Assessing the Tactical Case for AI ETFs After a Recent Pullback

The recent pullback in AI-focused ETFs has created a clear divergence from the broader market. Over the last month, the Ark Next Generation ETF (ARKW), the iShares Future Exponential Technologies ETF (XT), and the Roundhill Generative AI & Technology ETF (CHAT) have all posted losses, even as the S&P 500 has shown a gain. This underperformance stands in stark contrast to their strong historical returns, which frame the current weakness as a potential candidate for mean reversion. ARKW, for instance, boasts a one-year return of 38.7%, while CHAT's gain has been nearly 50%. XT's one-year return of 26.2% also indicates this is a minor hiccup relative to its own track record.

This setup is unfolding against a turbulent 2025 backdrop. The year was marked by the rise of low-cost AI initiatives from China, persistent tariff uncertainty, and intensifying overvaluation concerns in the AI space. These headwinds contributed to a volatile market, with the S&P 500's 18.1% year-to-date gain as of late December masking significant swings. The pullback in these specialized AI ETFs can be seen as a reaction to that specific mix of competitive pressure and valuation reset, even as the broader index found a path higher.

For a portfolio manager, this creates a tactical tension. The historical outperformance suggests these funds are fundamentally positioned for long-term growth. Yet their recent underperformance relative to the S&P 500 introduces a new layer of risk-namely, the possibility that the valuation premium they command may be more fragile than previously thought. The question now is whether this gap represents a temporary dislocation or the start of a longer-term repricing.

Portfolio Construction and Risk-Return Characteristics

The structural differences between these AI ETFs and broad market indices are fundamental. They are not simply tech funds; they are concentrated, actively-managed thematic bets. This creates a distinct risk-return profile that demands a tactical, not core, allocation.

Take CHAT as the clearest example. Its portfolio is built for alpha, not diversification. It holds just 47 stocks, with the top 10 representing roughly 45% of the portfolio. This extreme concentration, combined with a 92% annual turnover rate, means the fund is in constant flux, chasing the latest AI winners. This active, high-conviction approach is costly, with an expense ratio of 0.75%-over eight times higher than the Vanguard Information Technology ETF (VGT). The result is higher volatility, as measured by its beta of 1.63 versus VGT's 1.25, and greater tracking error against a broad benchmark.

ARKW and XT follow a similar high-conviction, thematic playbook. While their exact concentration metrics are not detailed in the evidence, they are explicitly actively-managed funds focused on exponential technologies and AI. This positions them as pure plays on a specific growth narrative, carrying significant thematic risk. Their performance is tied directly to the success and capital expenditure of a narrow set of companies, like the hyperscalers that CHAT targets. As one analysis notes, consensus estimates for 2026 capex by AI hyperscalers now stand at $527 billion. This spending is the engine for these ETFs, making their returns highly sensitive to a single macro variable.

For a portfolio manager, this defines the investment case. These ETFs should be considered tactical, high-conviction bets with a defined risk budget. They are not substitutes for diversified equity exposure. Their higher expense ratios erode returns over time, and their concentration and volatility introduce significant drawdown risk. The recent pullback is a reminder that thematic bets can reprice sharply when growth expectations shift. In a portfolio context, they offer a way to gain targeted exposure to a powerful trend, but only if allocated with discipline and an understanding that they are a source of alpha, not a source of stability.

Valuation, Catalysts, and Forward-Looking Scenarios

The path for AI ETFs hinges on a single, massive catalyst: the capital expenditure plans of the hyperscalers. Consensus estimates have risen sharply, now projecting 2026 capex by AI hyperscalers at $527 billion, up from $465 billion at the start of the third quarter. This spending is the direct engine for the companies these ETFs hold, from the cloud providers themselves to the semiconductor and infrastructure partners. For a portfolio manager, this represents a powerful, forward-looking tailwind. It suggests the underlying demand thesis for AI infrastructure remains intact and is accelerating, providing a fundamental basis for mean reversion in performance if the current pullback is purely a sentiment-driven event.

Analyst commentary reinforces this durable demand narrative. Recent reports highlight continued AI-driven growth for major cloud providers and their partners, framing the hyperscaler capex as a structural investment, not a cyclical spike. This is a key point: the spending is about building the future compute layer, which supports the long-term alpha potential of these thematic funds. The risk, however, is that the market becomes more selective. As noted, analysts have become more selective, rotating away from AI infrastructure companies where operating earnings growth is under pressure. This points to a bifurcation where only the purest plays on capex-to-revenue conversion will be rewarded.

The primary risk to the mean reversion case is a broader rotation away from growth themes. The recent pullback could be an early signal of that shift, especially if economic data or Federal Reserve policy begins to prioritize inflation control over growth. The 2025 backdrop was already turbulent, marked by sticky inflation, persistently high interest rates, and overvaluation concerns. If those pressures return, the premium valuations of concentrated AI ETFs would face renewed pressure. Their high volatility and concentration make them particularly vulnerable in a risk-off environment, where investors seek stability over thematic growth.

In practice, this creates a tactical setup. The $527 billion capex projection is a powerful bullish signal that should support the ETFs' valuations. Yet the recent underperformance against the S&P 500 indicates the market is already pricing in some of this risk. For a portfolio manager, the decision is about timing and conviction. The catalyst is clear and large, but the execution depends on macro conditions. A disciplined approach would be to view any further pullback as a potential entry point for a tactical allocation, but only with a clear stop if the broader rotation into value or defensive sectors accelerates. The forward-looking scenario is one of high potential return, but it is not without its own volatility.

Catalysts, Timing, and Risk Management

For a portfolio manager, the tactical case hinges on specific, near-term catalysts that will signal whether the current underperformance is a buying opportunity or the start of a deeper trend. The primary event to watch is the first-quarter earnings season for the hyperscalers. These reports will provide the first concrete data on whether the projected $527 billion in 2026 capex is translating into actual spending momentum. Any guidance that confirms or exceeds the consensus estimate would be a powerful bullish signal for the entire AI infrastructure chain, directly supporting the holdings in funds like CHAT. Conversely, any indication of moderation or uncertainty in capex plans would be a major red flag, likely pressuring the ETFs further.

Beyond the macro spending numbers, the quality of the underlying earnings growth matters. Analysts have become more selective, rotating away from AI infrastructure companies where operating earnings growth is under pressure. This suggests that for an ETF to generate alpha, its holdings must demonstrate a clear path from capex to revenue and profit. The recent positive commentary on Meta's acquisition of Manus for AI agents is a case in point-it highlights a specific, high-conviction growth story within the broader theme. A portfolio manager would need to see similar evidence of durable, profitable growth across the basket to justify a tactical allocation.

The high cost of these thematic bets cannot be ignored. The expense ratios, like CHAT's 0.75%, are a persistent drag on returns. This means the ETF must not only outperform the market but also outperform by a margin that exceeds its fees to generate net alpha. For a tactical allocation, this cost structure is acceptable only if the manager has high conviction in the specific catalysts and is willing to accept the fund's inherent volatility. These are not low-cost building blocks for a diversified portfolio; they are high-conviction, high-cost bets.

Given their concentration, active management, and sensitivity to growth cycles, these ETFs should be treated as tactical allocations with a defined risk budget. Their correlation with broader market cycles and potential for sharp drawdowns means they are not a source of portfolio stability. The bottom line is that the setup requires disciplined timing. The $527 billion capex catalyst is real and large, but the recent pullback shows the market is already pricing in risk. A tactical entry would be justified on a further, sentiment-driven dip, but only with a clear stop if the broader rotation into value or defensive sectors accelerates. The risk management imperative is to allocate only what one can afford to lose, given the fund's structure and the current market uncertainty.