Blockchain ETFs: Proceed With Caution

June 08, 2018

Lawrence JohnsonLawrence Johnson has been immersed in the world of fintech innovation for years, and now as part of Morningstar’s business development team, he’s working on connecting nontraditional financial players and newer companies that are leveraging new types of technologies with the financial services ecosystem. In this role, his attention is always focused on the newest and latest trends in fintech as it applies to finance and investing. Johnson will be speaking at the Morningstar Investment Conference in Chicago about blockchain, and how advisors should think of it. He offers here a preview. What's the most exciting or innovative piece of fintech you’ve seen recently, one that has really benefited finance and investing?

Lawrence Johnson: I think innovation comes in two forms. On the AI side, we’re seeing a number of companies that have been able to not only harvest a lot of this technology and translate it into insights, but they can go on the other side and capture the essence of an individual’s profile.

So, it’s not just about delivering more data and more information to an investor, but about being able to take into account their own needs and expectations, filter that through, and deliver types of insights that someone can actually act upon.

At the same time, individuals are now trusting some of these “engines” and tools to help them make these better decisions. There’s a beautiful mixing of trust and science in these tools. There's some kind of magic about getting it right at the right time for these investors. You interact a lot with advisors. Do they see AI and all this technological innovation still as very pie-in-the-sky, or are they finding tangible applications to their business model in the way they invest portfolios for clients? What are you hearing from them?

Johnson: We work closely with over 200,000 advisors, who are using our tools right now. We pivot in the distribution process for a lot of fintech companies.

I think there are really two trends there. On the one hand, we saw the rise of robo advisors that promise they could basically reduce costs and deliver much more accurate programs and strategies for investors. That caused a lot of uproar in the marketplace, and a lot of the advisors had to change the way they do their job. There's been a great impact by this technology.

But at the same time, when you look at these new platforms where relationships were entertained between an investor and these applications, we've seen a lot of these robos now starting to reintegrate the human factor in their offering. This ability to engage personally with a client remains essential in the area of investments.

In the end, with these technologies that were supposed to just disrupt the marketplace and push aside advisors, it turns out we’re learning that if an advisor is well-equipped with the right tools, right research and the right mindset for delivering better value, better outcomes for the investors, they’ll be the winning strategy. Last year, bitcoin was up 1,200%, but folks seem more excited about blockchain than cryptocurrencies themselves. Joe Davis at Vanguard, for example, said Vanguard is already using blockchain technology. They’re excited about it. But for bitcoin, he sees prices going to zero. What tangible, exciting applications do you see for blockchain in investing?

Johnson: When we look at blockchain, we have to break it down between a number of domains. You have applications that relate to payments, such as bitcoin, which was originally seen as a payment platform. Then you have a new type of asset class that’s emerging around the notion of token securities. You also have utility applications. And then you have blockchain, which, in itself, is a stack of technologies. We need to maintain these distinctions to make smart assertions around this whole area.

When you look at the activity in the marketplace, for instance, we’ve seen two sides. You have an entity like Bank of America, which, through its Merrill Lynch holdings, says they’ll not support anyone holding bitcoins or cryptocurrencies in their portfolio. They don’t see it as a proper investment strategy. Yet they became one of the most aggressive players in blockchain research.

There’s a distinction to be made between blockchain and the other domains of blockchain-inspired applications. That said, I also say we’ve got to make a decision between the cryptocurrencies and these initial coin offerings.

There's been a shift from bitcoin to blockchain, and now there's a shift toward tokenized assets. People are trying to invest in the protocols themselves, which are the set of rules, the mechanics, the code associated with a type of application.

Vanguard’s position is totally right. Bitcoin was, in fact, a use case, a test. People use it for other purposes; namely, to store value. And we saw the price skyrocket. But at the end of the day, there's no real reason for that price to be so high. We don’t think at Morningstar that that is an investment strategy to be considered.

Blockchain, however, is a beautiful application being delivered by a number of players around the world. I don’t believe it will be the platform of technology that’s going to disrupt every other platform.

We’re seeing on the tokenized assets side a number of players ow, that are creating alternative trading systems. They're creating ways for companies to be able to issue tokenized securities in a compliant manner; “compliant” meaning they satisfy rules related to securities. And they're also looking to create second-layer markets to be able to support that. So that side of the equation is something we’re going to hear a lot more from in coming months. We’ve seen five blockchain ETFs come to market this year. Do you think capturing pure-play blockchain exposure is even doable, or is it too soon to be trying?

Johnson:  I would say it’s too soon to invest in it. At MICUS this year, we’re going to have a panel on blockchain, and we’re going to be providing insights to advisors to help them guide conversations with their clients. We’re also going to provide them with frameworks on how to make sense and keep up with developments in the marketplace.

But the bottom line is that we don’t believe this market has reached a level of maturity sufficient for anyone to feel confident in these investment decisions. There's too much risk of volatility. And the technology itself still needs to mature.

Some ETFs focusing on blockchain-type of applications will have to wait a bit to see how the dust settles on who the winners are. There are really too many problems associated with the technology itself, with consensus and how monies can be managed.

So, I think it’s still too early for this. There are some beautiful applications being built, but a lot of technology is still looking for its identity, looking for the ultimate business case or use case to be able to hang their hat on. So, in your panel at MICUS titled “Blockchain: Evolution or Revolution?” the key takeaway for advisors is going to be, wait?

Johnson: There are going to be two messages. On the one hand, we want to come out with a balanced view. If people walk out and say, “We understand there are five domains associated with blockchain. We shouldn’t just put everything in one big pot. All five have their own idiosyncrasies and opportunities,” that’s great. If we deliver that message, we’ll be happy.

The other message we want to convey is that we don’t believe you should be investing in these products yet.

The reason is that we go back to the same methodology and approach we've followed forever, which is seeing how any asset class needs to deliver on certain criteria relating to risk of volatility, and predictability. If we can’t measure the value proposition, or the value of these assets, we don’t believe we can make any pronouncements on the quality and the suitability for investment. That applies to ETFs as well, right?

Johnson: No. On the ETF side, there have been a number of initiatives that have gone to the SEC, and the SEC has blocked off these investments. Some of them are predicated on aggregating investments with cryptocurrencies. But if you're looking at companies just focusing on blockchain, there’s probably some value there.

But you really have to understand where the market is. Again, a lot of these companies are still looking for the perfect use case. And it’s just not happening.

We’re seeing in financial services that a lot of people aren’t building blockchain applications, they're building blockchain-inspired applications that, at the end of the day, are basically database applications that can do a lot of the things blockchain purports to be able to do.

Contact Cinthia Murphy at [email protected]

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