Anxious About an AI Bubble? ETFs to Help Navigate the Risk

The AI trade has been a key driver of the broader market rally, but the gains have been relatively narrow, increasing portfolio concentration risk and leaving investors more exposed to drawdowns and volatility in the technology sector. The weakness in technology stocks during June underscored these…

As per a CNBC article, in June, approximately $2.3 trillion was wiped off the combined market value of the Mag 7 as investors grew increasingly concerned about the sustainability of massive AI infrastructure spending and whether the expected returns would justify the significant capital outlays.

The selloff serves as a reminder of the risks associated with a market rally, driven by a handful of mega-cap technology stocks, and offers a glimpse of the potential downside if concerns over an AI bubble continue to intensify. Investor sentiment has also been pressured by rising debt-funded AI spending and the prospect of a more hawkish Fed, reigniting concerns of an AI bubble.

Against this backdrop, the tech-heavy Nasdaq Composite has declined about 4.23% over the past month, reflecting the recent deterioration in technology sector performance and reinforcing the importance of diversifying beyond the AI trade.

Tech Weakness Revives Bubble Concerns

Just as the AI trade has fueled the broader market rally, concerns about an AI bubble have grown alongside it. According to a Reuters article, stretched equity valuations, volatile fluctuations in the valuations of trillion-dollar companies, and bouts of sharp selling have reignited fears that parts of the U.S. equity market may be overheating.

Despite the strong long-term outlook for artificial intelligence, many investors remain skeptical of the rapid appreciation in AI and semiconductor stocks, fueling concerns that Wall Street may be inflating another speculative bubble.

BofA Global Research's proprietary Bubble Risk Indicator further underscores these concerns. As quoted on the abovementioned Reuters article, the indicator, which measures bubble risk on a scale of 0 to 1, assigns the PHLX Semiconductor Sector Index a score of 0.91 and the Technology Select Sector Index a score of 0.82. The elevated readings suggest that valuation risks remain pronounced across the technology sector.

Additionally, per LSEG’s head of earnings research, Tajinder Dhillon, as quoted on the Reuters article, the S&P 500's price-to-sales ratio has climbed to 3.22, far exceeding its historical average of 1.84, adding to concerns that parts of the market may be overvalued.

Although technology stocks have regained some footing, with the Nasdaq rising about 0.94% over the past five trading days and 2.07% on Monday, investors still have reasons to remain cautious. Elevated valuations and concentration risk suggest investors may benefit from reassessing their portfolio allocations and adopting a more diversified, defensive approach.

Why Should You Consider Defensive ETFs?

In an economic environment characterized by persistent volatility and uncertainty, reassessing portfolio allocations with a greater defensive tilt may allow investors to place more emphasis on capital preservation and downside protection while maintaining exposure to long-term growth opportunities and remaining invested.

While this approach is generally more conservative in nature, it can provide a more balanced risk-return profile. As a result, defensive funds may play an important role in enhancing portfolio stability and reducing volatility without sacrificing long-term participation in the market.

Increasing exposure to defensive ETFs while diversifying beyond the technology sector can help build more resilient portfolios and reduce concentration risk. A broader allocation across defensive sectors may also provide greater stability amid elevated market uncertainty and shifting investor sentiment. Against this backdrop, maintaining a long-term investment horizon while gradually allocating to defensive funds may prove beneficial for investors.

Defensive ETFs for Investors to Consider

Below, we have highlighted a few defensive ETFs that investors may consider to broaden portfolio exposure beyond the AI trade and reduce concentration in the technology sector.

Healthcare ETFs

The healthcare sector is non-cyclical, providing a defensive tilt to the portfolio amid market turmoil. Further, the long-term fundamentals remain strong, given encouraging industry trends.

Investors can look at funds like Health Care Select Sector SPDR Fund XLV and iShares U.S. Healthcare ETF IYH.

Quality ETFs

Amid market uncertainty, quality investing emerges as a strategic response and as a buffer against potential headwinds. This approach prioritizes identifying firms with robust fundamentals, consistent earnings and lasting competitive strengths. Investing in such high-quality companies can mitigate volatility for investors.

Investors can look at funds like iShares MSCI USA Quality Factor ETF QUAL and Invesco S&P 500 Quality ETF SPHQ.

Value ETFs

Characterized by solid fundamentals, such as earnings, dividends, book value and cash flow, these stocks trade below their intrinsic value, representing undervaluation.

Vanguard Value ETF VTV, iShares Russell 1000 Value ETF IWD and iShares S&P 500 Value ETF IVE could be appealing options.

Low-Volatility ETFs

Low-volatility ETFs seek to provide a smoother investment experience by focusing on stocks that historically exhibit lower levels of market volatility. These funds commonly favor defensive sectors, including healthcare, utilities and consumer staples, where earnings and demand tend to remain more stable during uncertain periods. This makes them attractive for investors looking to balance market exposure with downside protection.

Investors can consider iShares MSCI USA Min Vol Factor ETF USMV and Invesco S&P 500 Low Volatility ETF SPLV.

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