Push Into Crypto Triggers Downgrade for This Fund

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Emerald Banking & Finance has moved outside its circle of competence. The Morningstar Analyst Ratings on its cheapest share class falls to Neutral from Bronze. More expensive shares remain rated Neutral. Longtime managers Ken Mertz and Steven Russell have historically focused on regional banks, which accounted for 70%-80% of portfolio assets. They used a sensible and structured approach to finding the best ones, relying on extensive interviews with management teams and valuation models estimating future cash flows, earnings, target prices, and downside risks. However, a big shift into cryptocurrencies in late 2020 and early 2021 calls the discipline of the approach into question. As of February 2021, regional banks account for just 33% of asserts--the lowest ever in the strategy's 23-year history--while cryptocurrencies and businesses exposed to them make up 23% of the portfolio. Several such holdings are tied directly to the price of these digital currencies--such as Grayscale Bitcoin Trust, Grayscale Ethereum Trust, Purpose Bitcoin ETF, Bitcoin ETF, and Bitwise 10 Crypto Index--which together account for 4.7% of the portfolio. These assets have no management teams or cash flows to assess, so such a large stake seems speculative rather than a diversifying extension of the existing process. Amid these significant changes, there's also concern around the team's long-term stability and resources. When Emerald's current owners acquired the firm in late 2018, Mertz and Russell signed five-year lockups, so they'll be here for at least two more years. But Mertz has more than 40 years in the industry and his continued presence much beyond the lockup is uncertain. Indeed, he has already begun transitioning some of his coverage to Russell and analyst Ori Elan. Given his experience and industry relationships, Mertz's eventual departure would leave the strategy less resourced versus other financial category peers. The cryptocurrency mania has been a big boost to recent results, but it could easy snap back the other way. There are other financials sector funds with more durable and consistent advantages. Process | Below Average Major shifts away from the managers' regional banking core competency warrant a Process rating downgrade to Below Average from Average. Comanagers Kenneth Mertz and Steven Russell historically focused on U.S. banks with market caps between $50 million and $2.5 billion, using Emerald's 10-step process to find the best names. These steps include extensive interviews with management, board members, customers, vendors, and competitors. The team also assesses competitive positioning and growth prospects, then builds valuation models estimating future cash flows and earnings to arrive at a target price and evaluate downside risk. The recent shift into cryptocurrencies calls the discipline of the approach into question. The managers often diversified their core regional bank holdings with an eclectic mix of other businesses such REITs, financial technology, insurance, and even gold miners. But these bets were at the margins and prudently sized. Cryptocurrencies have no cash flows or management teams to assess, so with nearly 5% of portfolio assets directly betting on their price, the move seems more speculative rather than a diversifying extension of the existing process. Furthermore, the strategy's fundamental character has changed: 23% of portfolio assets are exposed to cryptocurrencies, while the portfolio's historical 70%-80% stake in regional banks is now less than half that. The portfolio has historically allocated 70%-80% of assets to regional banks. However, as of February 2021, that number dropped to just 33% as the managers shifted into cryptocurrencies and businesses exposed to them. The portfolio's largest holding is cryptocurrency trading platform Voyager Digital VYGR. Its 7.3% weighting exceeds the 5% maximum the managers have typically used to limit risk. Silvergate Capital SI and Signature Bank SBNY are two other top holdings, at 4.4% and 3.4%, respectively. Although they are indeed regional banks, both now accept cryptocurrency deposits, which accounts for their prominence in the portfolio. Beyond these service-oriented businesses, several holdings are tied directly to the price of digital currencies. Grayscale Bitcoin Trust, Grayscale Ethereum Trust, Purpose Bitcoin ETF, Bitcoin ETF, and Bitwise 10 Crypto Index together account for 4.7% of assets, representing a fairly large, speculative bet. There's little diversification within the group, too, with Bitcoin accounting for around 3.6% of assets in total. The portfolio is increasingly concentrated with just 66 holdings, down from twice that four years ago. A hefty 41.7% of assets are in the top 10 holdings, several of which are cryptocurrency bets. Overall, 23% of assets are exposed to cryptocurrencies, which closely ties the portfolio's fortunes to this new, volatile section of market. People | Average Uncertainty around the team's long-term stability and resources warrant a People rating downgrade to Average from Above Average. The managers trace their roots to the strategy's 1998 reformulation as a financial-services product. Comanager Kenneth Mertz, a more than 40-year industry veteran and president/CIO of Emerald Advisors, has been a permanent fixture. He works closely with Steven Russell, who comanaged the strategy in its first three years. After a stint at his own asset-management firm, he returned to Emerald in 2006 and resumed comanager duties here in 2012. Both are manager-analysts. Mertz focuses on insurance, REITs, community banks, and macroeconomics. Russell focuses on banks and more recently cryptocurrencies, traveling widely to meet management teams on their home turf, generally having around 100 such meetings annually. When Emerald's current owners acquired the firm in late 2018, Mertz and Russell signed five-year lockups, so they'll be here for at least two more years, but given Mertz's tenure, his continued presence much beyond that point is questionable. Indeed, he has already begun transitioning some of his insurance and community bank coverage to Russell and analyst Ori Elan. Russell is the clear successor, but Mertz's experience and industry relationships would leave the strategy less resourced versus other financial category peers. Parent | Average A closer hew to core competencies helps Emerald keep an Average Parent rating. Emerald has not had much success trying to diversify its lineup over the years. For example, the firm acquired direct-lending and exchange-traded fund businesses, but both failed to scale and were quickly shuttered in 2019. Similarly, a small-cap value strategy acquired in 2015 was liquidated in March 2021 as assets fell to about $2 million. Although these repeated disruptions aren't a good sign, they could indicate Emerald is sticking closer to its wheelhouse. The firm's legacy strategies focus on small- and micro-cap growth equities in separate accounts and mutual funds. Emerald Growth and Emerald Banking & Finance hold nearly all the firm's assets and are more stable (though new, big stakes in cryptocurrencies in the latter deserve close attention). In October 2018, 1251 Capital Group--a small financial-services holding company founded in 2014--took a 51% stake in Emerald while leaving the rest of the firm with employees through its employee stock ownership plan. The deal gives Emerald investment autonomy but secured five-year commitments for its portfolio managers and CIO Ken Mertz. 1251 Capital also provides distribution. Emerald must be thoughtful about growth as some of its strategies are capacity-constrained, but having access to distribution expertise also allows it to focus on investing. Performance From the strategy's October 1998 reconstitution as a financials sector product through March 2021, its 11.2% annualized gain beat the financial category's 6.7% and the S&P 600 Financials Index's 9.6%, which historically came closest to matching the strategy's sizable regional bank exposure. Exposure to these banks typically drove performance. For example, the fund's bottom-decile results in 2018 and 2019 mirrored regional banks' underperformance versus larger-cap competitors that benefited from greater scale, diversification, and technological advantages as questions swirled about the strength of the U.S. economy. Regional banks were hit hard again in the 2020 bear market. The index fell 45.2% from its Jan. 2 peak to its March 23 trough, while the strategy declined 46.6% because of its characteristic overweight in regional banks. However, a shift into cryptocurrencies drove outperformance more recently and boosted the long-term record. The fund placed atop its peer group in the year ended March 2021, with a 32.8% gain versus the index's 18.9%. Cryptocurrency trading platform Voyager Digital VYGR--the portfolio's top holding--was the largest contributor after gaining more than 500%. A 6.2% stake in cryptocurrency bank Silvergate Capital SI also helped as it gained 91%. Galaxy Digital GLXY, a crypto asset manager, was another top performer, gaining 182%. Price It's critical to evaluate expenses, as they come directly out of returns. The share class on this report levies a fee that ranks in its Morningstar Category's second-costliest quintile. That's poor, and based on our assessment of the fund's People, Process, and Parent pillars in the context of these fees, we don't think this share class will be able to deliver positive alpha relative to the category benchmark index, explaining its Morningstar Analyst Rating of Neutral.