7 Best ETFs to Hedge Against an AI Bubble

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The artificial intelligence (“AI”) trade has had a good run over the past few years, with key tech stocks such as Nvidia (NVDA), Microsoft (MSFT), and Alphabet (GOOGL) posting strong returns. But with the stock market near all-time highs and growing fears of an AI bubble, some investors may want investments that can hedge their portfolio if AI stocks plunge.

The best exchange-traded funds (“ETFs”) to hedge an AI bubble may offer better relative returns than plummeting AI stocks and may offer absolute positive returns, at least in some cases. An ETF hedge may help you conserve cash for later when it’s time to invest more aggressively.

If the AI bubble bursts, it’s likely to lead to a recession with falling stock prices, declining GDP, and rising unemployment. In response, the Federal Reserve is likely to lower short-term interest rates to stimulate economic activity, including increasing business investment and spending.

So, the ETFs that may help investors ride out a bubble are those that typically benefit when the Fed lowers rates and investors suddenly begin looking for safer assets. These sectors include real estate investment trusts (“REITs”), utilities, preferred stocks, and bonds, among others. These kinds of investments typically pay out substantial cash, making them typical “turn to” investments for investors in tougher times.

These sectors benefit from lower rates in a few ways:

• For REITs and utilities, which use a lot of debt financing in their operations, the cost of debt is a key input in their cost structure. Lower interest rates make them more profitable.

• Lower rates also increase the value of these firms’ assets. When rates fall, real estate tends to become more valuable, and the value of cash-flowing investments rises.

• Cash-flowing investments such as REITs, utilities, preferred stocks, and bonds become more attractive as prevailing rates fall. That is, a security paying a 5% yield when rates are 3.5% becomes more attractive and valuable when rates drop to 1%, for example.

So, income-producing securities may hold up better in a downturn than the average stock, and they’ll pay cash while you wait, helping you amass cash for a later upswing in the market.

Best ETFs for an AI Downturn

The ETFs below include investments in REITs, utilities, preferred stocks, and U.S. Treasury bills. These sectors haven’t shown uniformly strong results over the past few years, as higher interest rates have hit some hard. So, lower rates in a recession should really boost these areas.

Still, each fund pays out substantial cash, which can help you weather a market downturn.

Funds consisting of preferred stocks offer high yields and the potential for major capital gains, at the cost of some downside risk. One fund below consisting of U.S. Treasury bills offers about as safe a short-term investment as you can find, giving you strong “optionality” when a down market eventually turns and it’s time to get back to investing in Big Tech stocks.

That’s generally the strategy here: Aim for lower but safer returns, so you can conserve capital in a down market, and then trade from these funds to higher-potential ones as the market turns.

More aggressive investors could consider some of the best dividend ETFs for strong returns.

1. Vanguard Real Estate Index Fund ETF (VNQ)

This Vanguard fund tracks the MSCI U.S. Investable Market Real Estate 25/50 Index, which includes REITs. REITs pay sizable dividends in exchange for not being taxed at the corporate level, and they have a strong, long-term track record.

The fund holds 140 positions, providing strong diversification across the sector, with the largest companies having the heaviest weightings in the index fund. The fund’s expense ratio of 0.13% is low, charging just $13 annually for every $10,000 invested.

Assets under management: $73.1 billion

Expense ratio: 0.13%

Top holdings: Welltower (WELL), Prologis (PLD), Equinix (EQIX), American Tower (AMT), Simon Property Group (SPG)

2. Schwab U.S. REIT ETF (SCHH)

This Schwab fund tracks the Dow Jones Equity All REIT Capped Index and holds more than 120 REITs, offering strong diversification across the sector’s largest stocks. Key sub-sectors here include telecom towers, data centers, and traditional retail.

The 0.07% expense ratio is nearly as cheap as a fund can be, and the fund pays a solid 3.3% yield, giving investors plenty of cash as they wait for the market to settle down.

Assets under management: $11.2 billion

Expense ratio: 0.07%

Top holdings: Welltower, Prologis, Simon Property Group, Digital Realty Trust (DLR), Equinix

3. Virtus Reaves Utilities Fund (UTES)

This actively managed fund was featured in our list of the best AI energy funds for its outstanding performance, with returns that far outpaced its rivals over time. While it and other utilities stocks are AI plays, they also offer the kind of “slow and rising” demand typical of low-risk stocks.

The fund’s expense ratio is on the higher side compared with similar passively managed funds, since it is an active fund. However, that has translated into its outperformance. Although it has the lowest dividend yield on our list, it has the highest average annual returns.

Assets under management: $1.2 billion

Expense ratio: 0.49%

Top holdings: Constellation Energy (CEG), Talen Energy (TLN), Vistra (VST), Xcel Energy (XEL), CenterPoint Energy (CNP)

4. State Street Utilities Select Sector SPDR Fund (XLU)

This passively managed fund tracks the Utilities Select Sector Index, which includes the key publicly traded utilities. The fund holds more than 30 stocks, and the slow-and-steady nature of utilities – with their high dividend payouts – makes them attractive as buy-and-hold investments.

The fund’s expense ratio of just 0.08% is low, costing investors just $8 annually for every $10,000 invested. The fund’s average annual returns have been solid over time.

Assets under management: $22.1 billion

Expense ratio: 0.08%

Top holdings: NextEra Energy (NEE), Southern (SO), Duke Energy (DUK), Constellation Energy, American Electric Power (AEP)

5. iShares Preferred and Income Securities ETF (PFF)

This iShares fund invests in preferred stocks and other income securities, allowing it to make an attractive payout. Its investments will tend to do well when prevailing interest rates are falling, meaning that a Fed rate cut or a series of them could help turbocharge the investment book.

The key advantage of this fund is its meaty monthly yield, which is likely to be the main driver of returns over time. In other words, while the fund may get a nice capital gain if prevailing rates move lower, its main source of return will be that dividend payout.

Assets under management: $12.8 billion

Expense ratio: 0.45%

Top holdings: NextEra Energy Units (2029), NextEra Energy Units (2027), Southern Units (2028), BrightSpring Health Services Units, NextEra Energy Units (2029)

6. InfraCap REIT Preferred ETF (PFFR)

This InfraCap fund is a much smaller player than the others on the list, but its portfolio of preferred stocks puts its yield at the top. Preferred stock acts much like a bond rather than a stock, with the payout being the key source of the investment’s return over time. Still, the fund may perform well if prevailing rates fall, making it more attractive.

Preferred stocks act much like high-yield bonds (formerly known as junk bonds), though their long-term record is fine. So, expect this fund to fluctuate with interest-rate changes even as the monthly payouts keep coming.

Assets under management: $120 million

Expense ratio: 0.45%

Top holdings: UMH Properties Series D (UMH-D), Digital Realty Trust Series L (DLR-L), Hudson Pacific Properties Series C (HPP-C), Pebblebrook Hotel Trust Series G (PEB-G), Vornado Realty Trust Series M (VNO-M)

7. iShares 0-3 Month Treasury Bond ETF (SGOV)

This fund doesn’t have a 10-year track record yet, but even in its short lifetime it has become quite popular. The fund holds only short-term Treasury bills, so it quickly reflects changes in the Fed funds rate. The short duration of its holdings means that it’s not subject to much interest rate risk (i.e., its value won’t change much in response to changes in prevailing rates).

The fund pays a monthly dividend at effectively the short-term Fed funds rate, so it’s a low-risk place to stash cash for short periods while you wait for the market to turn around. It’s the ultimate safe-haven trade for those who want to be sure their cash is there when they need it.

Assets under management: $104.9 billion

Expense ratio: 0.09%

Top holdings: U.S. Treasury bills

Regards,

James Royal, PhD

Editor’s Note: Whitney Tilson — the hedge fund manager CNBC called “The Prophet” — says America has reached its “Ripping Point.” The old financial order is being torn apart, and he believes most investors have no idea what’s coming in the next six months. He’s named the stocks he thinks will be destroyed in the chaos — and the ones he believes will soar. Watch his free presentation while it’s still available.