Animal Spirits Podcast - Talk Your Book: The Rise of Thematic Investing

Episode Date: December 26, 2022

On today's show, we are joined by Pavel Vaynshtok, Managing Director, Global Head of Strategy Indices at S&P Dow Jones Indices to discuss the history of indices, why thematics have gotten so popular, how S&P Dow Jones Indices constructs their indices, and much more!   Find complete shownotes on our blogs...  Ben Carlson’s A Wealth of Common Sense  Michael Batnick’s The Irrelevant Investor  Like us on Facebook  And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation.      (Wealthcast Media, an affiliate of Ritholtz Wealth Management, received compensation from the sponsor of this advertisement. Inclusion of such advertisements does not constitute or imply endorsement, sponsorship or recommendation thereof, or any affiliation therewith, by the Content Creator or by Ritholtz Wealth Management or any of its employees. Investments in securities involve the risk of loss. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. The information provided on this website (including any information that may be accessed through this website) is not directed at any investor or category of investors and is provided solely as general information.)  Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by S&P Dow Jones Indices. On today's show, we are talking with Pavel Weinstock. Pavel is the managing director and global head of strategy indices at S&P Dow Jones Indices. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holtz wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritthold's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions.

Clients of Rithold's wealth management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spores with Michael and Ben. I saw a tweet over the weekend from Tom Serafegas reporter at Bloomberg. And he had a tweet more than a third of the ETF. industry is less than three years old. That's a pretty mind-bending number. I think the only explanation for this is thematic ETFs. That makes sense to me. So a lot of the newer players in the industry are coming for these themes. This is probably by product. It can't be by acid chip because of course it's probably the plan for those stuff, but there's still new

ideas that are coming to market. It makes sense that thematics are getting so big for a number of reasons. In terms of the fund industry, how many different ways can you make a value ETF or fund? The quants can argue over which strategy is best, but it's splitting hairs at a certain point between the different kind of value or momentum or quality, whatever screen. The factor stuff has been kind of milk's dry. There's not much you can do in that space that's different anymore. Smart bid had its, what is it, I don't know, 2014 to 2018. And obviously technology is just a much larger piece of the stock market, if not the economy, than it was in years past, and it makes sense that people would want to get ahead of the next big

thing that's coming, the next ride, the next wave. Oh, so you're saying that in your mind, technology and thematic or synonymous? I think so. Don't you think? Even if it's an old school industry, it's probably going to be technology that comes in and makes it more efficient and approves it. One of the things on our talk that we got into today was one of the reasons why there's been such a proliferation is because technology has made it possible, just in the sense of companies is getting more granular with what they put in their reporting. That was interesting to me. I didn't think about that.

And data scraping, being able to scrape all of that. So that's AI stuff, basically making it easier. It's machine learning. It's pretty technical. I don't know if you don't understand. Right. But it does make sense to me that thematics are going to be the new active. Because for some people, if you say, I'm going to put five or 10 percent of my portfolio

into this thematic thing, and it's going to either be a grand slam or it's probably going to maybe fail and tinker out. I think that makes sense for a lot of people, as long as you have the core and explore idea behind it. You asked me last week, is it easier to pick stocks or pick stock pickers? Is it easier to pick stock pickers or to pick thematic sectors, thematic themes? Thematic themes. It's probably easier to stick with a thematic than it is with a stock picker.

Setting aside, who can produce more alpha, I think you probably have an easier time leaning into a thematic that's doing poorly than you would leaning into a stock picker. importantly. That's true. Also, with the thematic stuff, there's less ambiguity. You know exactly what you're getting. Yes, pot stocks, for instance. If you look at pot stocks, marijuana. Sorry, what should I call it? I don't know. Mary Jane. Actually, I think they refer to themselves as cannabis, the cannabis industry. I don't know what the drawdown is, but those stocks have done awfully. During a time when this is a huge, what's the MSOS? Is that the one? What's that? The one that I know is toke. That's one. I mean, it's in like an 85% drawdown for potstocks.

cannabis, ETF. That's a big theme that just hasn't played out in terms of performance. How about this? There's nobody who's sticking with an actively managed mutual fund that's down 85%. But there are definitely people who stick with a theme that's down that much. That's what I mean. It'll be interesting to see how much people actually stick with this stuff or if they just hop to a new theme. But interesting conversation. So we get into all of this and more with Pavel Weinstock with S&P Dow Jones Indices. Today we are joined by Pavel Weinstack. Pavel is the global head of strategy indices at S&P Dow Jones Indices. Pavel, welcome to the show.

Thanks for having me. All right. One of the themes that Michael and I have hit on in the past couple of years is that it feels like thematic ETFs and funds are the new actives for a lot of investors. It's newer and exciting places to invest and it's a little bit different. And it seems to be its own theme this year, not only this year, but I guess in the last few years. Is this just a marketing thing or is just an actual thing that is a complete total pivot in the industry? And why do you think this is happening? How did thematics get so popular?

Thanks for the question. I think it is absolutely the case that thematics have exploded in popularity. If you look back, say, 10 years ago, assets under management in thematics were around 100 billion. You fast forward to now, it's over 1.2 trillion. That is not a fad. That is real. So how have thematics become so popular? And there's a number of explanations for thematics popularity. To me, from my vantage point, let me describe to you what my vantage point is first. I am at S&P Dow Jones indices. We are not an asset manager. We're an index provider. We, of course, create indices such as S&P 500, but also we create IP in the areas that traditionally have been purview of active managers, factors, thematics, of course, multi-athetic strategies,

commodities, and so on. And what we do in the case, say, of thematics, we would partner with a product provider. We would create a theme, an index, that's our intellectual property, and the ETF provider would replicate that theme. So that is our vantage point. There's a number of reasons why thematic growth is not a fad, and why thematic have enjoyed such big popularity. Number one, until a couple of years ago, there was just no technology that you could use to create some thematics.

You could, of course, get exposure to technology theme, to a semiconductor theme through Giggs Industry classification. But what about clean energy? You now have technology to be able to attribute revenue to a utility company that comes from clean energy versus traditional energy. You just couldn't do that before.

You're saying that there just weren't enough companies that would have fit some of these themes before. For some themes, there were just not enough companies, but to a large extent, you just couldn't do it before. What about the packaging or what about the process? What do you mean you couldn't do it? Why not? For example, if you think about if you want to create a Metaverse Index,

if you look in the financial statements, there's really no financial revenue line. This is what comes from Metaverse. Or in the case of clean energy, If you look at our clean energy index, only 2% of the index is in the classic energy sector. Most of the securities are in utilities, in information technology, in industrials. If you want to create a battery metal index, you need to know how much production is coming from a particular mine. There was just not enough data sources to create these themes.

And for more nascent themes, and that's key, where the revenue is not as prominent or some themes don't have revenue, you need to use machine learning, you used to use natural language processing to be able to create this themes. Here's a contrived example, if I could. Exaggerated example. 2006, zero percent of Apple's revenue is coming from iPhone. The word mobile appears twice in Apple's 10K. You fast forward to 2007, mention of iPhone and mobile. is all over Apple's 10K. Revenue from iPhone is 1%. By 2008, that revenue is 6%, 2009, 30%. If you look at just financial statements, you could miss a company for several years. You really need natural language processing to identify company's emphasis on a nascent theme. You just didn't have some of the technologies to be able to create themes. Interesting. For the rise of the third,

Thematic ETF. How are we defining thematic? Is it anything other than a plain vanilla market cap weighted index? What exactly is thematic? Are the sector ETFs thematic? What's in the bucket? To us, and again, from my vantage point, thematics, and that's critical, it's not about individual stocks. It's not short performance chasing. It's long-term structural trends that play out over multiple years, if not decades. Here's an example. It's an exaggerated example. Look at Dow Jones Industrial Average in the year of 1900. And look at the same index 20 years later.

And again, Dow Jones Index is a proxy for the U.S. economy. It's an imperfect proxy, but it's a proxy nonetheless. In 20 years... I'm a Dow Jones defender, by the way. I'm a Dow Jones defender. It's good enough. Sorry. But if you look in 1920, here are the industries that were there in 1920 that were not there in 1900. autos, electrical utilities, telcos, oil. That's structural themes that clearly changed the

society. Well, there were telcos in 1920? In 1920 had the first telcos appear in DJIA. What was it? Westinghouse, ATNT, GE, and so on, electric utilities, Texas oil, Stude Becker. Ford was not a publicly traded company back then, but these are what thematic trends are to us. These are not just short-term themes. There's a structural trends. When creating these indices, I never know if it's indexes or indices. Maybe you can

tell me which one it is. You should be the official arbiter. Which one is it indexes or indices? Now, you're speaking with somebody for whom English is a second language. But I will say indices. Okay, do you ever say granular? I'm just asking. Was that? Get off it. Granul. So when you're constructing

these, I'm going to see indices. It makes you sound smarter. I think indices is the right way of putting it. What is the process? Because you mentioned that you have now the technology to maybe get ahead of some of these trends, but where do you even begin when you're trying to construct these things? It's good to use an example. First, let me use an example of our innovative indices of what we call indices of exponential innovation. Kensho new economies. Kencho is a machine learning company that was bought by SNP in 2018. We're using this NLP natural language processing capabilities to build indices. So what do we do with this? So first, Kenra is. So first, Ken,

our new economists is a composite of 25 areas of exponential innovation. We target granular areas of the fourth industrial revolution. These are sustainable farming, digital health, EVs, genetic engineering. So how do we do this? We first need to define the scope. What's in the scope for an index? And for that, you need a degree of thematic industry expertise. So we determine what's in scope. So, for example, Tesla has been obviously in the news recently, as it has been for a number of years now, but it's obvious that Tesla should be part of the EV index. What about ArcelorMetal? It's a large steel conglomerate, but what does it have to do with the V index? They manufacture something that's called electrical steel. It has certain magnetic properties that make it well suited for EV engines. So you need that

industry expertise to figure out what's in scope. So that's step number one. You need access to data sources that allow you, again, to determine what should and shouldn't be at scope. And what we do is that when we create our indices, we determine, okay, is Tesla a core company or a non-core company? Tesla is a core company for the EV index. Our Cylormetal to us as a non-core company. We overweight core versus non-core. We also believe that innovation happens everywhere with something like country new economies. The starting point is we weigh all of the securities by equal weight. We overweight core versus non-core. And then we make sure that the index is such that when you launch a product in it, it's investable. So we do adjust for liquidity characteristics.

But critically to us, the process needs to have a degree of industry expertise. You need access to data sources, and you need to have sophisticated capabilities to be able to create this indices. How much is S&P coming up with their own indices versus partnering with third-party asset managers who come to you and say, I've got an idea, I want to create an index? What does that relationship look like? We do both. If we think there's an innovative idea that the market will like, we'll launch an index,

and then we reach out to product providers to either launch ETFs on the index, we partner with banks for structured products, with insurance companies, and so on. So the idea generation comes from us and or a partner would come to us and ask us to create an index on a certain theme. So this ecosystem, it happens both push and pull, if you will. When considering how investors should see these things, you're not making any recommendation how you should invest in this or you shouldn't. How do you differentiate between something that's thematic and something that is a fad?

How should investors think about that kind of thing? What we create, our IP can be, of course, used tactically or could be used to bet on a structural theme. And how investors are using it. And again, it's investors and product for which we provide IP, for which we provide this indices. They are free to use it, obviously, however they want. But what we find is that when we're... create this theme. There's a degree of appreciations that the themes that we define and thematics are long-term structural trends and investors that we talk to use it as long-term ideas.

It also depends on what theme that is. If it's something a bit more specific, clean energy infrastructure, battery metals, then investors look at the theme in terms of how it fits into the overall portfolio, factor exposure, cyclical. drawdowns profile. If it's something such as Kensher new economy is that it's used either a core of an innovation portfolio as a potential growth replacement. Because with innovative indices, when you compare it with typical growth benchmarks, it looks favorable vis-a-vis growth exposure and so on. But there's a degree of appreciation that these are long-term structural trends as opposed to fads. When I think about thematic, like you just keep talking about the

Ken shall one. I guess you think of growth. You think of new themes, not necessarily old themes, but are there thematic indexes that might be more of the old economy, like more value-type names? Absolutely. And again, that goes into how you define thematic. So infrastructure, for example, is a big theme for us. Now, I'm not suggesting that infrastructure is value, but this is a theme that has existed for a long time. It's evolving. Clean energy. is similar to that effect. It's not necessarily growth versus value. It's where the market is moving to, and as companies are adjusting, we're evolving these themes. So Kenchran new economies to us is all about growth, but it's less about growth versus value and more about what theme are

you trying to capture in the basket of securities. Is ESG a thematic product, or would you say that's a separate bucket entirely? I think it's up to your definition. I would think it's both. Investors are clearly looking at ESG in a separate bucket. Now, whether or not you bundle ESG into sort of one package or you disaggregate environmental, social governance, I think it's just a meta definition. At the end of the day, we are providing solutions and it's up to investors to figure out what nomenclature they want to ascribe to it. When you are packaging products and putting together indices, how do you all think about the way to weight companies, whether it be by how strongly they are represented in the theme

or how big their market cap is or how big their growth is. There's all sort of different ways to wait an index. What do you all think is the right way to do it? It depends on the index. It depends on the purpose and it depends on what construction methodology is most well-suited. So I'll give a couple of examples. For something like Kentro, the starting point is equal weight. Because innovation happens everywhere. We don't want to overweight large caps versus smaller cap. We do overweight core versus non-core. There are some indices where we say, if you look at something like battery metal, so clean energy, or any index that's a theme where we really need to pay significant attention of how much a particular company is

participating in a particular theme, then we would oftentimes just weigh that company by the exposure to that theme without regard to market cap, but just simply by exposure. So the weighting approaches are either you equal weight just to make sure that every say innovative companies is weighted equally. That's number one. Or you weighed by the exposure score of a particular theme to ensure that the overall basket reflects that exposure to that theme. Or you do some combination of a score for a theme and market cap to ensure liquidity. In terms of turnover, if you're investing in a factor-based fund and it's based on valuations, the companies that do the best are eventually going to graduate out of those factors if they

become too overvalued. Does that sort of thing happen in thematics where some of these companies could be a core holding that eventually they mature out of that stage, they get to a more mature phase and they're not contained in this index anymore? How much turnover should we expect in these sorts of things? Absolutely. And I think that's frankly one of the difference between the old ways of passively managing a portfolio and index and the way that thematics is forcing the change in the way we're thinking about active versus passive. If you look at the particular theme, if a particular security is no longer playing, quote, in that theme, it has to be out of that index. So the turnover is driven less by if a value stock is no longer value, a growth stock is no longer growth, or high dividend payers no longer high dividend payer.

It's driven by, here's a thematic exposure. Does the stock that is in the index, does it still have exposure to that theme? Does it still play in the theme? If the answer is no, it has to leave the index. And conversely, as new entrants are coming into a particular space into a theme, they have to go in the index. So what we do at SNPs, we reconstitute index on a regular basis to make sure that the theme is reflected. Metaverse would be a good example here. There's more and more companies are participating in Metaverse, and the question is, okay, to what extent

a certain company is part of the Metaverse ecosystem? And what way should we ascribe to a particular company? And that depends on how much involvement it has in the theme. Do you think thematics are the new active? You've seen a lot of outflows out of actively managed funds. Do you think they're going into thematic ETFs or passive indexes or what would be your guess there? First of all, speaking from my vantage point, that's a fascinating question, partly because I spent most of my career as a systematic active Kwan guy. I think the active versus passive, with thematics becoming so prominent, active versus passive is somewhat an outdated terminology. to use. And I think that's for a number of reasons. As I mentioned before, you need thematic expertise to create this theme. That's something that passive did not need before. You need to have access to increasingly unique data sources. And it's, again, that's something that passive industry didn't have to deal with before. And if you're a stock picker, you never really had to have

sophisticated analytical capabilities to create your portfolios. You need that for thematic. So it's somewhat in outdated terminology is because for thematics, the way we're seeing them, it combines some elements of active, some elements of passive. I will say this. We think we created a systematic discipline, dispassionate, rules-based process that is well-suited for thematics. Pavel, I got to say, I hate to call out a foul ball, but that was a lot of buzzwords. It was systematic.

I think there was two or three others. That was good. I don't know if that's good or not. The biggest thematic ETF that the majority of investors know, especially retail, is the ARC innovation fund. And Michael and I have been trying to figure this one out all year. I think the fund is down 65% year to date. I think it was worse at some other points. And it's still seeing a good, heavy amount of inflows this year.

And our experience in the past, anything with heavy retail flows, money pours in when it does really well, and then money pours out when it does poorly. We're seeing the opposite this time. Money poured in it was doing well. and it's still pouring in when it's doing poorly. Do you think that's a function of this being a sort of thematic fund where people are betting more on the theme than the stock picks? What would you ascribe that to that we're still seeing money pour into this fund that is getting slaughtered this year?

It's obviously speculation. It's hard for me to answer that question, but I will say a couple of things. That's my personal opinion. It's quite possible that people are using that ETF as a proxy for growth. And while I cannot really opine on their process, I will say that if you look at the way we are constructing indices, speaking to the down, however many percent that product may be, we are making sure that we encapsulate the theme

and that returns are not dominated by stock-specific risk. That to us is key. And to your question, active or passive, if we look at what's the closest comparable to a fund like ARC, it's our innovative thematics can show new economies. If you look at the historical performance of that index, only 15% of stocks in that index outperform that index. So the implication is that the returns are driven by a handful of stocks. And that makes sense because to us, it's too early to pick winners and losers in innovation. Now, the question is, and to go back to your puzzle of why performance is what it is, while the flows are what they are, other than

growth proxy perhaps, is that, okay, fine. So say, what if you can pick those winners? I don't know if you're familiar with what we've been publishing for the past 20 years. There's a report called SPIVA, S&P Invexing versus Active. Are we familiar? Are you? Come on. Oh, yeah. Highly familiar. All right, good. Active had an amazing year to date. Absolutely amazing, according to Spiva. What's amazing? 52% of managers underperformed their benchmark. That is spectacular. Best in many years. If you look over five years, that number is 88%. Over 10 years, that number is 92%. Unbelievable. Think back to our belief that thematics work out over long term, five years. 10 years. So hence, that's where our approach comes in. Diversified approach, narrow enough

to encapsulate the theme, broad enough to be investable. And that's 15% of stocks that have performed an index. It's not what we do, nor the proof shows that it's really not that easy. To your point of not knowing what the winners are going to be, especially in these emerging technologies and spaces, you have to be fairly diversified because you want the winners to rise at the top, correct? That's right. I mean, it's also, at the same time, we're talking about thematics.

Is it about stock picking or is it about crystallizing a theme? To us, it's about crystallizing the theme and it's not about stock pickers. And we don't know, it's too early to pick winners and losers as long as you bet on the theme, and it's not dominated by stock-specific risk,

which is key for us. My hypothesis on why that fund is still getting inflows despite having a god-awful year is I think for the most part, investors are using it responsibly in terms of position sizing. If they were all in, I can't imagine that they would continue to add to it. I think it's a satellite holding alongside their meat and potatoes or vegetables or whatever you want to call it. That resonates. I mean, to the point that you use thematics as part of the portfolio construction and look at drawdowns and the factor exposure and so on

and see where it fits within your ecosystem. That makes sense to me. What are the biggest themes that you're focused on coming into the new year? I'm going to use buzzwords again. The reality is that people say we love our children equally, but I can tell you where we are seeing interest from the clients. It's the areas such as infrastructure, areas such as clean energy, not surprisingly. I go back to the what we call areas of exponential innovation, Kentra New Economist, which allows you to bet on a overall areas of exponential innovation

without narrowing to a particular theme. So definitely infrastructure, definitely clean energy. Like crypto infrastructure? No, no, no, no. Infrastructure, period. We do happen to have crypto ATFs as well. Anything with the multi-year tailwinds. So where can we send people to learn more about your research and process?

I think I would urge you and your listeners to go to S&P Dow Jones indices for methodologies on our indices and for research on any and all indices that we talked about today. Pavel, that was great. Thank you so much for coming on today. Thanks very much, guys. Nice to be here. All right, thank you to Pavel, who is a listener of the show, which is always nice to have, right? He said he listens to us jogging.

And the fellow bald. Fellow bald and a fellow user of the word granular. Thank you for coming on. Remember, that's S&P, Dow Jones, Indices, if you want to learn. more and send us an email Animal Spiritspot at Gmail.com.