Can the Mega-Caps ‘Magnificent 7’ Continue Outpacing the Rest of the Market?

Photo by Jametlene Reskp on Unsplash

2023 was the year of Artificial Intelligence (AI)

Investors in stocks hope for AI to be the next super-boom.

They hope to outperform the market for years to come.

They hope that the rally continues, especially in those companies that have performed superbly well and carried the stock market to new all-time highs:

A group of the largest companies on the planet dubbed the ‘Magnificent 7’. They include Apple, Microsoft, Nvidia, Alphabet (Google), Meta (Facebook, Instagram), Amazon, and Tesla.

These stocks have soared most in the wake of the AI rally.

In a blog post titled Are We in a Stock Market Bubble? from February 29, 2024, hedge fund legend Ray Dalio proposed that, while the stock market as a whole shows no conclusive sign of being overheated, the Magnificent 7 are “frothy” indeed:

Ray Dalio assesses the US stock market as being in a bubble when his Bubble Gauge is above the black line. That is currently not the case. (Screenshot from his blog post titled Are We in a Stock Market Bubble? from February 29, 2024)

Then he goes on to address the pink elephants in the room:

The “Magnificent 7” has driven a meaningful share of the gains in US equities over the past year. The market cap of the basket has increased by over 80% since January 2023, and these companies now constitute over 25% of the S&P 500 market cap. The Mag-7 is measured to be a bit frothy but not in a full-on bubble.

So, not in a bubble yet but frothy. That means it could go further up while a hefty double-digit percentage set-back is possible at any time.

The thing is, if you want to invest in AI and are not expert enough to pick individual stocks in the field, you’ll have to invest in some kind of index that covers companies that have benefited and prospectively will continue to benefit from ChatGPT and all its relatives.

Who’s that going to be? Correct: Primarily the Mag 7.

Take the Morningstar Global Next Generation Artificial Intelligence (AI) Index for instance. This AI stock index assembles a basket of stocks that are larger than large: so-called ‘mega caps’.

They are the largest of the large companies (vertical axis in the chart below), and they are considered “Growth” stocks rather than “Value” or “Blended” stocks because of current up-trends in their revenues and earnings (‘Gwth’/’Val’/’Bld’ on the horizontal axis in the chart below).

The stock style map of the Morningstar Global Next Generation Artificial Intelligence (AI) Index on Morningstar.co m, Screenshot taken on Jan 4, 2024

If you invest in an index like this, for example by buying shares of an ETF (What is an ETF?) that tracks an AI-focused index such as ticker symbols BOTZ or AIQ, you’d inevitably invest in the largest of the largest companies in the world.

You’d be outside the box, see the graph above, but you wouldn’t think outside the box.

Since, according to Ray Dalio, the Mag 7 are “frothy” while the rest of the market isn’t, maybe it’s time to look beyond the largest firms.

Fortunately, not all AI-themed indices are constructed like the one above. Some ETFs include medium and smaller companies in their make-up.

I researched two ETFs that seem to capture the entire spectrum of company sizes while investing in the AI theme: IRBO and WTAI.

Let’s look at them in a little more detail.

Please note: Don’t interpret the following presentation as a recommendation or an endorsement nor as personalized investment, financial, legal, or tax advice. It is simply intended as general information for your investment process. Please read the disclaimer at the end of this article. For personalized investment advice, you can work with me here.

IRBO — iShares Robotics and Artificial Intelligence Multisector ETF

This ETF tracks an index that invests globally, not just in the US. In its most recent fact sheet and according to its website:

The iShares Robotics and Artificial Intelligence Multisector ETF seeks to track the investment results of an index composed of developed and emerging market companies that could benefit from the long-term growth and innovation in robotics technologies and artificial intelligence.

What is interesting to note is that this index is constructed using equal weights. That means that the largest companies are not weighed more heavily just because they are worth more (and vice versa for the smallest companies). Instead, each stock gets an equal weight in the portfolio, enhancing the relative importance of smaller companies.

IRBO’s style map (blue dot and oval) shows that its portfolio consists of smaller companies than the AI index above on average while still being invested in growth stocks (Screenshot taken from Morningstar’s website on March 6, 2024)

WTAI — WisdomTree Artificial Intelligence and Innovation Fund

The investment objective of the second ETF is somewhat similar to the first one shown above. WTAI’s website states:

The WisdomTree Artificial Intelligence and Innovation Fund seeks to track the price and yield performance, before fees and expenses, of the WisdomTree Artificial Intelligence & Innovation Index, which identifies companies that are primarily involved in the investment theme of AI and Innovation.

The index it follows is neither a market-cap-weight nor an equal-weight index like the ones above but allocates its components by committee decision “based upon quantitative and qualitative criteria” (according to WisdomTree’s index methodology PDF, page 113).

Consequently, smaller companies have a good chance to get more significance in this index than their market cap would imply. They do as of now:

WTAI’s style map (blue dot and oval) shows that its portfolio is made up of smaller companies on average than the mega-cap-centered AI index above while being dedicated to investments in growing firms (Screenshot taken from Morningstar’s website on March 6, 2024)

Watch out, though: By nature of being invested in smaller companies than the sector average, their price volatility will likely be higher than if you put your money into large and mega caps. You must be able to stomach and sustain the larger amplitudes of ups and downs if you want to successfully invest here.

Will the AI rally continue in 2024 and beyond?

And if so, will the Mag 7 be on the forefront once again or will smaller companies have better gains?

Nobody knows for sure.

If and when you include any investment into your portfolio, including the ones presented above, make sure to not get greedy, to assess all risks involved by reading each fund’s prospectus, and to diversify your investments prudently. That way, you’ll benefit from market advances while being protected from the inevitable downside risk.

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The information in this article is not an offer or solicitation of an offer to buy or sell specific securities. Nor does it constitute personalized investment, financial, legal, or tax advice. It is for educational purposes and general information only and presents the author’s opinions which are subject to change without notice. Research for this article was done thoroughly from sources the author believes to be reliable and trustworthy, but the author cannot guarantee that the presentation is complete or correct.

Investments in stocks, ETFs, and other securities can lose value. There is no guarantee that this information will lead to investment returns or profits. Historical results and analysis are not a guarantee for future results. Model portfolio returns may not be achievable by all investors.

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