Taking the Mystery Out of Blockchain Investing

Why would one want a separate portfolio allocation to blockchain technology? It's a question nagging many professional investors as they see headline after headline on the topic.

In our view, the thesis is somewhat similar to sector investing: It can help advisors express thematic market views and/or capture potential alpha opportunities. Traditional sector opportunities may be growth-oriented, like technology funds, or income- and volatility-focused like utility funds, or potential inflation hedges like real estate and other real asset funds. In all, sector plays are a significant part of the investment universe, to the tune of over $750 billion in sector mutual funds and ETFs.

In the same way, an actively managed blockchain sleeve can add specific exposures to an equity portfolio, in particular:

a strong growth orientation;
a global tilt to that growth; and
a small/SMID tilt, as many of these current opportunities may be with smaller-cap companies just finding their markets.

Unlike single-sector funds, however, blockchain is a thematic play that cuts across multiple industries, from finance, to retail, to multiple parts of the tech sector (software, hardware and semiconductors). Blockchain is diversified along supply chains as well, where upstream companies make hardware and software to support blockchain systems; midstream companies aim to profit directly from blockchain technology adoption; and downstream companies accept payments or transactions based on blockchain-based currencies.

What's Driving Growth? Potential Disruption Across 30 Industries

Blockchain technologies are disrupting a lot of industries, chief among them being financial services. Take transaction banking, where blockchain technology is lowering costs and fees, according to a Bain & Co. study. So, banks piling into this space may be in for a rude awakening as downward fee pressure potentially turns an attractive, profitable business into a low-fee, commoditized business in a matter of a few years.

This kind of disruption isn't just happening in financial services. In retail, Overstock and Shopify are working quickly on enabling payments using cryptocurrencies. Walmart is using blockchain to improve inventory management. Global automakers are planning to apply blockchain technology to vehicle and consumer data. Chip manufactures each have exposure to different parts of the blockchain ecosystem, and thus, different prospects for long-term success.

We estimate that at least 30 industries could get swamped by a wave of blockchain innovation over the next couple of decades—from banking, to cloud computing, to energy management, to government and public records, to anything involving intellectual property.

An Actionable Investment Thesis

The ins and outs of blockchain can be complex. Some established firms excel at development and adoption (e.g. Overstock), while others put out blockchain press releases with nothing to back them up (e.g. Long Island Iced Tea). In the same vein, startups can offer radically transformative tech, or gimmicky flops.

It may take a blockchain specialist to uncover the difference, which is why we believe active management is essential in this space, where few analysts fully grasp the intricacies and potential impact of the technology — we believe that informed experts have the potential to add significant value.

As for cryptocurrencies (which are just digital tokens residing on a blockchain), our view is that in the long run, they could become an entrenched part of the global payments network. But right now one has to consider them more like venture capital or hedge fund investing.

Yet, equity investors may still find strong potential opportunity in the chipmakers, software/app developers, and "mining" companies that make up the backbone of the crypto ecosystem. This kind of indirect exposure may provide access to the secular growth trend without the volatility of investing in cryptocurrencies themselves.

What does all that look like in practice? A strong blockchain equity portfolio, in our view, would be global, with residual overweights toward the countries with the heaviest blockchain adoption: Japan, South Korea, China and other Asian markets. It would also have a small/SMID tilt, owing to its focus on up-and-coming developers of this technology. But it would be diversified across several sectors (retail, diversified financials and several subsectors within tech).

Over the past several decades, professional investors have used sector, factor and other satellite funds to express thematic market views and capture potential alpha opportunities. Using a blockchain fund is no different in that sense.

This emerging technology represents a secular growth story that comes along only once or twice in an investor's career, in our view. Blockchain-focused investing is a proxy for emerging growth companies, as well as entrenched leaders, that have a chance to dominate the blockchain economy as it unfolds over the next 10 to 20 years.

We believe such a fund could fit comfortably into a global growth strategy, an opportunistic bucket, an alpha-generating bucket, or a range of other growth-oriented segments of a diversified portfolio. It's up to each advisor to decide if, and where, such a secular growth play might fit into client portfolios.

But once you get familiar with the details, we don't believe that there's much mystery about the growth opportunity for equity investors and what's driving it.

Brian Kelly is portfolio manager for the REX BKCM ETF, which invests in blockchain- and cryptocurrency-related companies.