Fears of an artificial-intelligence bubble bursting may have you thinking about how to build a defensive portfolio. The problem? These days, finding a corner of the stock and bond markets untouched by AI takes some legwork.
Most technology stocks, especially semiconductor makers, are having another great year, leading the market with a 28% gain, even with a sharp reversal last week. It's hardly unprecedented. Over the past decade, tech's average annual return is nearly 25%, compared with 15% for the S&P 500 index. That has led to worries that market-tracking index funds are overvalued and far too concentrated. Today, tech, and its close cousin, communications -- a sector that includes Meta Platforms and Alphabet -- make up nearly 50% of the index. The market's top three chip stocks, Nvidia, Broadcom, and Micron Technology, make up about 12% of the S&P 500.
When -- or if -- the AI bubble finally pops, it's certain to hit your portfolio hard. One market simulation, conducted in May by United Kingdom investment bank Panmure Liberum, looked at three possible scenarios, ranging from a "short correction" leading to double-digit drawdowns in tech and many cyclical stocks to an all-out 2000-style crash, when the S&P 500 plunged 30% in the first year. "We cannot time the end of a market boom," wrote Panmure investment strategist Joachim Klement, but "we are convinced that investors need to prepare."
Of course, that's easier said than done. Simply selling out of the market is too risky. Pundits have been warning about tech concentration for years. Investors who heeded their advice and sold out of the Magnificent Seven three years ago, for example, would have missed out on a gain of more than 100%.
Interest rates are another issue. If the good times do end, the cause could be a slowing economy -- but it could also be another spike in inflation. Each of those two events would probably occasion very different responses from the Federal Reserve, with different implications for bonds and rate-sensitive stocks.
Perhaps the biggest problem, however, is that the AI trade is no longer really about tech stocks -- it has spread into almost every part of your investment portfolio. The boom has touched everything from copper miners to makers of gas turbines and cooling equipment to nuclear power producers. Even auto maker Ford Motor recently got a big stock bump when it announced plans to sell battery storage systems for utilities and data centers.
Overseas stocks and bonds aren't immune, either. South Korea's stock market has more than doubled in the past year, driven by chip makers SK Hynix and Samsung Electronics, despite plunging last week. And tech giants Nvidia and Amazon.com have been issuing debt hand over fist, changing the makeup of the corporate bond market, much the way their ballooning market caps have changed the stock market.
"This is a difficult time to be out of the market. It's also a difficult time to be in the market," says Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management. "Being in the market is very fraught because it's all one trade. It's expensive. It's concentrated, and everything is correlated to it."
Given all of this, investors need to be very careful. Fortunately, there are a number of steps you can take to protect yourself, from defensive sectors and dividend funds to alternative investments and bonds -- as long as you are careful to consider what is and isn't connected to AI. There are plenty of tools available. The proliferation of exchange-traded funds gives investors thousands of ways to slice and dice the market, while active funds offer options like dividends and overseas stocks.
Barron's interviewed a dozen fund managers and strategists about their best ideas. Here are five ways to play defense without getting out of the game.
If you're worried about an AI selloff, your first instinct might be to hide out in another part of the market. The strategy seemed to work a few months ago. From October to March, the Mag Seven stocks entered a near bear market, tumbling 19%, as investors questioned their massive spending. The market rotated from computer chips into "real assets" that felt reassuringly tangible, with energy, materials, and utilities all racking up big gains.
The problem? This wasn't so much a rotation out of AI but out of hyperscalers and into AI picks-and-shovels companies, with names like copper miner Freeport-McMoRan and turbine maker GE Vernova leading the way.
A major AI selloff isn't likely to benefit second-order AI companies but instead true defensive sectors. Traditionally, that would mean utilities, consumer staples, and healthcare. But there's a problem here, too, notes Duncan Lamont, head of strategic research at London-based investment manager Schroders.
Utilities have themselves recently become part of the AI trade. Witness the big run-ups in nuclear energy stocks or NextEra Energy's proposed $67 billion acquisition of Dominion Energy in data-center rich Virginia. They are also interest-rate sensitive. (Note the sector's 4% selloff since March, when rates began to rise.) That's a problem, since investors can't be sure how rates would react in an AI selloff.
That leaves consumer staples and healthcare, two sectors that have been left behind in part because they have so little do with AI. Both look cheap, at least compared with the richly valued broad market. Consumer staples trade at 19 times forward earnings and healthcare stocks at 18, compared with 21 for the S&P 500. These are the "least loved parts of the market," Lamont notes, but adds, "There is more of a margin of safety in their valuations."
The simplest way to add sector exposure is through an index ETF. The Select Sector SPDRs, targeting 11 sectors of the S&P 500, are one time-tested option. The consumer staples fund trades under the ticker XLP and the healthcare one trades under XLV. iShares and Vanguard both offer similar ETF lineups.
There are also active options, like the Janus Henderson Global Life Sciences fund, which has returned 12% over the past decade, putting it in the top 10% of its health fund category. "Our sector has been pushed aside a little bit, because there has been so much excitement about other areas," concedes co-manager Daniel Lyons. About a third of the fund is drug companies, and another third is biotechnology. The rest is split among medical equipment makers, managed care companies, and others.
The fund's top three holdings are Eli Lilly, Johnson & Johnson, and UnitedHealth Group. Lilly, maker of blockbuster GLP-1 drugs Zepbound and Mounjaro, isn't necessarily cheap at 28 times earnings. But, Lyons says, the company isn't just about obesity drugs -- it has also seen positive developments in cancer care and vaccine acquisitions.
Dividend stocks are a classic defensive play. Steady cash flows tend to provide a cushion against price swings, while the biggest dividend payers are often blue chips with solid, established businesses. And they have protected investors in the past. One recent study by Hartford Funds looked at market corrections going back to 1973. On average, the market declined 19%. Dividend-paying stocks fell just 14% during those drawdowns, while nondividend stocks declined 28%.
But investors need to be careful here, too. The market's most popular dividend fund is the Vanguard Dividend Appreciation, which boasts a standout record, having returned 13% over the past decade, putting it in the top 5% among dividend funds tracked by Morningstar.
But because it focuses on companies that grow payouts, its yield is low -- just 1.5%, slightly higher than the market's 1%. And its top three holdings are tech stocks: Broadcom, Apple, and Microsoft. Overall, tech stocks make up about 26% of its portfolio, making it less than ideal as a hiding place to ride out an AI selloff.
A better bet may be the Vanguard High Dividend Yield fund, which offers a yield of 2.2%, or the Schwab U.S. Dividend Equity ETF, yielding 3.2%. Both have less than 20% of their portfolios in tech, according to Morningstar. Neither has matched Vanguard Dividend Appreciation's 10-year returns, but during the October-to-March Mag Seven selloff, they fared much better. While Dividend Appreciation tumbled 2.7%, High Dividend Yield gained 4%, and the Schwab fund rose more than 16%.
Among active funds, Columbia Dividend Opportunity offers a similar profile, with a 2.5% yield and less than 13% invested in the tech sector. While Cisco Systems is among the fund's holdings, so are Exxon Mobil, JPMorgan Chase, Johnson & Johnson, and Philip Morris International. Co-manager Grace Lee says that she has gradually pared back the fund's tech holdings as they have appreciated to make sure the sector doesn't loom too large. In a tech selloff, she expects staples stocks like Philip Morris to hold up comparatively well. While cigarette sales are gradually declining, the company found a new avenue to growth with smokeless tobacco. "The dividend is extremely safe and supported by growing free cash flow," Lee says.
A big AI selloff would probably reverberate around the globe. Joachim Klement, who ran the simulations of an AI selloff, thinks that European stocks could actually be hit harder, at least at first. Their economies tend to be weaker, and U.S. investors would rush to repatriate their investments. Still, in the longer run, he expects defensive European stocks to be "the best hiding place," thanks to low valuations and lack of tech exposure. He recommends food, pharmaceutical, and telecom names. He also likes U.K. construction and German infrastructure stocks, which will benefit from promised government spending increases.
Targeting overseas sectors with funds is trickier than in the U.S., but iShares does offer a family of global sector funds that own a mix of overseas and domestic stocks, such as the iShares Global Consumer Staples and iShares Global Healthcare ETFs.
Investors who use broad-based index funds targeting developed and emerging markets need to be careful, too, and make sure they understand what they own.
The iShares Core MSCI Emerging Markets ETF is up 42% in the past year, in large part because its top three holdings are Taiwan Semiconductor Manufacturing, Samsung Electronics, and SK Hynix, all of which have seen their shares more than double. Vanguard's emerging markets offering -- the Vanguard FTSE Emerging Markets ETF -- is up just 21% in the past 12 months. The difference? Vanguard classifies South Korea's Samsung and SK Hynix as developed-country stocks, and includes them in the Vanguard Developed Markets Index fund, which has returned 29% in the past year. Selling out of a broad swath of the market to avoid a handful of tech highfliers is almost certainly self-defeating, but investors who mix and match iShares and Vanguard ETFs should make sure they don't end up with a double dose of South Korea.
Given all of this complexity, active funds can make sense. Los Angeles--based Causeway Capital Management is known for sussing out underpriced overseas stocks. Its flagship Causeway International Value fund has returned more than 10% a year on average over the past decade, beating the MSCI EAFE index by nearly a percentage point. Top holdings include Gucci-parent Kering, drugmaker AstraZeneca, and French industrial giant Alstom. While a global selloff would seem to be a headwind for a luxury stock like Kering, Causeway President Harry Hartford says pessimism is already baked into the share price, which has declined 15% this year, thanks to the Iran war, and is about 68% below its 2021 all-time high. "Our tendency is to lean into those dislocations, " he says.
When it comes to playing defense, bonds are always part of the discussion. The problem is that no one knows what script an AI wipeout might follow. When the dot-com bubble burst in early 2000, the Federal Reserve quickly slashed interest rates, giving bonds a tailwind. But the memory of 2022 -- when both stocks and bonds tumbled together -- lingers, too. Plenty of market watchers fret that what kills the AI party could be another inflation shock, which would tie the Fed's hands, muting any potential Treasury rally.
To guard against both possibilities, Morgan Stanley's Shalett recommends a barbell strategy. If interest rates climb, corporate bonds should hold up better, she notes, since their extra yield provides cushion against rate-driven price declines. If the selloff is recessionary -- perhaps prompted by a Big Tech company missing an earnings forecast -- Treasuries will be the ultimate place to hide out. "We're owning a little bit of both because we don't know which is going to happen," she says.
Investors can target those sectors with index funds like the iShares 3-7 Year Treasury Bond and the iShares 1-5 Year Investment Grade Corporate Bond ETFs. But there's a wrinkle here, too. Hyperscalers have been issuing debt hand over fist to fund AI investments -- more than $120 billion last year, with similar amounts or more forecast for 2026. Smaller players focused on the AI infrastructure buildout have also been flooding high-yield markets with new bonds. Yet concentration isn't nearly as dramatic as in the stock market: Tech's share of the Bloomberg Corporate Bond Index recently climbed to 10% from 9%, and could hit 12% in coming years, according to a recent forecast by LPL Financial.
All the same, if the goal is to avoid AI exposure, it may be worth looking at an active fund that has the freedom to break with the index. Craig Manchuck, co-manager of the Osterweis Strategic Income fund, says AI excitement has led "to a suspension of disbelief among fixed-income investors," who seem willing to buy bonds from AI picks-and-shovels companies simply because they have contracts to work with a hyperscalers.
"AI is an equity story. If you're getting equity returns, it's great, but why would you accept 6% or 6.5% on something else like that?" he says, referring to recent yields he seen.
Strategic Income, which leans toward high-yield bonds, has been steering clear of overhyped areas of the market, Manchuck says, and focusing on underappreciated issuers like home builders, mortgage companies, and natural-food companies. "They distribute to restaurants, hospitals, colleges, universities," he says of the latter. "They've all got fuel surcharges built into their pricing model, so they're fuel price insensitive. They've been very stable for a long time...people need to eat." Over the past decade, the fund has returned 5.3% a year on average, compared with 1.7% for its primary benchmark, the Bloomberg U.S. Aggregate Bond Index.
Some investors who had been resisting the trend of moving a small portion of their portfolio into alternatives are finally relenting. Aaron Mulvihill, global alternatives strategist at J.P. Morgan Asset Management, says he has been seeing increased interest, although the firm's data show that all but the very wealthiest investors typically have less than 5% in alternatives. "Last year, every investor was looking for ways to get more exposure to AI," he says. "This year, that's flipped on its head. They're looking for ways to diversify."
Of course, investors need to be selective here, too. A year ago, sales pitches for private-credit funds were everywhere. Now, investors are fleeing many of those funds, in large part over jitters of tech exposure, which accounts for about 25% of business development company holdings, according to UBS.
Mulvihill recommends that investors look at private-equity, infrastructure, and real estate funds. He also thinks hedge funds are an attractive possibility, since market volatility can be an advantage for them. Of course, many alternative assets are packaged into complex private funds, making them difficult to buy. One mutual fund option is AQR Diversifying Strategies, a fund of funds, which packages six of the hedge fund firm's strategies into single holding designed to deliver steady returns that aren't correlated to stock and bond markets. The fund, which launched in 2020, has delivered average annual returns of nearly 12% over the past five years, putting it in the top 10% of its Morningstar category.
Co-manager John Huss notes that the fund of funds is currently underweight in its allocation to AQR's multi-asset mutual fund, and overweight toward its market-neutral strategy. The multi-asset fund, which invests in major asset classes like stocks, bonds, and commodities, has a "long bias," he notes, so the current underweight allocation suggests the fund of funds is positioned defensively.
Huss says AQR isn't in the business of predicting whether tech stocks will sell off, but the firm's forecasts are clearly looking at the same charts as everyone else. "Valuations look rich in equity markets," he notes.
Write to Ian Salisbury at ian.salisbury@barrons.com
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July 02, 2026 01:00 ET (05:00 GMT)
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