Technological advances have made gaming a more rewarding experience for many users across diverse demographics. Looking ahead, developments like the Metaverse and artificial intelligence (AI) could revolutionize the gaming space and make it a more attractive investment. Additionally, esports have increased in popularity. from the COVID-19 pandemic. In the long term, this industry could become as prevalent as physical sports, as esports allows aspiring players to feel the thrill of intense competition without worrying about bodily injury and other health issues.
As a broader niche sub-component of the communication sector, the video game market could present inherent concentration risk that could be quite deficient as macroeconomic conditions decline. Similarly, values focused on video games may not have the same protection as those focused on communication as a whole. For these reasons, I rate the Global X Video Esports and Gaming ETFs (NASDAQ: HERO) a wait.
The communication sector is quite prevalent in the video game industry, but video games are a relatively less important part of the communication sector. The video game industry took a huge hit in 2022 when the bear market took over, causing the number of deals closed and the value of these deals to decline. Video game sales also declined from 2021 to 2022, and I think consumer spending in this space is due for further disruption before the end of this year. As recession fears continue to surface, 2023 is likely to be another uphill battle for many digital game franchises. Video game revenue is still projected to grow steadily over the long term, and this form of recreation could develop an even larger fan base than it already has. However, the road in the short and medium term seems quite bumpy.
HERO tracks the Solactive Video Games & Esports NR USD Index and uses a full replication technique. The designated index consists of companies that are poised to benefit from increased consumption in the gaming and esports arenas. These companies are primarily identified as video game developers and publishers, as well as content distributors and streaming services. Qualifying businesses must derive at least half of their revenue from video games and sports activities. The market capitalization of the same companies must also exceed $200mm and their average daily turnover for the last 6 months must be at least $2mm. This ETF is reweighted semi-annually.
This ETF mainly dabbles in communication with also a small amount of technology and cyclical consumption.
HERO member companies are located primarily in the United States and East Asia. East Asian countries represented in this ETF include Japan, South Korea, and Hong Kong. All of these regions have relatively lucrative gaming industries, hence their prevalence in this ETF.
In this fund of just over 50 holdings, the top 10 stocks account for just over half of the entire portfolio. The four leading stocks in HERO account for about a quarter of this ETF.
Therefore, concentration risk may be a prominent concern within this ETF, and investors may want to assess their confidence in letting just a few stocks make most of the move.
The esports industry is well positioned for long-term growth and is becoming a more popular scene for both competitors and the public. As shown in the chart below, revenue in this industry could exceed $2.2 billion as early as 2027.
Growth in the esports industry could catalyze the popularity and demand for certain video games, which could ultimately increase the price of HERO.
Unlike an all-encompassing communications fund, this ETF can be a unique alternative for those particularly interested in the gaming space. Therefore, HERO could offer more limited exposure compared to certain broad-focused alternatives, while providing the benefits of diversification not found in individual video game stocks. This could become a highlight of this ETF as the number of video game enthusiasts is increasing as well.
HERO has underperformed several of its more broadly focused alternatives. The narrow focus of this ETF may appeal to those with more specific interests, but it may also hinder gains. Below is HERO’s performance in 2023 compared to ETFs covering the broad spectrum of communication services.
Evidently, HERO’s momentum is lagging significantly behind some of its peers. This ETF may have a fundamental problem with momentum compared to funds that strategically capture the most profitable communication areas. A notable example of this is the SPDR Select Communication Services Sector ETF (XLC). In the long term, investors might want to consider how profitable video games are compared to communications in general, and whether HERO’s niche weighs against the opportunity cost associated with choosing this ETF over one of its peers.
This ETF is also quite volatile, which may be due to its narrower focus on video games rather than other areas of communication like the internet, streaming, and social media that might have more room for lucrative innovation. I have covered the Internet as an industry in my article on the Invesco NASDAQ Internet ETF (PNQI).
Virtual reality (VR) and augmented reality (AR) are becoming increasingly popular as they can offer a more realistic and immersive experience to gamers. Also, VR and AR have gotten a huge boost from developments in the Metaverse. I think Meta (META) has the potential to revolutionize gaming with this project. Therefore, the growth in the Metaverse, as well as VR and AR, could catalyze demand for video games and increase the price of HERO at the same time.
Content creation as an occupation is also gaining popularity, especially among the younger generations.
Video games are a primary source of content for such creators. As a result, the growth of this industry could laterally boost the growth of the video game market. This could provide HERO with a much-sought boost in the coming periods.
Video game consoles, as well as the games themselves, are becoming more expensive, and for many, they may be more of a luxury than a necessity. As a result, the demand for video games could be affected during an economic downturn. Furthermore, microtransactions are increasingly becoming an integral part of video games. This component has already provided video game companies with a generous cash boost. However, as prices continue to rise, microtransactions could deter consumers and stifle demand and enthusiasm for video games.
Online multiplayer is a core component of many game franchises and is beloved by many, as it allows players to meet new people and compete against real people instead of computer processing units (CPUs). However, this very aspect could be a breeding ground for privacy and security concerns. Especially with increasingly proficient and accessible AI systems, quickly accessing large amounts of user data for exploitation purposes could become much easier and a more significant threat sooner rather than later.
Gaming is likely to become a more popular and satisfying form of entertainment in the future, but this industry is not the most recession-resistant. Small-cap niche funds could take off in the long run just like video games themselves, but in the meantime, I think the current economic outlook warrants great caution. Amid tighter economic conditions, investors may be better off with broader communication funds. Therefore, I rate HERO as Hold.