AIQ: Portfolio Mismatch Due To Stock Selection Methodology (NASDAQ:AIQ)

Summary

Artificial Intelligence is the dominant investment mega trend followed by Interest Rate cuts, Inflation, India, Clean Energy, and so forth. Nvidia (NVDA) and a select group of semiconductor supply chain companies as well as companies affiliated with Open AI’s Chat GPT service are at the forefront of the AI theme. Thus, I analyzed one of the larger AI-focused ETFs the Global X Artificial Intelligence & Technology ETF (NASDAQ:AIQ) to gauge its suitability as a diversified tool to gain exposure to this megatrend. The conclusion was surprising, I found that the stock selection methodology favored companies that use AI in their products or services or that sell AI as a service, which means that its portfolio has a greater focus on the later stage development of AI vs the current high growth infrastructure stocks to build out and deliver large language models.

ETF Selection Traps

There are many ETFs with a Robotics and Autonomous Tech focus that incorporate AI into the strategy or marketing since AI is a newer phenomenon that has wholly dominated the investment world. Thus, it’s important for investors to at least scan the top holdings of these ETFs to gauge if they can provide a clear and direct exposure to AI. The following is a list from a well-known database provider when searching for AI-focused ETFs. As can be seen many are more broadly technology-focused or include robotics and other themes. I selected three peers for performance comparison. Invesco AI and Next Gen Software ETF (IGPT), WisdomTree Artificial Intelligence and Innovation Fund ETF (WTAI), and Amplify AI Powered Equity ETF (AIEQ).

Performance

AIQ is a relatively new ETF with a track record going back to mid-2019. I used performance data from the start of 2020 to compare AIQ to the more relevant peers as mentioned above. The ETF has performed quite well since inception, up 126%, but was outpaced by WisdomTree Artificial Intelligence and Innovation Fund ETF (WTAI) which may warrant a closer analysis in the future.

Index Methodology is Focused on AI Usage

Global X uses the Indxx Artificial Intelligence & Big Data Index to construct the AIQ portfolio. The Index methodology utilizes a two-tier focus for stock selection where the 1^st category is focused on the top 60 companies that develop and use AI in their products or services or that sell AI as a service. The 2^nd category is the top 25 companies that build hardware such as semiconductors, servers, etc. Even though the 1^st category is in its infancy the portfolio has a lower weight in the 2nd category of under 25%. It seems to me that the index construction is tilted to when companies use and sell AI which is more likely to be in the next few years and thus the ETF may be handy capped during the build-out stage i.e. when semiconductors, servers, etc., see significant growth.

Portfolio Price Target Upside of 9%

The ETF has 84 stocks of which I gathered consensus estimates on 34 or 81% of AUM which provides for a high statistical data set from which to derive accurate estimates. The weighted average upside potential of the portfolio is just 9% and barring Adobe (ADBE) the only main stands out are Chinese companies such as Tencent (OTCPK:TCEHY), Alibaba (BABA), and Meituan (OTCPK:MPNGF) with analyst upside estimates over 39%.

As can be seen, the AIQ portfolio is not dominated by AI infrastructure companies such as Nvidia (NVDA), Analog Micro Devices (AMD) Arista Networks (ANET), or Super Micro Computer (SMCI) but rather future AI users and service providers that do not yet have a significant growth footprint from AI, which is why this ETF may underperform key AI infrastructure players in the current cycle of development.

In addition, the Chinese companies have considerable headwinds as I wrote about in the article about (KWEB) KraneShares CSI China Internet ETF.

Revenue & Net Margins

Using the consensus data, I calculated that the ETF has over 10% revenue growth rate in the YE24-25 period driven by Nvidia, Meta (META), and Broadcom (AVGO), the latter due to the merger with VMware. Net margins are expected to increase from 16.6% to 20.5%, a massive gain driven more by cost normalization at a few companies that had low or negative margins in 2023 such as Samsung Electronics (OTCPK:SSNLF), Intel (INTC), Micron Technology (MU) and SK Hynix. Thus, in my view, the margin gains may not be sustainable beyond 2025.

EPS Growth of 17%

The consensus data points to high EPS growth of over 17% in the YE24-25 period driven by over 60% growth at Nvidia, 42% at Amazon (AMZN), and 32% at Netflix (NFLX). If you’re asking what Amazon or Netflix have to do with AI you’re not alone and this is indicative of the ETF stock selection method that focuses on companies that are likely to benefit from the utilization of AI in their business model despite not deriving significant earnings from this yet. Despite the stock selection drawbacks, the portfolio does have a high EPS growth profile which many investors may appreciate despite the AI exposure mismatch.

Valuation

I calculated that the ETF is not at all expensive at a 1.4x PEG (PE to EPS Growth) despite trading at over 24x PE on YE24 earnings estimates. The PEG is a relative valuation metric where a 1x ratio is viewed as fair i.e. EPS growth is the same as PE. The two recent analysis I conducted on the NASDAQ (NDX) via Invesco QQQ Trust (QQQ) and the S&P 500 (SPX) via the iShares Core S&P 500 (IVV) generated PEGs of 1.8x and 1.5x, respectively, suggesting that this ETF is cheaper than the market but has a high growth potential.

Conclusion

I rate AIQ a Hold. In my view, the ETF does not deliver compelling exposure to the current stage of AI development (infrastructure build-out) and instead is more focused on selecting stocks in the next stage of development, which is the use of AI by companies to deliver their product or service as well as sell AI as a service. The logic is not wrong but perhaps the selection and weights could be inverse to deliver investors better returns.