An old adage says to make hay while the sun is shining, and with interest in generative AI surging thanks to the likes of OpenAI’s ChatGPT and Google’s Bard AI, Roundhill Investments did just that by launching the world’s first ETF specifically focused on generative AI last week — the Roundhill Generative AI & Technology ETF (NYSEARCA:CHAT). While there are plenty of general AI-themed ETFs out there, this is the first ETF that specifically invests in companies advancing generative AI. Let’s take a look at what generative AI is, how CHAT invests in it, and evaluate CHAT as an investment opportunity. 

What is Generative AI?

As described by Roundhill, generative AI is AI that is “capable of creating new, unique content by learning patterns and structures from existing data.” For example, going on ChatGPT and asking it to write a poem or to create a screenplay based on some criteria that you give it is an example of generative AI in action. (The ETF’s ticker, CHAT, is clearly a nod to this model). Another example would be using OpenAI’s Dall-E 2 generator and having it create a work of art for you based on the prompts you give it. 

This differs from traditional AI in that it has “the ability to create new, unique content rather than just analyzing or processing existing information.”

Why Invest in Generative AI?

The examples of what generative AI can currently do are impressive — just a few years ago, it would have been hard to believe that technology available to the masses would be able to write term papers for students, pass the bar exam, or create images and video based on text-based prompts. The speed at which this new technology has been adopted is unprecedented. ChatGPT launched in November 2022 and reached 100 million users just two months later, becoming the fastest-growing application of all time, according to Bloomberg

While these are incredible advances, smart investors know that technologies need to make a financial impact as well in order to become good investments. The good news is that generative AI does not disappoint in this area, either. Roundhill believes that the current total addressable market for AI enterprise software is about $120 billion. Meanwhile, Goldman Sachs (NYSE:GS) believes that AI has the potential to create approximately $7 trillion in economic growth worldwide over the course of the next decade.  

The AI Investment Universe

Clearly, there is plenty of economic opportunity ahead of companies with generative AI applications. While OpenAI, the company behind high-profile AI products like ChatGPT and Dall-E, is private, there are plenty of ways to invest in publicly-traded companies with generative AI offerings. CHAT covers many of these companies by investing across several different areas that are relevant to generative AI — software, cloud infrastructure, semiconductors, network infrastructure, and services. 

The ETF currently holds 32 positions, and its top 10 positions account for 56.9% of holdings. You probably won’t be surprised to find out that CHAT’s top holding is Nvidia (NASDAQ:NVDA), the semiconductor giant whose chips power many generative AI solutions today. Nvidia is a fairly large position, accounting for 7.9% of the fund. Microsoft (NASDAQ:MSFT) isn’t far behind, with a 7.6% weighting.

Microsoft owns a stake in OpenAI, its Bing search engine now incorporates ChatGPT, and it is working with Nvidia to build an AI supercomputer. The third largest holding, Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), has plenty of irons in the AI fire and recently released its answer to ChatGPT, Bard, to the public. 

Below, you’ll find a list of CHAT’s top 10 holdings, giving you an overview of the ETF’s components.

CHAT also expands beyond the usual FAANG names with a top 10 position in China’s Baidu (NASDAQ:BIDU), which has its own answer to ChatGPT in its chatbot, Ernie, as well as other AI technologies with interesting potential like its self-driving technologies. CHAT also holds several other prominent Chinese tech stocks that are involved in generative AI, such as Alibaba (NYSE:BABA), Tencent (OTC:TCEHY), and SenseTime Group. 

As you can see in the table above, TipRanks’ Smart Score system takes a positive view of CHAT’s top holdings. The Smart Score is a proprietary quantitative stock scoring system created by TipRanks. It gives stocks a score from 1 to 10 based on eight market key factors. The score is data-driven and does not involve any human intervention. A Smart Score of 8 or better is equivalent to an Outperform rating.

Excluding its cash position and its SenseTime investment (which does not have a Smart Score), six of CHAT’s top eight holdings feature Smart Scores of 8 or above. Further, Nvidia, Adobe, and Arista Networks all boast ‘Perfect 10’ Smart Scores. 

CHAT stock itself features a Smart Score of 7 out of 10, just shy of an Outperform rating. 

Is CHAT a Buy, According to Analysts?

Analysts hold a relatively favorable view of CHAT, assigning it a Moderate Buy consensus rating. 69.68% of ratings are Buys, 26.16% are Holds, and 4.17% are Sells. The average CHAT stock price target of $28.14 implies upside of nearly 10% from the ETF’s current price. 

Risks to Consider

While generative AI is an exciting technological advancement, and CHAT does a good job of encompassing many of the different stocks that have the potential to capitalize on it, remember that no investment is without risk. 

One risk to note here is that this is a brand-new ETF. CHAT launched just a few days ago, on May 18th. Investors and analysts often place a significant degree of importance on an ETF’s long-term track record, but since it is only a few days old, CHAT doesn’t have much of a track record to judge it on yet, and it hasn’t had time to prove itself to investors. 

Additionally, since CHAT is so new, this is a very small ETF — its assets under management (AUM) of just under $2 million are minuscule in the context of the investing world. This small size could make CHAT more susceptible to volatility, especially in the event that the tech sector sells off. 

That’s one other thing for investors to consider. While CHAT and its holdings clearly have significant long-term potential, investor interest in AI has reached a fever pitch, propelling the tech sector and many of CHAT’s holdings to prices near their 52-week highs. Many of these stocks are now trading at expensive valuations — for example, Nvidia trades at nearly 70 times forward earnings, while Microsoft trades at 34.4 times earnings.

Shares of Nvidia have gained a scorching 118% year-to-date, while Microsoft is up 32.2%. The tech-oriented Nasdaq 100 (NDX) index is up 20.9% over the same time frame. At some point, it’s inevitable that this momentum will slow down, at least temporarily. If that happens, these stocks will cool off a bit, and investors may find more advantageous opportunities to buy CHAT. 

Speaking of the Nasdaq, one additional thing to consider is that while this is a generative AI-specific ETF, some of this theme can also be captured by simply investing in a tech-oriented ETF like the popular Invesco QQQ Trust (NASDAQ:QQQ), which invests in the Nasdaq 100. Like CHAT, QQQ also has large positions in Microsoft, Nvidia, and Alphabet.

While it doesn’t give you the exact same laser-like focus on generative AI that CHAT does, there is plenty of overlap between the two ETFs, and QQQ gives you a cheaper expense ratio (0.2% versus CHAT’s 0.75%) and a multi-decade track record of strong performance.

Investor Takeaway

Generative AI harbors tremendous long-term potential, and CHAT is primed to fully exploit the vast potential of Generative AI, investing in stocks related to this technology. I like CHAT’s precise focus on generative AI, which will disrupt many industries in the not-so-distant future. Also, CHAT’s holdings have strong Smart Scores and include many of today’s tech leaders, as well as some potential diamonds in the rough.

The risks here include CHAT’s lack of a track record (as a result of its recent launch), its small size, and its higher fees. Further, the excitement AI has already generated means that there also aren’t a lot of bargains to be had in the space, as investors have already bid many of these stocks up. As a result, there could be a pullback on the horizon before these types of stocks resume their long-term growth trajectories.

My strategy with an ETF like this (not financial advice) would be to start a smaller position, and then dollar cost average into it over time on pullbacks to build a full-sized position.

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