AgPa #44: Betting against Quant – Thematic Indices

Betting against Quant: Examining the Factor Exposures of Thematic Indexes (2021)
David Blitz
The Journal of Beta Investment Strategies Winter 2021, URL/SSRN

This week’s AGNOSTIC Paper examines a recent trend in the asset management industry: thematic indices. The sales pitch is simple. With a thematic index you can easily invest in the “next big things”. Artificial intelligence, aging population, e-sports and gaming, healthcare breakthroughs – just name your buzzword and you will find an investment product for it. This week’s paper is among the first that examine such thematic investments through the lens of the major factor premiums.

Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.

Setup and Idea

According to MSCI, thematic indices are “[…] a top-down investment approach that capitalizes on opportunities created by macroeconomic, geopolitical and technological trends. These are not short-term swings – but long term, structural, transformative shifts”. S&P is a bit more technical and explain that their thematic indices “[…] combine cutting-edge quantitative techniques, access to novel datasets and leading analysts’ expertise to capture long-term, market-altering themes with precision”.

To sum up: thematic indices employ some more or less sophisticated methodology to provide exposure to stocks that are expected to profit from a certain theme. The implicit assumption goes that companies which benefit from important developments should also deliver better returns for investors. It is already too simple at this point. We all know that NVIDIA is at the forefront of artificial intelligence hardware. But to get abnormal returns from this, today’s stock price must not fully reflect this information. Owning a winner is great, but if you pay too much, it could still be a poor investment. Obviously, this is a much more difficult question that most thematic indices leave open. But I don’t want to get too negative before we even started with the paper…

Finally, thematic indices are often implemented via ETFs which makes them easily accessible for investors. Regular readers of my blog should know that just because something is an ETF doesn’t mean it is a passive strategy. Thematic indices, as the name suggests, are explicitly designed to give you a selection of stocks that are related to a certain theme. Consequently, these are very active strategies which usually come at higher fees than ETFs on market-cap weighted benchmark indices.

Data and Methodology

The author collects data on thematic indices with at least 3 years of history (as of April 2021) from S&P and MSCI. The result is a sample of 36 S&P and 12 MSCI indices. Given two different index providers, there are some notable differences in the index construction. Most importantly, MSCI indices tend to be more diversified and market-cap weighted. S&P indices, in contrast, are equal-weighted and tend to hold fewer stocks. The sample starts in June 2013 but the full history is not available for all indices. The author consequently uses the longest available period for each index. Also note that some of the indices’ history could suffer from backfill-bias as the index providers report backtested data for the period before the “live calculation”. This especially applies to MSCI which, according to the author, just started their thematic indexing business in 2020.

To examine the performance and risk-return profile of thematic indices, the author uses the Fama-French five factor model augmented by momentum. In this application, the model thus includes the Market (MKT), Size (SMB), Value (HML), Profitability (RMW), Investment (CMA), and Momentum (WML) factors. The data comes from Kenneth French’s website.

Important Results and Takeaways

Thematic indices are more volatile and have higher betas than the overall market

To start with, the author shows that the average beta of thematic indices is about 1.2. Even more important, this is a very robust pattern as almost all indices have a beta larger than one (blue bars). The same applies to volatility. The ratio of thematic indices’ volatility and that of the overall market is also larger than one for virtually the entire sample (orange bars).

Exhibit 2 of Blitz (2021).

The results shows that thematic indices tend to come with both higher systematic (beta) and idiosyncratic (volatility) risk than the overall market. This is already a first reason for concern as we know from the Low-Risk factor that assets with higher risk tend to underperform. On the other hand, the results are not overly surprising. By construction, thematic indices focus on particular themes and therefore must give up some diversification benefits.

Thematic indices tend to hold expensive, low-quality stocks with neutral momentum

In the next step, the author examines the exposure of thematic indices to the Value (HML), Profitability (RMW), Investment (CMA), and Momentum (WML) factors. Once again, almost all thematic indices come with undesirable characteristics. Virtually all of them have negative exposure to Value and Profitability suggesting that thematic indices tend to hold expensive companies with weak profitability. With respect to the index providers, the picture is a little less bad for MSCI than for S&P.1I don’t want to use the word better as the MSCI indices still have negative exposure to the factors. There is somewhat more dispersion for indices’ exposures to the Investment factor, but the author argues that those are mostly in line with the negative loadings on Value and Profitability.

Exhibit 4 of Blitz (2021).

Interestingly, Momentum is not really an issue for thematic indices. As you can see in the chart, the exposures are much smaller and close to zero for most indices. The author relates this to the rather “slow” construction of thematic indices which aim to participate in truly long-term themes instead of short-term trends.

In summary, thematic indices tend to hold expensive, low-quality stocks with neutral momentum. If you believe in empirical research, factor investing, and (in my opinion) common sense, this is exactly what you don’t want to have in your portfolio…

There are still reasons why thematic indices exist

So if thematic indices have all these undesirable factor characteristics, why do they exist? The author provides four possible explanations.

The first is quite simple. Not all investors (fortunately!) believe in the major factors. Some people may disagree with the research I presented over the last weeks or simply don’t know about it. That’s fine and although I believe in the ideas, factor investors looked very stupid until recently when expensive growth stocks massively outperformed the market from 2018 to 2021. Based on the author’s analysis, you can theoretically use thematic indices as anti-factor strategy. However, I doubt that many people buy a Genetic Engineering index (see chart above) with the idea of implicitly shorting the Fama-French factors…

Second, thematic investors may be convinced that the idiosyncratic component of the underlying themes dominates the negative factor exposure. In English, the companies could become so great that their expensiveness and weak profitability today doesn’t matter. This is of course always possible, however, research shows that big winners are really rare and finding them ex-ante is quite difficult. At least to me, it seems too easy that thematic indices systematically catch them before others.

The third explanation is (in my opinion) the most promising one. Despite undesirable factor exposures, thematic indices performed very good over some of the last years. In fact, the author shows that the S&P indices delivered an average alpha of 9.5% per year during the sample period. The number is lower for MSCI but with 4.6% still high. It is no secret that performance attracts assets and some investors simply chase recent top-returns. In addition to that, thematic indices offer appealing stories which help to sell such strategies to (unsophisticated) investors.

Fourth and finally, investors in thematic indices may not only care about returns but also derive pleasure from participating in a big theme. Obviously, this argument is most relevant for sustainable indices.

Conclusions and Further Ideas

What should me make out of those results? Well, if you believe in the results of decade-long research, common sense, and the principles of fundamental investors like Warren Buffett, there is almost certainly no need for thematic indices. Having said that, the author warns that his paper is not comprehensive enough for general statements. There are many other thematic index providers and some of their products are certainly well-constructed and worth their fees.

From a theoretical (and common sense) perspective, however, I still don’t see plausible reasons why the idea Exposure to Important Theme = Outperformance should work. It is nice to own companies with exposure to interesting stuff but if they are more risky, expensive, and low-quality, they will most likely remain bad investments. In fact, another research note from a German asset manager also highlights that investors should judge thematic indices by their factor exposures rather than the current hype or latest performance.2The note is unfortunately only available in German.

Bottom line: it is generally fine to incorporate interesting and promising themes into a portfolio.3Full disclosure: I also invested in a thematic Healthcare ETF about 18 months ago. But after recognizing that I have no plausible idea why this thing should perform better than the market, I quickly sold it at a tiny loss. However, you should always control their exposures to the major factor premiums as those are probably more relevant for returns in the long-run. But when you look at factor exposures anyway, you can also just use them to construct the portfolio in the first place…

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1 I don’t want to use the word better as the MSCI indices still have negative exposure to the factors.
2 The note is unfortunately only available in German.
3 Full disclosure: I also invested in a thematic Healthcare ETF about 18 months ago. But after recognizing that I have no plausible idea why this thing should perform better than the market, I quickly sold it at a tiny loss.