Prediction: SOXX Is About to Outperform SMH. Here's Why.

The two largest semiconductor exchange-traded funds (ETFs) are the iShares Semiconductor ETF (NASDAQ: SOXX) and the VanEck Semiconductor ETF (NASDAQ: SMH). Combined, they have more than $115 billion in assets under management and are the two most popular ways to play the current chip rally.

At a high level, the two are pretty similar. Both have portfolios of around 25 to 30 names. They have nearly the same expense ratio. You might think the two are interchangeable.

They're not. In fact, some very simple differences in their construction strategies produce two very different portfolios. One factor in particular makes me think that the iShares Semiconductor ETF is the better choice moving forward.

Image source: Getty Images.

SOXX vs. SMH: Creating two different semiconductor portfolios

These two ETFs hold mostly the same individual companies. SOXX holds a couple more, but that's only because of a slight variation in how the funds define semiconductor companies.

The biggest difference is in the weighting scheme. Both are market-cap-weighted portfolios. Both also apply caps on the weighting of any one component in the portfolio. The VanEck Semiconductor ETF has a 20% limit at each quarterly rebalance. The iShares Semiconductor ETF has an 8% limit on the top five holdings and a 4% limit on remaining holdings at each quarterly rebalance.

Take a look at each fund's top five holdings.

Data sources: VanEck, iShares.

As you can see, SMH is more top-heavy and concentrated. And that's a risk I don't prefer to take.

Why SOXX has the edge over SMH

There are relatively few pure-play semiconductor companies, so any ETF focused on them will have some concentration risk. But any time an individual company accounts for more than 20% of a fund, it's a red flag.

Yet those outsize Nvidia and TSMC positions come with significant idiosyncratic risks.

Nvidia's China market is still essentially closed, and tariff risks could affect the overall growth story. Meanwhile, TSMC is already forecasting some margin dilutions related to its $50-plus billion capital spending plans. Near-term profitability could be constrained. As we saw with IBM's recent crash, the consequences could be severe for any slowdown.

Those catalysts may or may not turn into something bigger. But it's a risk you're taking when you invest in an ETF with a combined 30% allocation to those two companies.

Overall, I prefer the diversified approach of the iShares Semiconductor ETF and believe it will provide the opportunity for the fund to outperform over the next six to 12 months.

David Dierking has positions in iShares Trust-iShares Semiconductor ETF. The Motley Fool has positions in and recommends Advanced Micro Devices, Broadcom, Intel, International Business Machines, Micron Technology, Nvidia, Taiwan Semiconductor Manufacturing, and iShares Trust-iShares Semiconductor ETF. The Motley Fool has a disclosure policy.