ETF Edge - AI Revolution: Broadening Out Beyond Big Tech? 7/31/23

Episode Date: July 31, 2023

CNBC’s Bob Pisani spoke with Rich Lee, Head of Program Trading, ETF Trading and Execution Strategy at Baird – along with Todd Rosenbluth, Head of Research at VettaFi.With the AI revolution taking the world by storm, the bulls are hoping we’ll finally see the trend broaden out beyond just big-cap tech companies like Nvidia, Meta and Alphabet. And while there are a handful of ETFs heavily tied to AI out there, many ETF investors are hoping for a more all-encompassing, varied selection in the not-too-distant future. In the “Markets 102” portion, Bob continued the conversation with Todd Rosenbluth from VettaFi. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQQ, supporting the innovators changing the world. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange, traded funds, you are in the right place. Every week we're bringing you interviews, market analysis, and breaking down what it all means for investors. I'm your host, Bob Fazzani. Today on the show, we'll go deeper into the AI craze. With the AI revolution taking the world by storm, the balls are hoping we'll find.

finally see the trend broaden out beyond the realm of just big cap tech companies like Nvidia, Meta, an alphabet, and Microsoft. And while there are a handful of ETFs heavily tied to AI out there, they're a bit narrower than many ETF investors would like. What other ripple effects can we expect to see in the future? Here's my conversation with Rich Lee. He's the head of program trading and ETF trading execution strategy at Baird, along with Todd Rosenbluth, head of research at VETI.

Rich, these AI ETFs have a lot of familiar names in them. The Global X Artificial Intelligence Technology ETF, the AIQ, that's probably the most well-known. We have Nvidia in it. We have META in it. We have Tesla in it. We have Microsoft. We know all of these names. But there are attempts to get broader coverage out there.

What else is available in ETF land other than just buying something that's got, you know, Microsoft and Tesla in it for example? Sure. Thanks for having me, Bob. A couple of things with that. With regard to AIQ, WTAI and IRO, right? AIQ is a market cap-weighted ETF. I-Robo and W-T-I-R-T-I-W-T-I-E is equal-weighted, right? So you're going to get diversification from having something that's either market-cap-weighted,

which is going to tend towards the larger companies that are out there, or equal-cap-weighted, which is going to give you broad exposure. With regard to broad exposure, these ETFs have somewhere in excess of 85 to 155 names. On top of that, a lot of these names have global exposure. So in addition to names like Service Now in the U.S., you're looking at names like Finoch in Japan. So there is global exposure to it as well. So it's not just the names we commonly associate with AI. Right. So that's a very important distinction. You know, those that are set to an index that are market cap-weighted, and there you get that heavy, you get the Microsoft and NVIDIAs of the world. But there's ways

to look at on a broader level, Todd, where you get more equal-weighted ETFs that don't. So here's the problem I have for ETF investors in general. We've talked about this for years, you and I, other hot topics in the past, cannabis and crypto. The current choices are narrower than most investors believe. And now I see some arguing that the AI revolution should be broadening out, and investors are going to have a lot wider choices. I mean, what else was out there? He mentioned you.

I've heard all sorts of unusual things besides Salesforce that are out there, broadcom and other names. So from an ETF perspective, we're certainly seeing it. At VETIify, we actually track where people visit on our website. And in the last four months, we've seen consistent flows and trends towards robotics and AI ETFs using our Explorer data. So it's those ETFs that Rich was talking about, but it's also ETFs like Robo, which is a Robo ETF that's tied to a VETIFI index,

It's bots, BOTZ, which is tied to a global X product. It's IRBO, which is an I-Share's E-TF. They're using artificial intelligence and robotics. And so AI is going to empower the industrial space and robotics to make them work and become more efficient. We're seeing trends towards healthcare. We're intuitive surgical is a company that's benefiting from artificial intelligence. We're seeing eBay, e-commerce companies. The more that they know about...

Now, how is eBay benefit? I guess in the sense that you can use AI to more efficiently run the whole process, the website itself. Right. So to know more about the consumer trends and then position products based on it to become, again, more efficient. So AI is you can invest in companies that are directly targeted to it and that are indirectly benefiting from it. And those are some of the trends that we're seeing. So maybe another way to play this instead of we've had companies, for example, ETFs that have 100 names in. that are equal weight, but maybe take the Kathy Wood approach. More concentration is the answer here.

So I'll give you an example of this, folks. Roundhill has a new AI ETF, CHAT. This is an actively managed fund that only invests in 25 to 50 company. It's a little more concentrated than some of these other ETFs. It's global, involved in generative artificial intelligence and other related technologies. So there's some example here. Again, this is actively managed. This is not tied to an index.

So my point here is there are different ways to play this. You're not just stuck with Microsoft and Vivida necessarily. Here's a company that actively manages tries to pick stuff. Yeah. I mean, you mentioned ARCS, so they obviously have been tied to this as a broader disruptive technology theme. We've seen Harbor have a disruptive technology. Goldman Sachs has a disruptive technology ETF.

And these active managers are increasingly turning towards companies that can benefit from artificial intelligence or that are investing in. And they have the ability to swing in certain directions based on what trend is in favor and what trend is out of favor. So I think we're going to see more of that as active managers in the ETS space move into this world. So the viewer is probably sitting there saying, my head's spinning. I don't know what to do here. I might want to do something in AI, but which one do I pick? And what's interesting is it didn't matter this year.

I mentioned four. I just picked four of the biggest ones that are out there, AI ETFs. They're all outperforming. right across the board, the average market. 30 to 46% gains versus 19 for the S&P 500. So in a sense, being there was important. In fact, just owning the S&P would have mattered this year as an AI play at this point.

So this is why I tell people, they ask me all the time, what should I do? Don't panic too much and don't get too clever. If you really want to exhaust yourself, there are lots of ways to play this. I showed you. We just talked about it. But just owning the S&P 500, you would have been a beneficiary this year.

Or the triple Q's has exposure to obviously these mega cap growth companies as well that's benefiting, or QQQM, which is a lower cost version of it. AI has been driving the broader marketplace this year. Now, will it continue to do so in the second half of the year? And can these companies continue to become profitable as a result of these drivers? Those are the things I think many viewers are thinking about. Yeah. Rich, the AI revolution, and I constantly keep trying to broaden this topic out beyond Microsoft, there are more than just tech companies involved here. An old friend of my Julian Emanuel at Evercore ISI was out with a note recently saying even large industrial names can be beneficiaries.

And the trick here would look at something, a subspace, like industrial automation. So, for example, Ingersoll Rand and Eaton are two companies that are very involved in industrial automation. They have been outperforming the industrial space this year, I think partly on the idea that industrial automation would be a big beneficiary of artificial intelligence. There's Ingersoll Rand. Look at that. That stock's been up, you know, ever since this whole discussion on AI has been going on for the last six months. And the same with Eaton as well. So there are other ways to look at this. Sure, absolutely.

You're familiar with Amarro's Law, right? Amarro's Law basically says that humans tend to overestimate the impact of technology in the short run and like underestimated in the long run. They overestimate in the short run, underestimate in the long run, right? And so we're just in the sort of early innings of this, right? And if you think about industries where you may not traditionally associate with AI or tech, you think about industrial. So Ingersoll Rand, which is poised to capitalize on reshoring trends, automation, operational efficiency, same thing with Eaton, which are looking to look for automation and better processing through automation. They're going to have to look at things like AI as part of their business processes to realize some of these gains. So we're going to start to see AI creep into other sectors and industries.

We may not traditionally associate with tech or with AI. See, this is what makes me excited about this a little bit because you and I, Todd, have talked about the, the revenue problem. Like, okay, fine. You know, how much of a, are, we say Microsoft does an AI play, but how much of Microsoft revenues are really coming from AI? Well, it's more. And other companies might be a lot smaller, but if you can say, well, AI, they're going to be used, AI is going to be used in Ingersoll Rand and Eaton to improve the product in line. Well, that's kind of hard. It's not necessarily revenue play, That's just a productivity improvement play.

That could even be a margin improvement play on the bottom line. Harder to measure. We always say, oh, they're not important. It's only, you know, small percentage of their revenues are generated from whatever, crypto, cannabis, or, you know, now artificial intelligence. And that's the way that ETFs that are exposed to AI think about it is from a revenue standpoint. So the research-driven approaches that GlobalX uses or Robo uses or I-shares uses to support those indexes, is looking at companies from a revenue standpoint.

But yes, AI is going to drive, improve the profitability of so many of these sectors. Agriculture, for example, consumers, you mentioned, industrials. And so it's going to have a broader impact on the overall economy. It isn't just going to impact the technology stocks that are going to be beneficiaries of this trend. Yeah. So what else do you, if you believe that, then, almost anything is potentially rife. I mean, software as a service, you know, 10 or 15 years ago, revolutionized back office stuff because all of a sudden a lot of stuff that was difficult became a lot easier because of software as a service,

stuff that was redundant that we didn't need as many people. And we've lost some jobs as a result of that. And yet nobody sits there and cries about it. Everybody says we're more efficient. Well, even the financial technology space in general is going to be driven in part because of AI. It's going to help. Advisors do their jobs better. It's going to help.

investors store through the information better, it's going to process things. It's actually, we have FinTech as one of the areas that we're focusing on at VETify. We have an AI symposium that's going to take place August 30th, and Fintech as well as robotics and traditional AI are three of the themes that we're going to be exploring. And you work with VETI, those who don't know work with RIAs, registered investment advisors, and what they must be very interested in ways to use AI, not to pick stock so much or maybe, but more to help them run their businesses better, right? Yes, and I think advisors are trying to become more efficient,

free up their time to free up some of those back office capabilities so they can work more closely with clients, either in picking stocks or helping them plan out their goals. And so AI is certainly top of mind for those advisors. I don't want to spend my time doing accounting or hiring a team to manage the back office. I'd rather spend my time talking to clients and helping them out.

generating value for the clients, right? Absolutely. And I think about the ways AI are going to be so creative to the industry, you think about for us on the South Side, right? Data, data processing, differentiation of content, that's going to be a huge area to explore within the industry. And just like e-commerce kind of going back to Web.0, I think people under, you know, overestimated initially and underestimated the impact it had over the long run. And I think we're going to see the same thing play out with AI and the productivity games we're going

to see. Now, how about, let me just turn this upside down. We have been talking about using ETFs that are picking companies that would benefit from the AI revolution. How about the opposite? How about using AI to pick stocks? There are ETFs out there, and there's new ones coming. There's several that have been out there for several years. AIEQ, I think, is the old.

Put up AIEQ if you can. I'll show you this. This is one of the oldest one. Basically, the goal here is highest probability of capital appreciation. It's kind of a vague, but it uses what they call AI algorithms to pick stocks. And if you look at what they own right now, they own Mosaic, which is a material name. Wells Fargo, Bank Stock, State Street of Bankstock, Fas and All, there's a classic industrial name, and Numont, Mining, gold.

So that's kind of a strange group, right? The problem I have looking at these, there's AIQ, is it's a little opaque. Like, if you actually try to explain it, that's sort of proprietary, and they kind of like, you know, get a little, you know, iffy on you. But talk about this a little time. Yeah, well, the answer, when you ask a company why they own individual companies, the answer is the model told us to do it. Yeah.

It's not a very satisfying answer for an investor, but AI-driven ETFs, those that are picking stocks based on, we're seeing an increasing number of these companies. Tukrium has a couple of commodity ETFs that are going to choose which commodities to go long or long or short. We've got a company called Kraft that starts with the letter Q that has a momentum ETF and a risk on, risk off. It's just a, it's a perhaps a smarter way of picking stocks.

I know that computers can be smarter than I am, you know, whether or not they're going to be better at outperforming the broader S&P 500 or not. I don't think the evidence is there to do that. I mean, does it, are they really smarter? I'm not, I'm not entirely convinced. Yeah, I think I think that's a great question, Bob. I mean, if you think about what's happening in Hollywood night right now with the debate over using AI to replace actors or in publishing, we're in the early stages of this, and it'll be interesting to see how it plays out in the role that it'll play.

Can an AI outsmart a human, right? And what's the differentiation there? So I think time will tell and, you know, these ETFs attempt to kind of test that out. So this gets to this data mining problem. if AIs can find some new data set that they can exploit that humans haven't been able to exploit, in theory it could outperform. It's like the computer that fought with Lee Settall,

the guy who is the Go champion. It made a move in the fourth game that did not make sense on a traditional strategy, and nobody said, what's this thing doing? This is an idiotic move, and it won the game. It found some new way to win the game, and it sort of revolutionized some of, the strategy around go. Well, if this could happen in stock picking, then I'd say, wow, this is

interesting, you know. But I haven't seen it yet. And by the way, if that happened, wouldn't all the other AIs know it immediately? So the informational advantage goes away. That's my point. How long, there is no magic here about, oh, this is going to, AI, is going to outperform everybody. But then the assumption is that there's an efficient market overall within stocks. Exactly. And it depends. So yes, it's been better off being in a benchmark. S&P 500 than being in the average actively managed fund. But AMOM, which is one of these momentum ETFs that Kraft offers, is significantly outperforming the I-Share's momentum ETF, M-T-U-M-M-T-U-M.

How often does that... Ice-share's every six months? I-Share's rebalances every six months. This one can rebalance on a weekly basis or... Well, there you go, right there. Momentum is not momentum when you rebalance every six months. It's just not. I've never agreed with it.

I don't understand that, right? Do you? Is momentum every six? months, really? I thought momentum, like, the RSIs are 14-day indicators, usually relative strength indexes, folks. Those of you don't follow all this obscure jargon that Todd uses all the time. Not me. You use it. So that makes more sense to me. If you're going to have a momentum, it should rebalance regularly. Right. And benefit from the smart information that's continually being updated in the marketplace. Now it's time to round out the conversation with some

analysis and perspective to help you better understand ETFs. This is a the markets 102 portion of the podcast. We'll be continuing the conversation with Todd Rosenblu from VETify. Todd, thanks for staying with us. One thing I wanted to ask you about was the larger percentage of inflows going to active management. Now, you people at VETify, you watch trends very carefully, RIA trends. You recently ask advisors, what percentage of your fixed income exposure is tied to active management? And more than 50 percent, said the top choice was more than 50%. So active management seems to be having a moment with ETA,

with RIAs and ETFs, at least with fixed income. Right. So we've seen historically that investors that rotated from their active equity mutual funds into index-based equity ETFs, we didn't see that same trend. People tend to stay loyal to their active fixed income strategies. They believe that they can't manage duration, they can't manage the credit quality themselves, follow what's going on in the economy.

So they've stayed with active management instead of going to the low-cost index strategies. Now there's many more choices within the active fixed income space, active fixed income ETFs. A number of firms have come in over the last few years, and we think we're going to see even more happening as we move through the year and into 2024. I think one thing I just want to clarify on this. Every time this happens, the active people say, aha, you see, active management's finally getting attention. First of all, it doesn't mean anybody's necessarily outperforming, number one.

Number two, inflows this year have been pretty modest generally, equities and fixed income. And number three, just because there are inflows, these are inflows mostly from active mutual funds to active ETFs, not from passive ETFs to active ETFs. Correct. So most of the money in ETFs is still tracking an index. People who moved because they believe in indexing as opposed to active management, they're not likely to come back. If you went for three basis points to own Vanguard, total bond index ETF, or the I shares aggregate bond index ETF, you're likely staying loyal with that. But if you were believer in active management, now you have more choices within the ETF world.

We have Fidelity that's there. We have Capital Group with active fixed income ETFs. JP Morgan has the largest of those actively managed fixed income ETFs. We think we're seeing more of these firms enter the marketplace. They're giving investors a choice. BlackRock actually is Rick Reeder offering now an ETF. The ticker is B-I-N-C, Bink. He's running an ETF now, not just a mutual fund at BlackRock.

Yeah, that's important. I want to ask you about this whole trend company. into the ETF space because it keeps getting bigger. Last week, TCW Group, which is an LA-based firm, they acquired Engine Number One's ETF business. Of course, Engine Number One, very famous for its proxies, its involvement in the proxy business. And there were three ETFs that they acquired there,

$640 million in assets, and this included the vote to transform 500 ETF, VOTE. So tell me this what this means here. I mean, it seems like asset managers are really jumping into the ETF business. We are seeing that. So we're seeing, so we had TCW that's been a sub-advisor to first trust for a number of active fixed-income strategies. But they didn't have their own products. They weren't distributing their own products.

They weren't benefiting directly, more indirectly, from the ETF space. They're now the latest firm. Double-Line did this as well. Double-Line was a sub-advisor for State Street. They then, a year or so ago, they launched their first active ETS. both equity and fixed income, and I've seen really strong inroads. We think that's going to happen with TCW. They've now bought their way in.

These are not going to be the only three products that they offer. Now, this is not going to change anything in engine number one. The ETFs are going to still stay there, and in some sense, they might benefit from more distribution. Exactly. They're going to have the whole team at TCW helping them to generate interest in these products and we're likely to see a growing number of these products, thematic ones, perhaps. TCW actually runs active thematic mutual funds, a number of strategies. We're likely to see ETF versions, and we're seeing greater interest in thematic strategies,

as we talked about earlier today, in ETFs. And so we think TCW is going to continue to expand the lineup. But if you own one of these ETFs from engine number one, no change for you. Still going to be run the exact same way, just have more resources behind it. So are there other, I mean, you mentioned double line, and Jeff Gunlock, are there, Of there other sub-advisors out there that I might look at this and say, hey, double-line did it. T-CW just did it? Should we do it?

Well, I think we're going to see more firms coming to the market. But do they have a product differentiator? You know, that's the hard part. These firms come in. There's almost 200 ETF funds, families now. And frankly, I can't keep track of all of them at this point. But a lot of them exist on the very periphery of any kind of profitability at all. Some like Schwab can come in with the simple index funds, and they're so big, the distribution is so big, they'll do all right.

But a lot of other people I look at them and I say, what's the differentiator? So I think what we're seeing is that some established mutual fund companies like TCW and others are going to increasingly look towards the ETF space. We also have large registered investment advisors or folks that run separately managed accounts that are going to turn to the ETF structure to become more. more efficient and run their practice through there. I think we're starting to see more of these firms, some that are looking to partner with Goldman Sachs with their accelerator program. I think we're going to see more. The ETF space is going to keep getting bigger.

That's a good thing for you and I covering this space. It certainly is. I've been doing this 20 years covering ETS and it amazes me. Up, down markets, the inflows just continue. Todd, thanks very much for joining us. Todd Rosenblum is the head of research at VETify. And thank you for listening to the ETF Edge podcast. Invesco, QQQQ,

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