AI ETFs Are on the Rise. Are They Worth the Risk?

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. It’s hard to escape the artificial intelligence hype. It’s everywhere. Companies are adopting AI into their processes. Many people are talking to chatbots, and investors are making bets on which firms or themes will win. But do you need to own an AI ETF to benefit from the boom, or do you already have enough exposure? Morningstar’s associate director of US passive strategies research Dan Sotiroff has investigated whether the additional volatility of an ETF focused on AI is worth the risk.

Thanks for being here, Dan.

Dan Sotiroff: It’s good to be back.

Hampton: Of course. Well, how should investors think about the impact of artificial intelligence on broad-market ETFs?

Sotiroff: Broad-market ETFs are absolutely the right place to start. I think it’s probably a statement of the obvious here that a lot of the big AI companies have been dominating the market and therefore dominating a lot of the big broad-market ETFs. The bigger picture here, as I think about this a lot, of every other technology that humans have invented, all the way going from the wheel up to the internet now. The story that’s going to play out, I think, is going to be very, very similar. There’s a ton of potential with this technology. We’re still kind of in the early days, trying to figure it out. Everybody’s getting the questions of how are you using this at work and stuff like that. And I think we’re kind of experimenting. We’re still trying to figure it out and trying to figure out how to incorporate this in our day-to-day.

But again, we just think back to the internet. It’s like back in the late ’90s, it was a lot of hype, but then eventually try imagining doing your job today without accessing the internet in any way, shape, or form. It’s nearly impossible. So, I think that’s going to be sort of the technological cycle that we see over the next five, 10, 15, 20 years or whatever. In the short term, getting back to the indexes here and the ETFs that are tracking them, a lot of big companies are really dominating the indexes and dominating the performance and driving the market.

In the long term, I think it’s going to be more spread out. This technology’s going to get incorporated everywhere. Companies of all shapes and sizes and walks of life are going to be benefiting from it. The other thing that’s kind of nuanced here that we’re starting to see come out is that you’re seeing a trickle-down effect to some of the infrastructure companies because there’s this buildout of data centers, and there are more power needs to actually power the computers and the racks of GPUs that are going into these data centers and whatnot. You’re seeing all sorts of other sort of plays on this broader AI theme. It’s not just the chip manufacturers or the developers like Nvidia NVDA and Microsoft MSFT. It’s all these other materials companies and energy companies that are associated with the actual infrastructure underneath it that are actually starting to come into play now.

Hampton: As a follow-up, do most investors already have a sizable position in AI?

Sotiroff: Absolutely. I think it goes without saying, again, the largest stocks are really driving the market and hence dominating a lot of these indexes. The other angle here is that it actually trickles over into foreign markets too, because when you look at foreign markets, you’ve got companies like SK Hynix SKHYV and Samsung, both out of South Korea, Taiwan Semiconductor Manufacturing Company TSM; some of the biggest stocks in foreign markets are also tied into this AI play as well. It’s not just the US anymore. This is very much a global theme that we’re seeing start to take hold.

Hampton: Do smaller companies still have opportunities with larger tech firms dominating the AI arena?

Sotiroff: It’s a fair question because they’ve been sitting on the sidelines for a while, and I know anybody that’s been holding a small-cap index or a small-cap fund for a while has not seen great performance. And the AI story just sort of makes that even worse because it’s more big stocks dominating the conversation. But you have to remember, AI technology is still in its infancy. It has the potential to improve a lot of businesses, including smaller businesses out there. So, I think in the long run they’re going to be OK. They’ll take advantage of a lot of the artificial intelligence technology and the other technologies around it and become bigger, better, more robust businesses down the road. I’m tripping over my words. But getting back to the infrastructure angle here, when you think of mining and energy companies, a lot of those are smaller kinds of value-oriented companies.

When you look at just what types of funds are doing well this year, small value is actually kind of beating the market this year by a little bit. So you are starting to see that start to come into play. Some of it is infrastructure. Some of it is also, I think it’s just the Iran war, and there’s a sort of constrained supply on a lot of basic commodities that these types of companies produce. So, I think there are sort of other things starting to play in here, but definitely the infrastructure story is one we’ve been hearing more and more about.

Hampton: How should investors think about thematic AI ETFs that have been rolling out over the past several years?

Sotiroff: I understand the excitement, first of all. It’s a really sexy area of the market to be in right now. Everybody wants to buy in; the performance looks great. But you have to be really, really careful here. A lot of these thematic ETFs, in general, not just AI, but they’re very concentrated, and they’re making a big bet on a theme that’s starting to get stale. It’s been going on for a few years now. So, it’s getting a little long in the tooth, so just be careful. And you have to remember when you’re getting into thematics and AI specifically like we’re talking about here, you’re really making three bets here. The first bet you’re making is that the theme comes true, and I think that’s largely already shown itself; it’s manifested. The other bet that you’re making is that you’re betting that the ETF you pick holds the right stocks, and we’ll talk more about that in a second.

But then the third bet you’re making is that the expectations aren’t priced in, that there’s still more room to run. And that’s a little bit hard to wrap your head around, especially at the price multiples that some of these companies are trading at. They look really expensive right now. And a lot of the news is already in the headline. And if you’ve seen it on the front page of The Wall Street Journal or any other media outlet, chances are it’s probably baked in the stock price at this point. So, just be very careful about that. And a lot of these ETFs, they’re very risky. They’re very volatile. They also are smaller. So, the chance that they stick around for another few years—not high on the potential list of outcomes there. And they’re expensive, too. Remember, you’re getting sort of bespoke exposure to a very small subset of the market, and the asset managers creating these are not hesitant to charge you for that. So, there are a lot of things you’ve got to really watch out for when you get into these. And again, you already have a lot of exposure in the market, so stick to that for now.

Hampton: I’m looking forward to your answer to this question. If you move part of your total stock market allocation to an AI ETF, what would have been the performance recently?

Sotiroff: Yeah, so you’ve done pretty well, odds are. The vast majority of the thematic AI ETFs in our database have outperformed the market. What’s interesting, though, is that there’s a really wide dispersion in that performance. So some have outperformed by a couple of percentage points. Some have outperformed by 50, 60, 70 percentage points. And this gets back to that second bet that I was getting to is that the way you can construct a portfolio of AI stocks, the stocks that you choose and how you weigh them can have dramatic effects on the actual returns that an ETF generates. And they can vary pretty widely, just as widely as there are infinite ways you can build a portfolio of these stocks. There’s an infinite range of returns you can get. That’s really going to be the determining factor here is you can get a very, very wide dispersion of returns.

And that’s kind of common what we see in a lot of thematic ETFs that are targeting sort of the same theme or concept. They can vary widely in how they perform, and that’s because they’re following different processes and different methodologies underneath the hood. A lot of people want to ask, well, how do you pick the right one? It’s like, I don’t know. You’re kind of guessing. You don’t really know what you’re going to actually get on the other end of this. Again, that’s another risk factor that you have to consider here is that you may not be in the best-performing one at any given point in time.

Hampton: That’s how investing goes, huh?

Sotiroff: That’s how it goes. Yeah.

Hampton: You’re biased as an ETF specialist, but I’m going to ask you this question anyway. Do you think ETFs are the ideal way to invest in artificial intelligence?

Sotiroff: Yes, of course, I’m biased. Well, let’s frame it in the broader ... What else could you do to get access to AI? You could buy individual stocks. I think an ETF is a better play than individual stocks. For one, you’re going to be diversified across a number of different companies. How many is going to vary based on, like I just said, there are various processes underneath the hood of a lot of these ETFs. Something you have to look into, but you’re going to be holding more than one ETF. It’s going to be more tax-efficient. So, as stocks come in and out of the ETFs, hopefully, if it’s managed correctly, you’re not going to be on the hook for the capital gains taxes. But really the best way, though, is you’ve got to watch out for fees at the end of the day, too. That’s the other thing. That’s probably the one benefit you get with individual stocks is you don’t have to pay an asset management fee.

But the other thing to keep in mind here is a lot of these are large-cap growth stocks at the end of the day. So, they’re big, they’re liquid, very easy to get access to. They fit great within an ETF. I really like passive exposure if you’re going to be using a thematic ETF here. Reason being is that active managers in the large-growth segment tend to not have great success rates over their passively managed peers. It’s very, very difficult. And again, because these stocks are large and liquid, a lot of the information shows up in the headlines every day. It’s already kind of baked into the price. So, I think passive ETFs for that reason make a lot of sense.

Hampton: How should folks invest in AI through ETFs?

Sotiroff: Well, let’s keep in mind what our time frame is here. Ideally, you’re looking at a very long time frame. Themes come and go, as almost by definition they are of-the-moment sort of investments. So because of that, thematic ETFs are going to be sort of a very short-term vehicle if you are using them. Just be aware of that. News and expectations, again, already baked into prices, so it’s very difficult to actually outperform. So, the way I would frame this is let’s start with just a broad-market ETF. Going back to what we’ve been talking about through our whole conversation here is that a lot of your broad market ETFs out there, think of iShares Core S&P Total U.S. Stock Market ETF, ticker ITOT, or Vanguard Total Stock Market ETF, ticker VTI

. Those are already going to be dominated by a lot of the biggest AI stocks that are out there.

And Schwab and State Street have their equivalent total-market ETFs. They’re all sort of doing the same thing at the end of the day. They’re all priced similar. So, start there. It’s cheap. It’s more or less a forever fund you can keep in your portfolio for years, if not decades. So if the AI trade doesn’t work out in the next few years, you’re going to be OK. You’re not boxing yourself into a corner or something like that.

The other thing I was going to say is, so if you wanted to go a little bit more concentrated than that, the next step is you could go to a large-growth ETF because, again, a lot of these are large-growth stocks at the end of the day. So think of your Vanguard Growth ETF, ticker VUG

, iShares Russell 1000 Growth ETF, ticker IWF. Both cover the segment. They’re very cheap. Again, Schwab, State Street have their own equivalents. So, go out there, you can find those. They’re all kind of doing the same thing at the end of the day. They’re all priced very similarly. But that’ll get you incrementally more targeted exposure to those large-growth stocks that are sort of all baked around the AI theme, but you also have a little bit more diversification. There’s going to be some other companies in there.

The third way you can do it is with a thematic fund. We have a Bronze rating right now on iShares AI Innovation and Tech Active ETF. The ticker is BAI. It sits in the technology category, so it almost looks more like a broad technology fund. It is actively managed, which breaks what I was saying before. So, just be aware of that. And it’s definitely leaning toward the growth side of the style box right now. The biggest holdings are kind of what you’d expect: SK Hynix, Micron MU, AMD AMD, Broadcom AVGO, Nvidia. All the big names that you would expect around the AI theme are in there. But again, this is a thematic fund. It’s going to be more concentrated. It’s going to be more expensive. With that, you get a little bit more risk. You probably get a little bit more volatility. Just be careful with that. And that’s one of the reasons we have it rated at Bronze. It is more focused on a specific theme and not the broader technology universe as a whole. So, that’s kind of a way to think about it. Start broad and then go a little bit more narrow as you want to dial up your exposure to AI.

Hampton: What’s the takeaway for investors eager to benefit from this AI tech trend?

Sotiroff: A lot of them, quite honestly, you don’t have to do a whole lot. If you have an S&P 500 tracker or a US total-market tracker in your portfolio already, which I suspect a lot of people do, you’ve already got a lot of exposure to this. AI stocks are driving the market. That’s probably the bigger thing we’ve been saying all along here. So, I wouldn’t worry about it. You don’t necessarily need to get more exposure to it because really all you’re doing at the end of the day is you’re amplifying your exposure to a lot of expensive stocks. And we know historically that’s going to stop. They’re going to come down back to earth at some point. But again, if you’re holding one of those total-market funds over time, this technology’s going to trickle down to everybody, and everybody’s going to start to benefit more broadly. So, you’ll still get the benefits if you’re holding one of those broad-market funds over the next five, 10, 15, 20 years, whatever it may be. That’s the bigger lesson, I think, in all of this.

Hampton: It’s a long game.

Sotiroff: It’s very much a long game at the end of the day, much like the wheel and the internet and everything else that has come before it. So, yes.

Hampton: Well, Dan, thank you for coming to the table and sharing these great insights.

Sotiroff: You’re very welcome.

Hampton: That wraps up this week’s episode. Thanks for making this show part of your day. A couple of reminders: Give Investing Insights five stars on Apple Podcasts to help others find the work we’re producing for you, and subscribe to Morningstar’s YouTube channel to see new videos from our team. Thanks to senior video producer Jake VanKersen. I’m Ivanna Hampton, editorial multimedia manager at Morningstar. Take care.