HERO - HERO: Fashionable ETF Only During Good Times

2023-09-29 12:35:45 ET

Summary

• Global X Video Games & Esports ETF lacks key players in the gaming sector.
• Investing in HERO may be risky due to high interest rates and potential overvaluation of growth companies.
• The ETF is inefficient and it seems to be a good idea only in favorable times.

In this article, I delve into the Global X Video Games & Esports ETF (HERO). Following my previous article on the ESPO (ESPO) Gaming Sector ETF (you can find the link here ), I decided to take a closer look at this ETF. HERO, being from the same sector, shares many of the same challenges as ESPO. While HERO may appear well-diversified, a thorough analysis of the ETF's characteristics reveals the absence of some key players in the sector. Furthermore, despite the gaming sector's strong growth and promising future, the current market conditions may not favor investments in it. In fact, it could be an opportune time for selling, because of high-interest rates and growth estimates that may not entirely align with the actual demand within the industry.

HERO Breakdown

Starting with an examination of the ETF breakdown, HERO appears to be well-positioned and diversified from a geographical point of view, with its top three holdings being the United States (34.6% of the total weight), Japan (28.0%), and China (12.2%).

The ETF has a total of 50 holdings, with none exceeding more than 7% of the total weight, indicating a well-distributed portfolio. The primary holdings include Activision Blizzard (ATVI), NetEase Inc. (NTES), and AppLovin Corp (APP).

HERO primarily focuses on mid-cap growth companies with market capitalizations ranging from $2 billion to $10 billion. Notably, some major players in the sector are missing.

As I highlighted in my article on ESPO, there's a notable absence of companies such as Microsoft (MSFT), Nvidia (NVDA), Meta (META), or Tencent (TCEHY), which have made significant investments in the sector. Consequently, the ETF appears to be more concentrated on lesser-known players within the sector. This, however, presents a double-edged sword: while it may potentially offer higher returns than the average, it also exposes investors to higher drawdowns.

The Challenge with Growth Companies Amid 5.25%-5.5% Interest Rates

The primary challenge facing HERO isn't diversification but rather the current macroeconomic context. While building a balanced portfolio with HERO, alongside other major players not included within it (as previously mentioned, META, MSFT, NVDA, etc.), could potentially mitigate losses and ensure profits over a 5 to 10-year horizon, holding only HERO at this moment appears to be a very risky idea.

A closer examination of the constituent companies reveals a common pattern: most are disruptive companies that heavily rely on leverage to fuel their growth. In an environment with historically high interest rates, investing in companies with elevated multiples (HERO has currently a PE of 27.70) and challenges in repaying or financing their debt seems excessively risky.

In fact, in line with conventional financial wisdom, the current macroeconomic cycle favors a focus on companies with robust cash flows. In essence, mid-cap growth companies should be approached with caution, a point that has to be underlined especially after the Federal Reserve's indication of "Higher for Longer" regarding interest rates.

Other Risks to Consider

First and foremost, when examining the statistics, what stands out about HERO is its Sharpe ratio. While the industry average stands at 0.86, HERO has a Sharpe ratio of -0.47, which is significantly unfavorable. Additionally, the Treynor Ratio doesn't offer much reassurance either, with a reading of -11.56, particularly when considering the risk-return profile of the ETF.

Another notable risk concerns the gaming sector itself. Growth estimates appear exceedingly optimistic in my view, with a CAGR of 13.4%. However, as I discussed in my ESPO article, several aspects do not convince me. These include Chinese policies regarding smartphone usage by children, which impacts mobile gaming (an anticipated major driver of growth, especially in Asia), and the not-so-good reception of the metaverse and augmented reality headsets, despite being highly praised in the growth narrative of the gaming sector.

Finally, when we assess HERO's performance, we observe that since its inception in 2019, the ETF has significantly underperformed the S&P 500, with a return of +19.47%, nearly 20% less.

Furthermore, examining the trend in the graph, a familiar pattern emerges, resembling that of many disruptive companies: when things are going well, there's a rush to invest in them due to their trendiness, but as soon as challenges arise (such as rising interest rates), the often unjustified high multiples deflate, leading to a collapse in valuations. By the way, very similar to what happened in 2000.

In Conclusion

For these reasons, I find HERO to be an intriguing ETF because it includes numerous small and disruptive companies in the sector. However, I believe that recent valuations and overall performance have been excessively influenced by trends and the fervor to invest in what seems to be the future's high-growth sector. Now, as attention (and capital) shift toward AI and with rising interest rates adding to the complexity, I consider current multiples to still be overly inflated. Consequently, I see ample room for HERO to decline further, making it, from my point of view, a "Strong Sell."

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