When retail investors watch mega-cap hyperscalers pull the broad indexes into a concentrated corner, the natural, contrarian response is to look downstream.
Believe me, I am not a big fan of small-cap stocks en masse. However, as I’ve noted here recently, I think that market conditions require us to look there, and just about everywhere that isn’t mega-cap AI stocks. Hey, who said investing was supposed to be comfortable?
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The logic seems bulletproof: If Nvidia (NVDA) and Broadcom (AVGO) are virtually printing money on artificial intelligence infrastructure, then the smaller, agile tech players must be getting ready to catch the secondary wave. Investors go hunting for an exclusive small-cap AI trade, expecting to find the tech giants of tomorrow trading at a deep discount today.
My conclusion is that it is going to be more difficult to do this via the index ETF approach. Stock by stock is more likely to work beyond a traders’ time frame. This is part of what I determined when hunting for good Chart of the Day candidates when I filled in for Barchart columnist Jim Van Meerten recently.
But if you look at the vehicles built to track this space — specifically the Invesco S&P SmallCap Information Technology ETF (PSCT) and the SPDR FactSet Innovative Technology ETF (XITK) — the reality of the tape hits you like a cold bucket of water. There is no booming, exclusive small-cap AI trade.
What you actually find under the hood of these ETFs isn’t a collection of stealth software disruptors. It is a highly cyclical, capital-starved, legacy hardware junkyard that exposes you to immense macro risk with almost zero participation in the actual AI boom.
What Do Small Cap Tech Stock ETFs Own?
To see why the “small-cap tech will save us” narrative falls flat, you have to bypass the marketing brochures and audit the ledger of their top holdings.
PSCT (The Cap-Weighted Small Tech Basket)
PSCT limits its universe strictly to the tech sector of the S&P SmallCap 600. When you buy it expecting cutting-edge AI software, your top positions are dominated by semiconductor component and contract electronic manufacturing firms, as well as some companies that make testing equipment for the tech and communication sectors. Many are not new. They are just not huge.
www.barchart.comXITK (The Disruptive Innovation Proxy)
XITK tries to fish in a slightly sexier pond, tracking companies deemed innovative by FactSet, a leading Wall Street stock research firm. Yet, because it includes micro-cap and small-cap names alongside a few mid caps, its top allocations tend to feature highly speculative, volatile operators. That includes crypto mining-adjacent stocks, whose ship may have already sailed.
While it catches occasional vertical spikes when speculative sentiment hits a fever pitch, it lacks the institutional, recurring-revenue foundation required to mount a sustainable, independent bull run.
www.barchart.comThe core fundamental flaw keeping small-cap tech from being a late bull market cycle savior comes down to something not closely related to the stocks and businesses themselves. It is the market’s preference for where capital must be allocated. It is AI. And that crowds out demand for many other intriguing businesses.
Artificial intelligence is an unprecedentedly expensive technological paradigm. Building, training, and scaling AI models requires billions of dollars in upfront liquid cash, liquidity that only mega-cap hyperscalers possess.
Small-cap tech companies are facing an entirely different economic reality. Because short-term interest rates remain restrictively high and may even be heading higher, small and micro-cap firms cannot easily issue cheap debt to fund research and development.
Then, there’s the talent drain. Top software engineers and AI scientists are being aggressively poached by multitrillion-dollar behemoths who can offer massive equity compensation packages. Small-cap firms are losing the intellectual arms race.
Many of the smaller chip-component manufacturers inside PSCT rely on just one or two major mega-cap buyers for their entire annual revenue. If Apple (AAPL) or Nvidia decides to bring a component design in-house, the small-cap supplier faces instant, catastrophic revenue destruction overnight.
www.barchart.comThis chart for PSCT tells me that it has played almost all of its “goodwill” cards for this cycle. That is, it rode the coattails of all things AI and tech. But now there’s not much left for an ETF which, as noted above, sells at 35x trailing earnings. That’s what a near double in price will do to an ETF’s basket of stocks.
www.barchart.comThe idea of an “exclusive small-cap AI trade” is a marketing myth. The architecture of the AI boom is structurally designed to reward absolute scale, deep pockets, and massive data monopolies.
When you buy a vehicle like PSCT or XITK, you are not buying a junior version of the Nasdaq-100 Index ($IUXX). You are buying a high-beta, asset-heavy basket of secondary suppliers that absorb all the downside of restrictive monetary policy while capturing none of the high-margin software upside of the technological shift.
If you want to step away from mega-cap tech concentration, do not run to small tech ETFs expecting a hidden goldmine.
Instead, look inside these ETFs and try to find not the needles in the haystack, but the stocks which have a sustainable business (wide moat), reasonable valuation (likely due to some falling out with investors), and a chart pattern that can potentially produce at 15%-20% gain to start. That’s what I’m looking into. I’ll be back with more soon.
On the date of publication, Rob Isbitts did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
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