By Anil Rao, Executive Director, Equity Solutions Research, and Thomas Verbraken, Executive Director, MSCI Research at MSCI.
The pressure of the crowd: Stress testing thematic indexes
Thematic investments, to date, have gathered assets this year at the same steady pace they did throughout 2020.
The Financial Times noted recently that thematic ETFs had over $40 billion of inflows through the first two months of this year, bringing their total AUM to just shy of $400 billion.
Investors could be concerned about whether this fast-growing segment has become crowded and poses a sell-off risk.
In this blog post, we use MSCI’s stock-crowding model to identify which themes could be considered crowded. We then stress test those themes to understand how they could respond to an equity sell-off triggered by macroeconomic headwinds.
This crowd has energy
The exhibit below shows the weight of crowded stocks in each of MSCI’s thematic equity indexes, as of March 2021. This measure is based on a stock-crowding model that incorporates valuation, trading volume, volatility, momentum and short interest.
Source: MSCI.
We found that most of the thematic indexes were not considerably more crowded than a growth benchmark, represented here by the MSCI ACWI Investable Market Index (IMI) Growth Index, which had approximately 1% crowded stocks by weight. One theme, however, did stand out. The MSCI ACWI IMI Efficient Energy Index had 8% crowded stocks by weight as of the end of March 2021. For reference, this was similar to the level of crowding we saw in smaller-cap US technology stocks in 1999.
Tracing the Efficient Energy Index’s crowding history, beginning in 2017, we see in the exhibit below that the index became progressively more crowded throughout 2020 as equity markets rebounded from their lows in March of that year. The theme continued its upward trajectory through the end of the year and into the first quarter of 2021.
We also found that the future-education and genomic-innovation themes responded similarly until late 2020. Their crowding could reflect investors’ appetite for firms involved in telepresence and genomic sequencing, for example. Positive vaccine-related developments may have led, in part, to their becoming less crowded toward the end of the year.
Source: MSCI.
The potential impact is large. The Efficient Energy Index consists of firms that offer products and services that promote power generation using renewable sources. We found that the five largest renewables-themed ETFs by AUM had similar to slightly higher weights in crowded stocks. Additionally, many of the most crowded stocks were held across multiple funds.
Stress testing and tail risk
Next, we stress-tested the efficient-energy theme in three macroeconomic scenarios of varying severity. These scenarios follow from our earlier blog post on stress testing inflation, and ranged from optimistic (reflation) to a benign slowdown (an overheated economy) to a severe economic headwind (stagflation). While stagflation might be considered a lower-probability tail risk, its severity is helpful to further understand the link between crowding and a sharp potential market sell-off.
The scenario results for the efficient-energy theme, as well as the MSCI ACWI IMI Growth Index and the broad-market MSCI ACWI IMI, are shown in the exhibit below.
Source: MSCI.
The model’s results indicate that the efficient energy theme is more sensitive in the severe scenario than the growth benchmark, which in turn is more sensitive than the MSCI ACWI IMI. The efficient-energy theme underperforms growth in the severe scenario by over 10%.
A tale of two factors
Why is the efficient-energy theme more vulnerable than growth in this scenario? We look at this potential underperformance based on the style factor, industry, country and currency exposures the Efficient-Energy Index has compared to the growth benchmark.
Source: MSCI.
Of these, style factors stood out sharply as the difference maker, as shown in the exhibit above. Within style, momentum and volatility were the largest detractors. We previously highlighted these two factors for having rewarded investors handsomely in 2020 but historically jolting investors during market reversals. As shown in the exhibit below, the largest potential losses for the efficient-energy theme arise from its positions in high-momentum US and European stocks, according to our model.
Source: MSCI.
Under pressure
Investors in thematics face a challenge in balancing exposure to long-term trends such as renewable power generation given substantial recent inflows. Tools such as crowding scores and stress testing could provide useful insights to help address this challenge.
Our analysis revealed the pressure from crowding was real, but the verdict on its impact was split. Compared to the broader market, most themes were far from the madding crowd. The current drawdown in the efficient-energy theme, however, could be explained, in part, by its elevated level of crowding and its factor sensitivity in the preceding months.
The authors thank Jay Yao for his contribution to this post.
(The views expressed here are those of the authors and do not necessarily reflect those of ETF Strategy.)