Top Strategists Share 5 Ways Investors Can Hedge the AI Trade

Key Takeaways

• The booming buildout of AI infrastructure is impacting financial market performance more in both stocks and bonds.
• Many stock sectors that once diversified against big tech and AI are now much more correlated with the industry.
• Strategists say dividend payers, quality companies, and alternative strategies can diversify against AI risk.

The artificial intelligence trade keeps driving momentum in the market, and not just in tech and semiconductor stocks. Across sectors, major indexes, and style box categories (think value stocks), investor fortunes are increasingly tangled with AI. Even the bond market—the conventional hedge against risk and volatility in stocks—isn’t exempt, and neither is private equity.

“There’s a lot of money cross-purposed in this industry,” says Steve Sosnick, chief strategist at Interactive Brokers. “If you’re just putting the money … into an S&P 500 index fund, like it or not, you’re 45% or more invested in AI,” he says, referring to the proportion of the index comprising AI-linked stocks.

Wall Street pros have warned about this type of concentration risk for years, but it’s arguably grown more acute as the AI buildout has gained steam, now encompassing credit markets as well as a larger swath of the equity market. “It’s a bit of an unnerving moment,” says Michael Clarfeld, a manager of the dividend strategy at ClearBridge Investments.

Hedging that risk can be a tough trade-off for investors, since the AI trade continues to drive the market to new highs. That’s why Olaolu Aganga, head of portfolio construction and analytics at Citi Wealth, emphasizes that it’s not enough to diversify only for diversification’s sake: “We need to make sure the diversification we are seeking is also generating returns.”

Method 1: Sector-Based Diversification

Investors looking for a sector-based approach to diversification should keep in mind that traditional diversifiers away from tech may no longer serve that purpose, according to ClearBridge’s Clarfeld. “You need to be really mindful.”

Energy and utility stocks, for instance, are now linked to big tech through the data center buildout. The same is true for some industrial companies, especially heating and cooling firms. Similarly, some alternative asset managers are involved in financing those AI projects. Shares of newly AI-linked sectors can and do slide when investors get nervous about the trade’s durability.

Many managers like healthcare as a diversifier because it’s relatively unconnected to the AI trade, but that comes with plenty of its own downside risk. It’s “very idiosyncratic,” says Citi’s Aganga, “driven by policy decisions and governments,” which can be challenging going into elections. She says she tends to avoid that type of risk, and because of this, she doesn’t particularly like the healthcare sector as a diversifier.

Instead, Aganga says she likes the second- and third-order beneficiaries of AI, like cybersecurity firms. “The bigger [the technology] gets, the more the need for cybersecurity and to protect your data at an enterprise level, at an individual level.” Another example is the commodity firms that provide steel and copper to expand the power grid for data centers. Aganga says those could benefit as the AI buildout continues, but there are also demand drivers beyond AI in the mix.

Method 2: Quality Companies

Kristy Akullian, head of iShares investment strategy for the Americas at BlackRock, says that for investors looking to dive deeper than the sector level, identifying quality businesses can help reduce some of the risk associated with the crowded AI trade. “It’s not taking any big sector bets. It’s actually staying relatively close to the broader market, trying to identify the stocks with higher profitability, more stable earnings, and stronger balance sheets,” she explains. She says firms that meet these criteria are also likelier to outperform than their peers when interest rates are elevated.

For ClearBridge’s Clarfeld, that means looking to established businesses like elevator firm Otis Worldwide OTIS, insurer Marsh MRSH, and Honeywell Aerospace HONA. While these stocks aren’t exactly hidden gems, he views them as compelling buys because of their low valuations and distance from the AI trade.

“We have our highest-conviction portfolio in a very long time because we’ve been able to buy these things that we know are great businesses at very reasonable prices,” Clarfeld says. “There’s this big question of what’s going to happen in AI, and nobody knows.” But with quality businesses elsewhere in the market, “you don’t have to be brilliant enough to predict what’s going to happen with AI. You just look at the traditional investment considerations around risk and return and current yield, and you can make the math work.”

Method 3: Dividend Stocks

BlackRock’s Akullian says dividend stocks are another attractive way to hedge against AI risk.

First, she says the sectors associated with higher dividend payers tend to be more value-oriented, and therefore less associated with big tech and less susceptible to AI-related disruption.

Second, Akullian draws a line between the long-duration AI trade, which requires investors to bet on earnings growth and cash flows years or even decades into the future, and shorter-duration dividend stocks. When rates rise and investors get nervous about AI’s prospects and ballooning capital expenditures, AI-linked stocks come under pressure. On the other hand, dividend stocks are all about near-term cash flows.

“Dividends are almost definitionally a way to hold stocks that are not overspending on capex,” Akullian explains. “Instead of capex, they are choosing to return cash to shareholders.” That “makes for a really useful counterbalance to the long-duration nature of many of the AI stocks.” Dividend stocks are outperforming the broader market this year, with the Morningstar Dividend Leaders Index up more than 19%, compared with 13% growth for the Morningstar US Total Market Index.

Method 4: Bond ETFs

When it comes to AI, strategists say bonds are no longer the diversifier they used to be. Much of the bond market is tied up in massive borrowing to fund AI infrastructure. And with rates rising, fixed-income investors aren’t seeing their bond holdings provide as much ballast against volatility in equities.

BlackRock’s Akullian says her team is fielding questions about how to diversify away from the AI theme in fixed income and stocks. She points out that recently, a third of new long-duration debt issuances in investment-grade credit have come from hyperscalers borrowing billions to fund the AI infrastructure buildout. The same dynamics are at play in high-yield markets, and even in some securitized debt markets.

“We have to be really thoughtful about what parts of our portfolio have different return drivers, and so increasingly as the same companies that represent large, concentrated positions in equity indexes are making up a bigger share of representation in fixed income indexes as well,” Akullian says.

Within fixed income, Morningstar associate director of manager research Daniel Sotiroff says ETFs tracking the bond market are still a good way to diversify away from the theme. They’re “less volatile than stocks, and their yields are more attractive than they have been in years. That means they’re far less likely to incur losses when the stock market dives, as they did in 2022,” he writes.

Method 5: Alternative Assets

Alternative assets like gold and commodities can also diversify a portfolio, since they often have different return drivers compared to AI-linked equities or bonds. Aganga of Citi Wealth likes gold, which can function as a fixed-income placement and a return stream uncorrelated with the rest of the market.

BlackRock’s Akullian adds that alternative strategies, like hedge fund strategies or even long and short strategies, are accessible to investors via mutual funds or ETFs, and can drive returns uncorrelated with the rest of the market.

The Bottom Line for Investors

In all, strategists say the amount of AI risk in a portfolio should depend on an individual investor’s tolerance and goals. “At the end of the day, it’s about building a portfolio that you are comfortable with,” says Akullian. “There are no rewards without risk,” but long-term investors should aim to hedge that risk enough that they won’t be compelled to sell if the market falls.