An ETF for the Rise of the Machines

The machines are coming. Robotics and artificial intelligence are no longer just products of Hollywood. Businesses are increasingly using these tools to reduce costs, improve efficiency, and better serve customers. Adoption is likely still in the early stages, as advances in technology improve these machines’ capabilities and make them cheaper.

Global X Robotics & Artificial Intelligence ETF BOTZ offers a good way to profit from this trend, though it isn’t for the faint of heart. This compact portfolio has considerable exposure to firm-specific risk, and it is far from cheap. But this focus allows it to deliver clean exposure to firms that are likely to benefit from the growth of this technology.

A Durable Trend The business case for automation is strong. Labor costs in emerging markets, where many firms have located much of their labor-intensive operations, have risen considerably over the past two decades. The rise of protectionism has made offshore production less appealing. Yet, relying on low-wage labor in the United States and other developed markets presents environmental, social, and governance risk, as firms may be accused of paying less than a living wage. There's also a risk that minimum wages could increase. The novel coronavirus crisis exposed further problems with relying heavily on manual labor, as production slowed in labor-intensive factories.

Automation can help companies reshore operations, reduce labor costs, and mitigate potential supply chain disruptions. Machines don’t get sick or tired, they don’t form unions, and they tend to be more consistent than humans, allowing for greater quality control. Simple repetitive tasks are most conducive to automation, but technological advances are allowing machines to handle more-complex tasks, from enabling vehicles to drive themselves to analyzing medical images. Beyond streamlining operations, AI can help firms improve their marketing efforts with more targeted ads and promotions.

It’s clear that robotics and AI will become a bigger part of how business is done and more integral to many consumer products in the future. That’s not sufficient to make a robotics and AI exchange-traded fund like BOTZ a good investment. The market is well aware of this growth opportunity. It’s the reason many companies positioned to directly benefit from these trends are trading at rich valuations. Yet there may be more room for these firms to surprise on the upside, as the opportunity is big and will probably become larger over time, as advancements in technology expand what is possible.

Competition could erode the profitability of the early leaders in this segment. While this risk is unavoidable, ETFs can mitigate the risk of losing to new entrants by investing in them if they are publicly traded.

Strategy Overview BOTZ is one of the better options for exposure to robotics and AI because it has stricter requirements for inclusion than its closest peers. As such, it offers a narrower portfolio of companies that are poised to benefit directly from growing adoption of this techology. This gives it considerable exposure to firm-specific risk. But it also doesn't water down the fund's exposure to the firms that will likely benefit the most from this trend. Still, this fund would work best as a small satellite position in a diversified portfolio.

This fund replicates the Indxx Global Robotics & Artificial Intelligence Thematic Index. This strategy targets developed-markets stocks that generate most of their revenue from business activities linked to robotics, industrial automation, AI, or autonomous vehicles (including drones). This is a high hurdle that filters out firms that develop robotics and AI if their business is more closely tied to other products.

The index is willing to consider firms that don’t clear that hurdle only if fewer than 30 stocks would make the cut. But even then, firms must still have a core competency in robotics or AI, or be otherwise positioned to facilitate the adoption of those technologies. Stocks that make the cut are weighted by market cap, subject to an 8% cap when it rebalances each year.

Portfolio Not surprisingly, this is a concentrated portfolio. It includes 31 stocks, and the top 10 of those represent nearly two thirds of its assets. This concentration partially owes to the fund's market-cap-weighting approach. The fund's closest peers use a form of equal weighting to better diversify risk. While it would be nice if the portfolio were less top-heavy, market-cap weighting tilts the portfolio toward larger firms, which tend to be more profitable.

The fund’s top holdings include firms like Nvidia NVDA, ABB ABB, and Intuitive Surgical ISRG, which all have considerable direct exposure to robotics or AI. Nvidia is well-known for its PC graphics cards, but it also makes graphic processing units with applications for AI training and autonomous driving. ABB develops industrial robotics and automation solutions, while Intuitive Surgical makes robotics for surgery.

The portfolio has some exposure to foreign-currency risk, as most of its assets are invested outside the U.S. Japan and the U.S. represent the portfolio’s top country weightings. Its holdings also primarily fall in the industrials and technology sectors.

Valuations here are high but not extreme. The fund’s holdings look expensive relative to forward earnings, but they look cheaper relative to book value and sales, trading at lower multiples of those metrics than the constituents of the Russell 1000 Growth Index. Consensus long-term earnings growth estimates presented in Morningstar Direct suggest the market has similar growth expectations for the holdings of this fund and the Russell 1000 Growth Index.

It’s prudent to keep a close eye on valuations, but it appears that the market hasn’t become overly enamored with these stocks yet. That may be partially because the fund’s holdings currently generate lower returns on invested capital than the constituents of the Russell 1000 Growth Index. As adoption of AI and robotics grows, that may change.

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