All the year’s market gains come from AI stocks… how do you invest in AI today?… be careful about buying an ETF… Louis Navellier’s warning about spreads… how to use ETFs
Yes, “AI” is a buzzword, and investors need to investigate any company making big claims about their AI integration.
But let’s not confuse “buzzword” with “fad.”
The internet was not a fad and neither is AI. In fact, it’s a quantum step forward, and that’s not hyperbole.
In yesterday’s Digest, we highlighted how AI is going to transform the health care industry. Obviously, the societal impact won’t stop there.
AI will create a clear line-in-the-sand for practically all business sectors.
On one side will be the companies that adopt AI’s powerful capabilities and use them to further their growth.
On the other side will be all businesses that can’t effectively incorporate AI or try to continue with “business as usual.”
Well, there is no more “usual.” There are only the companies that can continue to thrive in this new landscape.
Take student education company Chegg. Last month, following a downbeat earnings report, its CEO admitted that ChatGPT was negatively influencing its business.
The stock imploded 48% in a single day and hasn’t recovered since.
Now, Chegg might find a way to incorporate AI into its offerings and thrive, but Wall Street certainly doesn’t appear confident of that today.
As to those companies poised to capitalize on AI, the most obvious are the tech elite, like the FAANGs. They have plenty of cash on hand that can fund AI-based innovations to their current business model and products/services.
Today, Wall Street is rewarding these tech-elite while mostly ignoring everything else.
To illustrate, look where the returns are so far in 2023
While the S&P is up about 9% on the year that’s misleading. Almost all of those gains have accrued to AI stocks. Non-AI stocks haven’t returned anything.
In fact, it’s worse than that – they’re down.
The chart below from Societe Generale illustrates that without AI stocks, the S&P would actually have lost 2% so far this year.
So, where is all of this AI-capital flowing toward? How do we invest?
There are two broad buckets.
First, there are companies using AI to improve their products/services to dominate their competition.
Second, there are the “picks and shovels” companies that enable AI – think hardware, software, and the overall “tech” infrastructure required to make AI happen.
As an example of the first kind of company, take Microsoft and Google incorporating AI into their search engines to make them better. Microsoft is using GPT-4 in Bing, while Google is using its own AI technology in its chatbot, Bard.
As to a “picks and shovels” approach, one of the companies that’s attracting the most attention is Nvidia. Its semiconductor chips are a critical component of the “computer brain” that drives AI intelligence.
Now, clearly, we’re incredibly early in this AI-based takeover. So, while there are some companies that are more obvious candidates for your investment dollars, many of tomorrow’s biggest winners aren’t household names yet.
This suggests that a basket approach could be a helpful way to invest. In other words, rather than throw, say, 33% of your total investment capital into Microsoft, Google, and Nvidia, you would spread that money over 12 – 15 stocks, a few of which are fliers that could experience monster growth.
Now, you might be thinking “why not buy an AI ETF?”
Well, I agree with the thought, just be careful about the implementation.
Be aware of what you’re buying and don’t overpay
Yes, an AI ETF could be a great idea. It could also be a great way to pay filet mignon prices for a bologna sandwich.
To illustrate, let’s look at one of the most popular artificial intelligence ETFs on the market today, the Artificial Intelligence & Technology ETF, AIQ, from Global X.
Here’s how Global X markets the product:
Artificial intelligence spans multiple segments, and its most innovative companies include both household names and newcomers from around the world. AIQ invests accordingly, without regard for sector or geography.
Sounds good, right?
Well, it is pretty good, and its performance so far this year is pretty fantastic. It’s up 24%.
But let’s add some context…
AIQ is a weight-averaged ETF, meaning it invests more heavily in certain companies in its portfolio than others. So, what are the top 10 holdings in AIQ?
As you can see, this is nothing but well-known, mega-cap tech stocks. Nothing you’re probably not already very familiar with.
Now, sure, AIQ invests in dozens of other stocks, but their weightings are tiny compared with that of these top 10 holdings. In fact, these 10 well-known mega-caps account for 36% of the performance of the entire ETF.
Now, let’s add in the cost.
AIQ’s expense ratio is 0.68%. Although that’s not off-the-charts expensive, it’s certainly not cheap.
So, what’s the better way?
Those top 10 AIQ holds look pretty familiar, right?
If we look at the bread-and-butter Nasdaq 100 and its top 10 holdings, we find that 80% of them are the exact same as the top 10 holdings in AIQ. We’re talking Microsoft, Apple, Amazon, Nvidia… and so on.
So, let’s say you invest in QQQ, which is the ETF from Invesco that seeks to track the Nasdaq 100 Index.
Well, by doing that, you’re basically getting the exact same heaviest-weighted stocks as in AIQ – except instead of paying 0.68%, you’re only paying 0.20%.
And if you don’t think this adds up over time, you’re wrong. This seemingly small difference, compounded over a longer investment horizon, can mean thousands of dollars of return differential, depending on how much you invest.
And what about the returns?
Well, QQQ is actually beating AIQ on the year. As you can see below, it’s up 26% compared with AIQ’s 24%.
(And don’t miss the near lock-step performance of the two funds.)
You can pay more for AIQ, but why would you want to?
There’s another reason to be cautious of investing in an ETF
While this reason isn’t specific to artificial intelligence, it’s important to understand, nonetheless.
Legendary investor Louis Navellier dove into this problem earlier this week using the example of KRE, which is the SPDR S&P Regional Banking ETF.
If an investor sold KRE on the week that Silicon Valley Bank was crashing, they got fleeced 12% on average, because KRE was trading at a discount to the underlying value of those bank stocks.
Then if the investor bought KRE when it turned around, they paid a 4% premium.
This is how Wall Street makes money. It fleeces you.
Here’s the reality: An ETF may sound enticing because there’s no commission fees, but there is a catch… the spread.
What ETFs do is they put a spread on top of a spread. It’s like getting an extra scoop of ice cream, and the firms make more money.
For any readers less familiar with a spread, it’s the difference between what a buyer is willing to pay for an ETF and what a seller is willing to accept.
We call these the “bid” and “ask” prices. From this, we get the official term, the “bid/ask spread.”
This spread can be narrow or wide. One of the variables most impactful of the spread’s size is liquidity. If the underlying assets that investors want to buy and sell are plentiful, that abundant liquidity reduces the spread.
But if those underlying assets are hard to come, meaning there are only a handful of buyers and sellers, then the respective bid and ask prices that buyers and sellers are hoping to transact at could be miles apart. This lack of liquidity widens the bid/ask spread.
So, where does Wall Street fit in here? And how is it fleecing you?
Well, remember, it’s not just you and someone else in a market transaction. There’s a middle-man who’s bringing you two together – the Wall Street market-maker. And in exchange for its role in matching you and the other party, this market-maker gets their cut.
The problem is that with ETFs, this size of this cut can be absurd.
As an example, Louis pointed toward the iShares Select Dividend ETF (DVY), which is the biggest dividend ETF available. During the “flash crash” on August 24, 2015, DVY had an intraday spread of 34.95%.
So, if you had a market order in during this time, you bought/sold at prices that were miles away from actual underlying asset values.
It’s yet another reason to be careful of loading up your portfolio with ETFs – especially if you’re an investor who’s more active, trading in and out of the market.
Returning specifically to AI and ETFs, perhaps the best way to use ETFs is as research
If we look at AIQ’s holdings outside of the top 10, there are lots of lesser-known names…
Synopsys Inc… Datadog… IonQ… Teradata… Okta… UiPath… Ambarella… Cognex…
What do these companies do? How “pure play” is their exposure to AI? Which one will time reveal as a diamond in the rough?
This is where you can begin your own research.
Use the list to identify a group of AI stocks that you believe have promise, then create your own, personalized AI ETF without any fees at all.
Wrapping up, not only do you want AI in your portfolio, you need it. At the same time, we’re in the early stages of this technology – the gold rush days where everyone is scrambling for the big strike, but not exactly sure where to find it.
That’s why a diverse, basket approach is a wise way to approach the market. Just be sure you don’t pay top dollar for something you can get for free.
Have a good evening,