Thematic Investing 2.0 - Why is it important?

Why invest at all?

Before addressing thematic investing, let’s explore why people invest at all. Forget about the nuance of whether a company is public or private, where the company operates, or even what broader industry it's a part of. Investors want to own a stake in a business because they believe in one simple concept: the price of that stake will appreciate over time. If we are thinking through things logically (otherwise known as not speculating), that expected return should be derived from an investment thesis.

For most investors, the simpler the thesis the better. An investor should be able to summarize their idea with a single sentence, leaving the overly complicated and convoluted language to the investment bankers and financial pundits. Ideally, a thesis should read something along the lines of: “I bought shares of Ulta Beauty because they have a strong e-commerce platform and carry Kylie Jenner’s cosmetic line”. More sophisticated investors may have more complex sentences, but you’ll find a similar sentiment underlying nearly all investments.

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We couldn’t agree more at Roundhill, which is exactly why we developed the Roundhill Global Esports Index. Esports was a beta you hadn’t found yet and it is hard to track. But we’ve done the hard work for you. Follow along on our website or Bloomberg at ‘NERD Index . Signing off for now.

What is thematic investing?

Peter Lynch would be the first to tell you: “know what you own, and know why you own it.” His well-documented strategy has never been more relevant than it is today. In the current world of high-frequency trading and quantitative strategies, the average investor will be hard-pressed to beat the professionals by analyzing financial statements. If you have an ‘edge’ as the little guy, it’s because certain trends in brand consumption are first observable at an anecdotal level. (If you’ve never read Peter Lynch, please do yourself a favor and pick up One Up on Wall Street.)

But there are two major problems with this level of simplicity when taken at face value: (1) it completely ignores valuation, capital structure and other idiosyncratic risks; and (2) it naturally skews toward consumer product companies. Which is exactly why Lynch recommends this as a starting point, a screen if you will, to begin analysis. However, most of us don’t have the necessary knowledge base, analytical abilities and/or time to go about analyzing companies one by one before making an investment. This is where thematic investing comes into play.

Thematic investing takes the concept of investing in companies based on a simple thesis and applies it to a portfolio of holdings. In the vein of the above example, we can streamline our Ulta Beauty thesis to: “beauty products will continue to grow.” A thematic portfolio of ‘beauty product companies’ might then include Avon Products, Sally Beauty, Elizabeth Arden, and Estée Lauder. While these companies have different financial situations, varied expertise within the beauty industry, and a range of hallmark products, the portfolio as a whole will likely benefit if our thesis proves true. Our work as investors then becomes identifying beauty product companies, instead of picking the winners within the industry. On this playing field, we can compete with the algos and quant funds.

Energy Drinks and Index Weightings

Imagine it’s December 30, 1999, right in the early stages of the dot-com bubble. While researching Pets.com one late night on Yahoo! Finance, you try your first ‘Red Bull’. It gives you the energy needed to fuel your late-night research. The next day, the eve of Y2K, still wide awake and alert from your newfound caffeine addiction, you decide that energy drinks will be a big trend in the new millennium. So you build out a basket of stocks to play this theme.

Over the next 15 years, U.S. energy drink consumption increases nearly 50 times and brands like ‘Red Bull’ become a household name. So the thesis was right, but was the investment worthwhile?

Keeping our example simple, let’s say your research led you to three companies: Coca-Cola, PepsiCo and Monster Beverage. Then, at market close on December 31, you invested in those three companies. How did your “thematic investment” do? We quickly find that how you made your investments is as important as what you invested in. In this case, all three companies were up, by a lot. But to really know how you did, we need to know how much was invested in each position.

Most baskets, or ‘indexes’ as they are formally known, invest on the basis of market cap. This means, at the simplest level, the bigger the company, the larger the weighting. Taking it a step further, a $50 billion company would be assigned a weighting 2 times that of a $25 billion company, and 100 times that of a $500 million one. Other ‘thematic indexes’ opt for equal weighting. In that structure, if there are five companies, they each receive 20%; if there are ten companies, they are each assigned 10%. For our hypothetical ‘energy drink’ thematic investment, the returns of these two strategies are illustrated below. These returns assume the portfolio is rebalanced each quarter.

As you can see, each strategy performed very well. Our ‘equal weight’ portfolio achieved a 30x return, our ‘market cap’ a 3x return. Given the higher performance of ‘equal weight’, one might correctly assume that our smaller companies outperformed the larger ones. Over this time frame, an investment in Monster Beverage (MNST) outperformed Pepsico (PEP), which in turn, outperformed Coca-Cola (KO). For reference, the S&P 500 increased less than 2x over the same period.

Now let’s try things a bit differently - the ‘Roundhill’ way of thematic investing, if you will. Instead of weighting equally or on the basis of market cap, let’s say we invested based on exposure to ‘energy drink growth’. While exposure to this beta might be difficult to assign, let’s make the (obvious) assertion that MNST is more of an ‘energy drink company’ than PEP or KO. On that basis, we assign MNST 1.5 times the weight of KO and PEP. This comes out to weights of 43%, 29%, 29%, respectively. In this scenario, our return balloons to an incredible 49 times our original investment.

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“There is no such thing as alpha”

Now, obviously, this cuts both ways. If MNST underperformed over this timeframe, the strategy would have lost. But it didn't, and that’s why we picked the example (we’re still Wall Street guys at heart, after all 😉). Jokes aside, it appears as though the ‘Roundhill’ thematic weighting did the best job of investing in the ‘energy drink beta’. When comparing the growth in energy drink consumption to our ‘thematic weighted’ portfolio, the end-result is nearly identical - both are up roughly 5000%.

The difficulty with many themes is that the beta isn’t always easily identifiable. Sometimes, when developing a new index, you actually define the beta itself. In a recent tweet, Fintwit regular @SuperMugatu said it best: ‘There is no such thing as alpha. Alpha is an error in your linear regression. Alpha is just a beta you haven’t found or one that’s hard to quantify and track.’ We couldn’t agree more at Roundhill, which is exactly why we developed the Roundhill BITKRAFT Esports Index. Esports was a beta you hadn’t found yet and it is hard to track. But we’ve done the hard work for you. Follow along on our website or Bloomberg at ‘NERD Index <GO>. Signing off for now

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