By Jason Zweig
Two companies at the heart of the artificial-intelligence boom, Nvidia and Super Micro Computer, have racked up supernatural gains. Yet some exchange-traded funds specializing in AI and other so-called disruptive innovations are lagging so far behind these stocks, you might not guess they even own them.
That's why you can't just say, "AI is hot, so I'll just buy an AI fund." When stocks go up as much as Nvidia and Super Micro have lately (78% and 298%, respectively, so far this year), specialist funds can fall behind -- by design.
The lesson here is that the most obvious way to capitalize on a trend isn't always the best way.
Among 17 ETFs specializing in AI and related disruptive technology, only three have outperformed the S&P 500 over the past year.
The $1.9 billion SPDR Kensho New Economies Composite ETF and the $248 million WisdomTree Artificial Intelligence and Innovation Fund are lagging by about 10 and 7 percentage points, respectively. Several "disruptive" ETFs have done much worse.
That's because the bulk of the S&P 500's 34% total return in the past year has come from Nvidia and other giant companies perceived as likely beneficiaries of AI, including Amazon.com, Meta Platforms and Microsoft.
Those gains have been so concentrated in so few stocks that even specialized funds have ended up underexposed to the winners.
As a rule, most disruptive funds, including ETFs, don't want any single stock growing so big that it crowds out their other holdings. Otherwise, a fund that had, say, 4% in Nvidia a year ago would have nearly 15% in it now -- far more than the managers or most investors probably want to risk.
That's true for passive funds that seek to replicate the returns of a disruptive-stock index. It's also true for active funds run by stock pickers seeking to beat the market by picking future winners.
Some of these ETFs are designed to put approximately the same amount of money in each stock. That's sensible in theory: If it's innovation you're after, then instead of trying to find the winning needle in the disruptive haystack, why not buy the whole haystack?
In practice, though, Nvidia and a handful of other companies have leapt out ahead in the AI race, at least so far -- leaving equally weighted funds in the dust.
"If your number-one goal is capturing momentum, this strategy is not designed for that, because we are going to rebalance," says Christopher Gannatti, global head of research at WisdomTree, whose AI fund is roughly equal-weighted. It makes some semiannual adjustments as market conditions change; the fund has 2.2% in Nvidia.
"We don't believe we know the future well enough to be putting upward of 6% or 8% in any one company," says Gannatti.
Some disruptive funds don't limit their maximum exposure to a single stock as tightly, setting a cap of 4%, 5% or even 8%. ETFs that track an index may "rebalance," or adjust their positions, every six or 12 months. In the meantime, a big winner like Nvidia can exceed the cap.
At iShares U.S. Tech Breakthrough Multisector ETF, for instance, the maximum holding size is 4%. But any positions larger than that won't be trimmed until the next semiannual rebalancing date, the third Friday in June.
So, for now, Nvidia makes up 6.4% of that iShares fund, and Meta Platforms, another hot stock, has swollen past 5%. Nvidia is about 5% of the S&P 500 by market value; Meta, 2.5%. That helps explain why the iShares breakthrough ETF is up 11.3% so far this year, 3 percentage points ahead of the S&P 500.
"If there's a revolutionary breakthrough, you can see large bursts of momentum in a shorter period of time as the market re-prices the opportunity," says Jay Jacobs, U.S. head of thematics and active equity ETFs at BlackRock, which runs the iShares funds. "And you don't want to rebalance away from that too much."
Thus, betting within a sector as hot as AI has a damned-if-you-do-damned-if-you-don't aspect.
If you diversify, you dilute the mighty force of a superstock like Nvidia. If you don't, you run the risk of being overexposed to future declines in the few stocks that have powered all the gains -- and underexposed to smaller companies that could drive the next wave of innovation.
"People want instant gratification, and they want [the gains from AI] to happen today, but it will take longer than they expect, and the journey will be bumpy," says Adam Benjamin, a technology portfolio manager and research analyst at Fidelity Investments. "This is not going to be a straight line."
My own view is that, while today's hottest disrupters might not fade anytime soon, they won't stay hot indefinitely -- and the journey might turn bumpy even for today's leaders. They could end up getting disrupted themselves.
If AI does turn out to be as big a deal as everybody expects, many other industries will benefit -- perhaps even more than the pure-play AI companies.
After a brief boom in the late 1990s, the biggest beneficiaries of the internet weren't those companies that facilitated access to it, like Cisco, AOL or Yahoo. Rather, it was rather the industrial, service and retailing outfits that used it to cut their costs and expand their markets.
In the long run, then, the best way to profit from AI might not be to concentrate on AI stocks, but just to hold all stocks through a total stock-market index fund. That way, no matter how surprising the ultimate winners turn out to be, you'll already own them.
Write to Jason Zweig at intelligentinvestor@wsj.com
(END) Dow Jones Newswires
March 15, 2024 11:15 ET (15:15 GMT)
Copyright (c) 2024 Dow Jones & Company, Inc.
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