Rebalancing of the Giant Tech ETF, with Nvidia up and Apple down! Is the expected "hundred billion impact" on Friday just this?

AI frenzy made NVIDIA the world's largest company by market value this week, the market also discovered that the technology industry ETF with a management scale of up to $80 billion (code XLK) has long been attracting a large amount of funds.

According to EPFR Global data, as of the week ending June 19th, about $8.7 billion flowed into XLK, accounting for one-third of the total capital inflow into US stocks during the same period.

Why would such a large amount of funds flow into a single ETF? Some analysts believe it may be related to XLK's "heartbeat trading" on "Triple Witching Day".

However, the decline was not significant, with Apple's stock price falling by 1% on Friday, while NVIDIA fell by about 3%.

Why is XLK selling Apple and buying NVIDIA?

XLK mainly tracks the Technology Select Sector Index. Like many index funds, XLK rebalances its portfolio quarterly to bring it back to its initial state in compliance with the rules.

XLK is not a simple market-cap weighted index, but a "modified" market-cap weighted index. To avoid excessive concentration on a few companies, in addition to market-cap weighting, XLK also sets limits on individual stock holdings, for example :

1. The weight of a single company cannot exceed 22.5%

2. The total weight of stocks with weights above 5% cannot exceed 50%

3. Once the 50% holding limit is exceeded, the remaining individual stock weight cannot exceed 4.5%.

The specific holdings of XLK are used below to explain why XLK had to rebalance on "Triple Witching Day" on Friday.

According to ETF Action data, as of May 30th, the top three holdings of XLK were: Microsoft (22.5%), Apple (21.5%), and NVIDIA (5.4%).

Obviously, the weights of Microsoft, Apple, and NVIDIA exceeded the 5% threshold. Microsoft, the largest holding, had a weight of 22.5%, and the combined weight of the three was 49.4%, complying with the rules.

However, unexpectedly, NVIDIA's market value briefly surpassed Apple last week. If no rebalancing is done, NVIDIA's weight would also increase to around 21.5%. In this case, the total weight of Microsoft, NVIDIA, and Apple would reach 65%, significantly exceeding the 50% limit set by XLK, so Apple's weight had to be reduced.

This is what happened on "Triple Witching Day" on Friday. XLK had to rebalance by selling about $11 billion worth of Apple shares, reducing its weight from 21.5% to around 4.5%, and then buying about $10 billion worth of NVIDIA shares to increase NVIDIA's weight to over 20% to comply with the rules This is also why investors closely watched the market value battle between Apple and Nvidia last week, because whoever has the higher market value will receive a higher weighting, while the loser's weighting will drop by about 75%.

Some analysts pointed out that the $8.7 billion inflow into XLK last week was likely part of XLK selling Apple for rebalancing trades.

Todd Sohn, ETF strategist at Strategas Securities, said that the massive inflow last week may be part of XLK's "heartbeat trades" to sell profitable Apple stocks without being taxed.

What are heartbeat trades?

In the U.S. ETF industry, funds like XLK often rebalance to comply with regulations. If stocks sold during rebalancing have unrealized gains, Uncle Sam will come after you for capital gains tax. To tax-efficiently rebalance, funds often engage in "heartbeat trades".

Factset analyst Elisabeth Kashner pointed out that the purpose of heartbeat trades is not to meet public demand for ETFs, but to achieve tax deferral in the portfolio rebalancing process, with ETFs and large investment banks as the main participants. The process does not involve cash transactions but rather asset swaps into stocks. It involves three main steps:

Step 1, Inflow: In a heartbeat trade, a cooperating investment bank will first have a large inflow of funds into a specific ETF, such as XLK, which absorbed over $8 billion last week. This inflow is typically not in cash but through the exchange of physical assets (such as Nvidia stocks) for ETF shares.

Step 2, Rebalance: The ETF will then rebalance its portfolio, buying or selling a large number of stocks to comply with regulations. (This time XLK is selling over $10 billion of Apple stocks and buying Nvidia)

Step 3, Outflow: In the final step of the heartbeat trade, the previously inflowed funds will rapidly flow out of the relevant ETF. This is usually achieved by the investment bank exchanging ETF shares back into physical assets (such as stocks).

This process, with the large inflows and outflows of funds resembling the pulsating heartbeat on a chart, is called "heartbeat trades".

Mohit Bajaj, ETF director at WallachBeth Capital, said that XLK may experience a large outflow of funds next week as the final step of the heartbeat trades.

Main Purpose of Heartbeat Trades

The main purpose of heartbeat trades is to help fund managers achieve tax optimization. When ETFs engage in physical exchanges, they can avoid capital gains tax that would arise from selling appreciated assets.

It is worth noting that Kashner pointed out that heartbeat trades are essentially a tax deferral strategy, not a permanent tax avoidance method, as it only defers tax obligations through reasonable rules. Once an ETF eventually liquidates a stock, the related capital gains tax will still need to be paid But for Wall Street, today's $1 is different from tomorrow's $1. The later the capital gains tax is paid, the higher the potential return.

Although heartbeat trading is highly praised by Wall Street for its efficient tax reduction efficiency, it has also sparked some controversy.

JeffreyColon, a law professor at the University of Chicago, pointed out that compared to mutual funds, publicly traded partnerships, and direct investments by investors, heartbeat trading gives ETFs an unfair tax advantage. The U.S. Congress should eliminate tax exemptions for asset swaps or reduce related exemptions. Either choice would align the taxable income of ETF shareholders with their economic returns