Is This Low-Cost AI ETF Your Best Value Play for the Next 5 Years?

Nvidia (NASDAQ: NVDA) makes up roughly 8% of the S&P 500 (SNPINDEX: ^GSPC). It accounts for over 17% of Vanguard Information Technology ETF (NYSEMKT: VGT).

So much concentration in one single artificial intelligence (AI) stock is a big problem. This is why investors looking to get into the niche should probably consider an AI exchange-traded fund (ETF) that is built from the ground up to have more diversification.

Putting all of your AI eggs in one basket

Investors are clearly betting big on Nvidia today, noting that the stock has risen a shocking 23,000% over the past decade. For reference, the S&P 500 index has only gained around 220% over that same time span. In some ways, it isn't shocking that investors are falling over themselves to own Nvidia, given the stock's performance. However, past performance is not a guarantee of future returns.

Data by YCharts.

In fact, there are very real concerns today that Nvidia's strong performance is a sign that there's a bubble forming in the AI space. Bubbles go through very distinct phases, the last of which is the bubble bursting. When that happens, investors overly concentrated in the high flyers are likely to end up feeling the biggest pinch. If you have a five-year time horizon, you need to carefully consider the risk that the AI bubble will burst on you.

Image source: Getty Images.

Spread your risks the smart way

The reason the S&P 500 index and many ETFs have such a large position in Nvidia is because they are market-cap-weighted, so the largest companies have the biggest impact on performance. There's nothing wrong with market cap weighting, as it mimics how the real economy works. But it ends up exposing investors to extra risk when booms turn to busts. Equal weighting is the approach used by First Trust Nasdaq Artificial Intelligence and Robotics ETF (NASDAQ: ROBT).

Equal weighting is what it sounds like: each stock is given the same weighting. And that means that every stock has the same potential to impact performance. But the bigger impact right now is that no single stock will make up a disproportionate share of the portfolio. The largest position in First Trust Nasdaq Artificial Intelligence and Robotics ETF is just over 2% of assets, and it isn't Nvidia. Moreover, the ETF has 113 holdings, which is more than many of its AI-focused ETF peers. For portfolio diversification, First Trust Nasdaq Artificial Intelligence and Robotics ETF looks like a clear leader.

Adding to the diversification with First Trust Nasdaq Artificial Intelligence and Robotics ETF is the stock selection approach. The stock selection universe is broken down into enablers, engagers, and enhancers, with assets within each sector included in the ETF split between them 25%, 60%, and 15%, respectively. What each of those designations means is less important than understanding that the portfolio is specifically focused on ensuring a basic level of diversification.

Limit your risk if you are trying to create long-term value

To be fair, First Trust Nasdaq Artificial Intelligence and Robotics ETF has not been the best-performing AI ETF over the past year. But given its focus on diversification at a time when one AI stock is driving the market, that makes total sense.

However, given the AI boom that has taken shape and the lofty prices being afforded to some AI stocks, investors might be better off with First Trust Nasdaq Artificial Intelligence and Robotics ETF from a risk/reward perspective. And with a fairly reasonable expense ratio of 0.65%, it is low-cost insurance against the AI valuation bubble that could pop at some point in the next five years.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.