How Do Blockchain ETFs Work?

The global mania surrounding cryptocurrencies' underlying blockchain technology is opening up new avenues for investment and trading through recently launched exchange-traded funds (ETF).

Though U.S. regulators have rejected ETFs based on bitcoins, they have approved blockchain-based ETFs, paving the way for the launch of ETFs based on the underlying technology. Canadian regulators have also approved the country’s first blockchain ETF called Blockchain Technologies ETF (HBLK), which was launched in early February 2018. (See also: SEC Denies Winklevoss Twins' Bid to Launch Bitcoin ETF.)

Two recently launched blockchain ETFs in the United States include the Reality Shares Nasdaq NexGen Economy (BLCN) ETF and the Amplify Transformational Data Sharing (BLOK) ETF, which have managed to collect $240 million worth of investments in a week, which is a remarkable feat for new launches.

This article examines blockchain ETFs, how they work, where they invest, the underlying methodology they follow, and the inherent risks.

While the blockchain-based monetary system, like bitcoin, is under review by different regulators across the globe, the underlying concept of blockchain has seen high adaptability and potential.

Beyond cryptocurrencies, the blockchain is finding increasing use in various other sectors, that include services, supply chain management, digital apps development, digital entertainment industry, biotechnology and even agriculture. This has caused a lot of technology companies to embrace the blockchain technology for developing new systems, and also explore possibilities of porting the existing systems to blockchain base for enhanced efficiency and improved utilization.

As per BLCN ETF's factsheet, blockchain has the potential to save infrastructure costs for banks in the range of $15 billion to $20 billion by 2022. Moreover, around 10% of the global GDP is expected to be stored on blockchain platforms.

Investors are opening up to the idea of investing in blockchain, which is emerging as a specialized sub-sector that sometimes gets classified under the technology sector, and sometimes under the finance sector.

These investments can be made through various means. For instance, one can directly purchase virtual currencies belonging to various blockchain-based systems, like the ether token on Ethereum. However, that can be a complex affair for the common investor, and also carries inherent risk of losses should that particular blockchain system fail. (See also, An Introduction to Ethereum Classic.)

An easy approach is to invest in shares of listed companies that are working in the blockchain space. For instance, if IBM is making significant progress in developing blockchain-based systems and gaining revenues from it, their shareholders can expect to benefit from increased returns on IBM stock. However, this approach also carries stock-specific risk. (For more, see IBM Could Ride Blockchain Craze to New Highs.)

Enter blockchain ETFs, which offer an efficient investment vehicle to invest in a select basket of blockchain-specific stocks. An ETF, or exchange traded fund, offers dual benefits – it offers diversification by spreading money across multiple stocks like a mutual fund, and live real-time trading opportunities like a stock that changes with every tick, allowing intraday trading opportunities to active traders.

Such blockchain ETFs track the performance of an underlying index which acts as a benchmark.

Let’s examiner the underlying index and methodology behind the working of an ETF with an example.

The BLCN ETF is a passively managed ETF that attempts to track the performance of a specially designed index called the Reality Shares Nasdaq Blockchain Economy Index. This index is comprised of companies which are involved in research, development, support, or utilization of the blockchain technology and associated businesses.

The index methodology assigns a “Blockchain Score” to each potential company stock that may be an eligible candidate for inclusion in this index. This score is based on several factors about how the business of the company is contributing to the blockchain ecosystem, its blockchain product maturity and associated economic impact, investments and expenditure on research and development activities, company results, and innovations.

This factor-based methodology ensures that the potential of a blockchain company and its business is gauged with higher accuracy for realistic economic profits, renovated business prospects, and operational competence. The 50 to 100 companies with the top Blockchain Scores qualify for entry in this index, and the same stocks get replicated in the BLCN ETF. The index is rebalanced every six months.

On the other hand, the BLOK ETF is an actively managed ETF which aims to invest in global companies that are deriving significant income from transformational data sharing-related business, or are engaged in the research and development, proof-of-concept testing, and/or implementation of similar technology.

For both the BLCN and BLOK ETFs, global companies from a wide range of industry sectors are open for investments. They include companies from the banking and financial sector, technology, IT services, hardware, internet, telecom services, and even biotechnology which may be using some form of data sharing or blockchain-based systems. (See also: Can Blockchain Make Medications Cheaper and Safer?)

For instance, the BLCN ETF is holding companies like Cisco Systems Inc (CSCO), Intel Corp (INTC), Overstock.com Inc (OSTK), Microsoft Corp (MSFT) and Barclays PLC (BCS), while the BLOK ETF's holdings include Taiwan Semiconductor Co (TSM), NVidia Corp (NVDA), IBM Corp (IBM), Overstock.com Inc. and GMO Internet Inc.

As blockchain technology remains open and global, companies from across the world are included in these ETFs. Regionally, both ETFs have the bulk of exposure to North America-based blockchain companies, while the rest is shared by Asian and European companies in varying proportions.

No investment comes risk-free, and the same is true for blockchain ETFs.

Being a theme-based investment, blockchain ETFs carry the inherent risk of non-performance, non-adaptability, or failure of blockchain ecosystem. While there is an increasing level of acceptance for blockchain systems, the concept is still in a nascent stage and remains dependent on the evolution of the overall ecosystem, the reliability and stability of the blockchain network, its configuration, and its successful adoption.

Another inherent risk is that one may end up betting a significant portion of money on technology-based startups which are prone to failure. While the diversification through ETFs mitigates such stock-specific risk to a good extent, the risk of certain holdings not performing well remains nevertheless.

Additionally, there is a mixed bag in the top holding companies of such ETFs, which have a big overlap with existing technology and internet companies.

For example, although Microsoft and IBM are among the top holdings for both BLCN and BLOK, they are essentially technology companies deriving a larger share of their revenues from non-blockchain based products and services. Similarly, Cisco and Intel are primarily hardware components companies which derive most of their revenues from networking equipments and computer processors, while having a limited share from hardware that is used in blockchain-based systems.

Blockchain segments may be contributing only a small part of overall revenues to such stocks, making the overall returns vulnerable to the non-performance of their majority non-blockchain segments.

One also needs to be aware of the expense ratio charged by fund houses, and the trading charges levied by such ETF units.

While purchasing such ETFs, one needs to account for the fact that they are betting on a mixed bag of stocks that are expected to benefit in the long run from the overall emergence of blockchain.

Blockchain ETFs have opened a new horizon for common investors to benefit from the blockchain sector. While firm believers in blockchain technology can invest in their selected ETF in the long term, those seeking short-term or intraday trading opportunities can also actively trade them like a stock. (See also, What Is the Difference Between Blockchain ETFs and Bitcoin ETFs?)

Investing in cryptocurrencies and other Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.