All you need to know before investing in the AI boom

Stocks in artificial intelligence companies have been on a tear this year and could boost your portfolio in 2021

2AT4N5E DJ android, disc jockey robot with microphone playing music on turntables, cyborg on stage with deejay audio equipment, back view, 3D rendering. Alamy
Beta V.1.0 - Powered by automated translation

Once the province of science fiction, artificial intelligence is today widely used by businesses and tech start-ups. The power of AI – which includes subfields like machine learning, natural language processing and computer vision – means it can be used by companies to obtain a huge competitive advantage, whether it’s discovering a new medicine or suggesting new products for customers to buy or movies to stream.

The impact can be seen in the market, where even amid the heady growth of tech stocks in 2020, the performance of AI companies and some AI-focused investment funds stand out. And with McKinsey estimating that the economic benefit of AI for the global economy could be as high as $15 trillion over the next decade, there’s no reason to believe the party is over – even as some analysts question sky-high valuations of tech stocks.

“Every industry is being transformed by AI, and this will only accelerate in the current economic environment as companies look to improve productivity, reduce costs, and enhance human-machine collaboration,” Masroor Batin, chief executive of wealth management for the Middle East and Africa at BNP Paribas, says.

The importance of AI has been proven across multiple areas of the economy in a Covid-19 dominated 2020. Not only are major corporations upping their investments in IT, including AI, cloud and cybersecurity, AI has also played a critical role in accelerating the development of technologies to combat the Covid-19 pandemic.

Nevertheless, investing in AI is less clear cut than investing in, say, solar energy producers or e-sports companies. For one, there is no firm definition of what constitutes an AI company.

And with so much hype around AI, investors need to be able to separate the wheat from the chaff, “For [AI] to be meaningful, it has to produce an exponential benefit, not just be marketing hype,” says Matt Ocko, co-managing partner at venture capital firm DCVC.

What’s an AI company?

The good news for investors is that those with diversified equity portfolios will already have exposure to some of the world’s most successful AI companies – in the United States, that’s familiar big cap names like Google, Amazon, Microsoft, Apple, Tesla and Nvidia.

Voice assistants such as Siri and Alexa use AI to power conversations; Google, Amazon and Microsoft provide machine-learning-as-a-service to many other companies; and Google and Amazon use AI to serve customised ads and make product suggestions.

FILE - In this Sept. 5, 2014, file photo, the Apple logo hangs in the glass box entrance to the company's Fifth Avenue store in New York.  Companies like Apple and Walt Disney as well as Walmart's philanthropic foundation are investors in a $23 million venture fund aiming to use tools like artificial intelligence and blockchain technology to improve global labor practices. Working Capital was launched Tuesday, Jan. 30, 2018  by Humanity United, a foundation that's part of the Omidyar Group started by the founder of eBay, Pierre Omidyar. (AP Photo/Mark Lennihan, File)

AI companies can be split into two groups: large service providers and specialist niche players, according to Michael Topley, head of sustainable portfolio management at Barclays Private Bank.

Large cap technology stocks already enjoy strong cash generation, market leadership and often a good track record of capital allocation through acquiring emerging technologies, while as providers of AI services they will enjoy classic network effects as they attract more users, he believes.

“This AI will be something akin to the internet – an omnipresent service that you can access for all your cognification needs. The companies providing these services will likely enjoy increasing rates of return to scale and strong barriers to entry,” he says.

Meanwhile, niche players may prove to be attractive investments, investors could be taking on “idiosyncratic risk around the efficacy of their algorithms, the size of their addressable markets and their ability to fend off competition”, Mr Topley says.

Although some parts of the technology space seem overheated, “there is a very good reason for the price appreciation many of these names have enjoyed, and my conviction in the ability of these companies to generate cash flow in the future has further increased since the start of the year”, Mr Topley says.

Looking beyond large caps

For investors convinced of AI’s transformational capabilities, there are a number of thematic investment funds that can provide broader exposure to the sector.

Actively managed funds include Allianz Global Artificial Intelligence fund, which has returned around 64 per cent year to date. Another actively managed fund is ARK Innovation ETF, which covers a broad technology swathe such as AI, autonomous vehicles and robotics, and is up around 83 per cent so far this year.

One element that both funds have in common is that their single largest holding is Tesla, which, at its peak in December, was up more than 600 per cent since January 1.

Jeremy Zhou, vice president and head of indexing solutions at FactSet, says they typically look for “pure play” companies that generate about 50 per cent of revenue from a specific industry or technology when constructing an index related to a theme like artificial intelligence.

When you are dealing with pure play companies, generally the likes of Google, Amazon, and Facebook are going to get kicked out [of the index], or at least will retain a very small weight

“When you are dealing with pure play companies, generally the likes of Google, Amazon, and Facebook are going to get kicked out [of the index], or at least will retain a very small weight due to the broad nature of their businesses,” he says.

FactSet has constructed a number of indices around AI, including one that is tracked by the iShares Robotics and Artificial Intelligence Multisector ETF, which has returned above 40 per cent this year.

When it comes to thematic funds, many combine AI with verticals including robotics, manufacturing and healthcare – Mr Zhou says these sectors have been the early adopters of AI.

But adoption is speeding up, and AI is increasingly playing a role in consumer sectors. In May, ROBO Global, an index and research company, launched a new pure play AI ETF, following on from two existing ETFs covering AI in robotics and in healthcare.

"The timing was right for this fund because we see an inflection point in artificial intelligence. We think it's going to be a major driver of innovation and growth across many industries,” says Lisa Chai, senior research analyst at ROBO Global.

Ultimately, the value of AI lies not in the technology and algorithms themselves, but in organisations' abilities to harness them, says Ms Chai. “Investors should pay attention to the innovation impact that AI is making ­– we think that there will be clear winners in this space as adoption of AI matures over the next decade.”

Despite the optimism, Ms Chai says it’s important to dig deeply into a company to see how it’s using AI, and the investments it’s making, such as hiring data scientists, since some companies play up the role that AI has within their business to take advantage of the hype.

That view is echoed by Mr Ocko, who says that some companies utilise AI in a manner that’s performative, applied to older undifferentiated technology, or even “just cynical marketing”.

Could a backlash hit valuations?

While the business outlook for AI may seem to be an open-and-shut-case, it remains questionable how much of AI’s impact will be positive and how much will be negative – something that could spark a backlash against AI companies. Contentious areas include facial recognition, racial biases, deep fakes, and the amplification of disinformation via social media networks, including the rise in conspiracy theories such as anti-vaccination.

McKinsey estimates that the economic benefit of AI for the global economy could be as high as $15 trillion over the next decade. Reuters

On the positive side, the impacts of AI-driven technologies are vast, such as detecting criminality or automating risky and dangerous jobs. With the need to reduce human contact amid the pandemic, some of these processes have multiplied. "Companies have been forced to adopt smarter, faster, lower cost, more human beneficial approaches. And if there's any silver lining for the pandemic it's that this society-wide good has been accelerated," says Mr Ocko.

But at the same time the pandemic has highlighted the dangers of the spread of disinformation.

Companies are already seeing a backlash against AI, but this is leading tech companies to self-regulate, Ms Chai says.

Funds also have ESG screens in place, while regulators have a role to play, she adds.

“It’s a little bit of a wild west at this moment as to how these technologies are being used. But right now we're starting to see a lot of the consortiums, and academia and technology companies and policy-led players working together [to develop standards],” she says.