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As AI Momentum Cools, Software and Defense Stocks Take Focus

BY | ETF Database
9:22 am ET 11/12/26 | 5 VIEWS
The AI momentum trade is fading, according to Baron SMID Cap ETF (BCSM) portfolio managers Laird Bieger and Randy Gwirtzman. In their third-quarter 2026 letter, the managers wrote that investors had bought AI-related names “almost exclusively and at essentially any price.” They believe the shift should favor their long-term fundamental approach.Key Takeaways: Software firms with private data or specialized tools beat the broader software group in the third quarter. Defense stocks slid on worries that the midterm elections could change control of Congress. A backlog of more than 18,000 aircraft could keep existing planes flying longer and needing more upkeep. Higher rates, data center construction delays and lofty valuations all weighed on that trade, the managers wrote. Semiconductor stocks in the Russell 2500 Growth Index, the fund’s benchmark, fell 17.9% in the third quarter. Chip materials and equipment stocks dropped 23.4%, and BCSM is underweight both groups. The managers tie much of the fund’s 2026 results to that shift. Through Sept. 30, style headwinds from momentum and beta explained just under 4 percentage points of BCSM’s shortfall against its benchmark, according to the letter. Both factors reversed in the third quarter, adding about 3 points to relative performance. BCSM’s net asset value fell 2.87% in the third quarter, while the index dropped 10.35%, according to Baron. As of Sept. 30, 2026, the fund’s active share was 95.7%. Investors also began to recognize that AI-generated code cannot replace every software company, the managers wrote. Their first-quarter letter named software types they expect to coexist with large language models. Those include firms with private data AI cannot access, specialized industry software and products pairing hardware with software. See more: How BCTK ETF Invests Across the AI Value Chain BCSM’s software holdings rose nearly 28% in the third quarter, compared with 3.8% for software in the index, the letter showed. Data backup company Rubrik, Inc. (RBRK) was the top contributor, adding 1.35 percentage points to the fund’s return.Defense Stocks Lose Momentum on Election WorriesIndustrials cut 6.17 percentage points from BCSM’s third-quarter return, mostly from aerospace and defense, according to the letter. Shares of defense supplier Mercury Systems, Inc. (MRCY) slid on worries about a possible change in congressional control after the midterms. “We think budgets will rise regardless of the composition of Congress,” Bieger and Gwirtzman wrote. They added that their holdings focus on fast-growing areas such as missile defense, space, unmanned vehicles and hypersonics. Aerospace and defense was BCSM’s largest sub-industry weight at 13.5% as of Oct. 31, 2026, according to Baron. More than 18,000 aircraft are on order, according to International Air Transport Association estimates cited by the managers. That is likely six to 10 years of production, so the managers expect existing planes to fly longer and need more maintenance. Passenger air traffic has shrunk only three times in the 25 years they have followed the industry, the managers wrote. Those declines followed the Sept. 11 attacks and the 2008 financial crisis, and came during the 2020 COVID lockdowns. For more news, information, and analysis, visit the Market Insights Content Hub.

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