Hungry Eyes for AI in ETFs

It’s hard to talk about the stock market without also talking about AI.

By now, investors know well that only a handful of companies have a gigantic footprint in market-cap-weighted indexes and that those stocks’ returns are behind the market’s performance. Heavy exposure to Nvidia (up 38% year to date), Microsoft (22%), Alphabet (45%), Palantir (131%) and other names near the top of the S&P 500 has helped goose returns to 15% this year, and some ETFs that focus on AI and technology have done much better. Of course, the downside to top-heavy portfolios is that a change in the fortunes of a few companies can have major consequences for investors, which has been a selling point for the small number of equal-weighted stock ETFs on the market.

“Only around 17% of the stocks in the S&P 500 have outperformed the index. It is clear that the index has been driven by the top 10 to 15 stocks, and I think the opportunities that are outside of the index represent something that people need to take advantage of,” said Omar Aguilar, CEO and CIO of Schwab Asset Management. “We have been on this journey for two and a half years of encouraging clients to reduce their exposure to the concentrated part of the market,” he told ETF Upside at the company’s Impact conference in Denver this month.

It’s What Sells

The top reason that ETF owners cited for adding to their holdings this year is growth potential for AI, according to a recent survey of 1,000 investors by Charles Schwab. It’s also the top factor prompting them to consider buying more. Per that report:

• Just over half said AI’s potential is a reason to invest more, compared with market volatility (42%), high interest rates (40%), inflation (40%), US trade policy (39%), recession fears (38%) and geopolitical conflicts (31%).
• When choosing actively managed ETFs, 63% said the potential for outperformance was their reason, while 51% said it was to access alternatives and 45% cited protection from losses.

Hate to Burst Your Bubble, Bub: There is indeed a level of concentration in the S&P 500 unlike any other time, with the top 10 companies accounting for 40% of the index’s value, Kevin Dreyer, co-CIO of value at Gabelli, said during a presentation at the Impact conference. The average price-to-earnings ratio on stocks in the index is nearly 23%, up from just over 21% a year ago and less than 19% over the past 20 years, he said. Still, that mostly reflects earnings, Gabelli portfolio manager John Belton said. “The fact that Nvidia has been such a good stock is really an earnings story,” he said. “There doesn’t seem to be a valuation bubble here.”

In commentary published late last week, Raymond James CIO Larry Adam said that while it’s tempting for people to compare current valuations to those of the dotcom era, today’s fundamentals are stronger. “Back then, businesses were rewarded simply for having ‘dot.com’ in their name,” he wrote. “Today’s AI leaders are profitable and growing.”