: the Vanguard Total World Stock Index Fund, which includes 10,010 names, ranging from giants like Nvidia to tiny firms like Advanced Ceramic X Corp. It’s like the investing version of hoarders.1 Meanwhile, all the way on the opposite side are Marie Kondo-type funds that track just a few carefully curated names.
Now this isn’t a story of less is more or bigger is better. Because the number of holdings only tells us so much. The size of each holding, or its weight limit, can have a much bigger impact on the risks and returns you ultimately experience.
When talking about a stock's weight or position size in an ETF, the term refers to how much of the total portfolio the name constitutes. Take Apple*, for example. Currently, the iPhone maker takes up about 6.65% of the S&P 500, meaning, for every $100 invested in an ETF tracking the benchmark index, about $6.65 goes into Apple.2
On its own, Apple accounts for only a slice of the S&P 500. But combine it with the other six members of the Magnificent 7, and roughly 35%3 of your supposedly 500-stock portfolio is concentrated in just seven companies. When those stocks soar, the S&P 500 tends to follow. When they stumble, the index – and the ETFs tracking it – often stumble with them.
That’s an important distinction to remember. Because two ETFs can hold the exact same stocks yet deliver very different levels of diversification and performance simply because they’re weighted differently.
In order to qualify as a Regulated Investment Company (RIC) under U.S. tax law, most diversified ETFs must follow what's known as the 25/50 Rule, a standard rooted in Internal Revenue Service (IRS) diversification requirements.4
The rule specifies that:
The goal here is to prevent diversified funds from morphing into single-stock bets during a roaring bull run. But this rule doesn’t apply to all ETFs.
For example, gold ETFs that simply hold physical bullion are set up as grantor trusts instead of RICs, so they aren't subject to the 25/50 rule. Likewise, some highly concentrated exchange-traded products, such as certain single-stock leveraged funds, use different legal structures than traditional stock ETFs, meaning they don't follow the same diversification requirements.
This is the most common approach to ETF construction, where larger companies make up a bigger share of the portfolio. In other words, a $3 trillion company carries far more weight than a $30 billion one. As a result, when the largest stocks rise, they can have a disproportionate impact on the fund’s performance. In a market-cap-weighted ETF, a handful of big names can end up driving most of the returns.
In an equal weight fund, every stock has the same percentage allocation, regardless of company size. For example, in a 500-stock fund, each name would have a roughly 0.2% allocation. This tilts the fund toward smaller companies and forces periodic rebalancing to maintain the same weights. Managers need to sell what’s gone up and buy what’s underperformed to maintain the equal weights. It's a disciplined contrarian approach, built right into the fund.
A less common method bases portfolio allocation on a company's sales rather than its stock price. This approach can often lean toward value stocks, since a company with massive revenue but a modest valuation gets a larger slice than its market cap might justify.
In short, market-cap weighting follows the crowd, equal weighting fights it, and revenue weighting follows the cash register.
Theory is tidy but it’s when the rubber hits the road that things get interesting. Let’s consider three well-known examples of ETF holdings management in action.
The Technology Select Sector SPDR Fund (XLK) caps its single largest holding at 23%, and stocks with weights exceeding 4.8% are collectively capped at 50% according to index methodology. In a sector that’s dominated by a few behemoths, these caps prevent a few giants from swallowing the entire fund.5
The Nasdaq-100 employs a more dynamic safeguard. If stocks each weighted at more than 4.5% collectively account for more than 48% of the index, a special rebalancing is triggered to trim those positions. This circuit breaker activates only when concentration reaches a dangerous level. Nasdaq has invoked this rule more than once during tech-driven rallies.6
The Motley Fool 100 Index ETF (TMFC) takes a cleaner approach with a straightforward 4.8% weight cap on individual holdings.7 No single name is ever allowed to dominate, full stop.
These are all different funds, but the identical instinct prevails: don’t let one position dominate portfolio returns.
So why all the fuss? Because concentration is a double-edged sword, and the sharp side cuts both ways.
When a few holdings dominate, an investor’s fortunes depend on a small cast of characters. History is littered with these cautionary tales. Remember how heavily tech-weighted indexes were hit when the dot-com bubble burst in 2000. A fund that's "diversified" on paper can behave like a concentrated bet when its top names explode. That's the quiet danger of unchecked market-cap weighting.
Ironically, concentration also undermines the very reason most investors buy an ETF in the first place. If five stocks make up half a fund, it’s not really a basket of securities. It’s five names plus some background noise. The diversification you wanted and paid for has been diluted.
There's a less obvious cost, too. When a fund is forced to trim a swollen position to stay within its limits, it sells shares. Selling can trigger capital gains that get passed along to investors. Thoughtful weight caps help funds manage rebalancing gradually rather than dumping winners in a panic, hopefully sparing their investors a nasty year-end surprise.
Weight limits are where investment philosophy and math come together. Lean too concentrated, and diversification is exchanged for high stakes bet. High conviction investing has its place but that’s not what most index investors have signed up for. Spread too thin across 10,100 names, and the best ideas are diluted into irrelevance.
The funds that get it right treat weight limits not as a bureaucratic rule, but as a steering wheel that keeps a portfolio aligned with its strategy.
Have a look at the fact sheet for any ETF you own. Consider the top ten holdings and how they are weighted. If the top three positions had a brutal year, how would you feel? What would happen to index performance? Negative feelings might suggest that your fund’s weighting philosophy doesn’t match yours.