Fresh Capital Inflows Boost AI ETFs During Market Turmoil

A Surprising Inflow in a Volatile Quarter

According to J.P. Morgan Asset Management's recently published "Guide to ETFs," AI-themed exchange-traded funds experienced a significant surge in inflows, despite enduring a turbulent second quarter for the sector. Jon Maier, the firm's chief ETF strategist, said, "many investment categories are slowly turning into AI plays." He added, "It's all kind of feeding into the AI story … the applications, the energy [and] the AI models."

The second quarter of 2023 saw notable market swings driven by interest rate uncertainty and a rotation out of growth stocks, yet AI-focused ETFs bucked the broader trend. This resilience highlights investor conviction in the long-term potential of artificial intelligence, even as short-term market noise persisted.

The AI Ecosystem Is Broader Than You Think

Jon Maier, who oversaw the insights team that produced the report, noted that AI-themed ETFs and infrastructure are increasingly intertwined. "Many [themes] are morphing towards AI and the ecosystem surrounding AI," he said. That includes applications, energy, and AI models. This broadening makes AI-themed ETFs more diversified than a pure-play tech fund, as they capture exposure to the entire supply chain that supports artificial intelligence.

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The Quiet Migration: Out of Mutual Funds, Into ETFs

The same report from J.P. Morgan revealed that mutual funds are seeing a notable decline in overall inflows, even as ETFs continue to attract fresh capital. "That's only going to continue," Maier said. Maier further stated that the data in the report indicates that mutual funds have experienced net outflows over the past several years.

Maier contrasted mutual funds: "Imagine if you bought a mutual fund in 2022 and you're down 20%, 30%, 40%, depending on what part of the market you bought, and you still got a capital gain of 6%. You're not happy."

The Tax Advantage of ETFs

A key reason investors are moving money from mutual funds to ETFs is a difference in how taxes are structured. When a mutual fund manager sells securities at a gain, the fund must pass those gains to shareholders as capital gains distributions, regardless of whether the shareholders themselves sold any shares. This can create a tax liability for investors in down markets.

In contrast, ETFs typically do not generate taxable events because of their in-kind redemption process, making them more advantageous for long-term investors. This tax efficiency has become a significant factor for retail investors seeking to minimize annual tax bills.

The broader migration from mutual funds to ETFs has been underway for over a decade, fueled by ETFs' lower expense ratios and transparent holdings. J.P. Morgan's report indicates that this trend is accelerating as investors become more aware of the structural advantages.

AI-themed ETFs, in particular, have drawn interest because they offer a way to bet on the AI boom without the tax drag that mutual funds can impose.

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