Blockforce Master Fund Q3 Review

(as of 10/31/2020): MTD*: 9.98% YTD: 53.3%

Well, It’s been a while.
I haven’t written you in a while, so this one is a bit of a rambler. If you make it to the end, thank you. I send updates like this to our hedge fund investors on monthly basis or I try to. If you’d like to be on this list, please let me know.

First and foremost, hello everyone! I hope you still remember us and look forward to our not so monthly commentary. In case you are not aware we are in the midst of the sale and subsequent transition of the Reality Shares ETF business. Of course, we would never think to neglect any of our portfolio related responsibilities, but at times like this, some of the investor communications get consumed by what seems to be the never-ending exit. We sold the business several months ago but now we need to execute the shareholder proxy vote. We anticipated with our shareholder base that it would close in October. Now it’s looking a bit like November or possibly even as late as January.

I feel a bit like Al Pacino in The Godfather III

I am now painfully aware that the shareholder proxy voting system in the United States Securities industry is woefully inadequate. Raise your hand if you have ever tossed a shareholder proxy vote in the trash. We are all guilty of it, and now I’m feeling it from the other point of view. It really has been interesting going through this. It has been a wonderful opportunity for me to speak firsthand to some of the wonderful investors in our ETFs. As you probably know, ETF issuers rarely know who the end client is. The problem, of course, is that most of our funds were purchased for those end clients by their advisors as part of an asset allocation. So the end shareholders often don’t even know which funds they own or why they own them. They rely on their advisor to make those decisions. This would be a fine system if their advisors were the ones responsible for voting on their client’s behalf, but that isn’t the case most of the time.

So we mail and we disrupt their dinnertime with annoying calls asking them to vote their proxy. Of course, it doesn’t help much that the elections are going on at the same time.
Alas, it will be over soon, but it is a stark reminder that the traditional investment world still has a lot of bloat and archaic problems that the blockchain and cryptocurrency system either avoids or has the potential to solve. In fact, this is why I got so excited about this space to begin with and why I am even more excited about it today. We are hopeful once we transfer the ETFs to the other trust, that will free up a significant amount of time for more communications and in-depth commentary on the market as well as the fund. Thank you for bearing with us in the meantime.

We continue to focus all of our efforts on the investment side of things for both businesses, but unfortunately, we aren’t always great at getting these letters out in a timely manner. That is my fault, I always end up thinking of one more thing to say or insert into the letter while my team rolls their eyes as we miss another deadline. I promise to try to be more methodical or at the very minimum share my quick thoughts on the markets and the fund’s activities. I know how important it is for you as investors. However, I will also say that my phone is always open to you if you ever want to call and get a personal update either on the fund or the markets, or even some personal thoughts on allocations you are considering in the space.

Market/Economic News:
Although this year hit the record for the unprecedented use of “unprecedented” in reporting negative news, the world of cryptocurrencies and other digital assets managed the chaos rather efficiently. There is an unprecedented amount of institutional investors allocating a portion of their balance sheets to bitcoin. Just to name a few, Paul Tudor Jones, Jack Dorsey (Square), MicroStrategy, Stoneridge Capital. PayPal now allows for users to trade, store, and send cryptocurrencies. We believe a combination of all of the above-pushed bitcoin above to high $13K levels on 10/21/2020, numbers that we haven’t seen since 2019 and early 2018. As I type, bitcoin is rallying to $15,700.

September and October:
Major industry developments continued to take place in September and October, as the cryptocurrency market recovered from the steep sell-off earlier in September. At the beginning of September, bitcoin made a quick push to the $12,000 level only to give up about 18% in the next four days. After finding a bottom around $9,900 bitcoin and the respective cryptocurrency markets began to claw back some of that early drawdown, finishing the month at approximately $10,800. This type of volatility is healthy for the market especially in a world where volatility is low and funding rates are close to zero. Traditional trading desks and hedge funds are looking for more aggressive markets to trade. This allows for fresh liquidity to flow in and price discovery for the cryptocurrency markets. These developments are all necessary elements of a maturing asset class. October showed stable growth for bitcoin with no significant volatility in either direction but the last 10 days showed a strong uptrend momentum. “Alts” did not follow the same pattern as BTC. Through the end of September the MVIS Small Cap cryptocurrency index was up almost 100% for the year. By the end of October, it was up just 10%. We believe the big inflow into Bitcoin while other assets sit on the sidelines is due to investors “FOMO” (Fear of missing out) to bitcoin as no one wants to miss out on numbers we have not seen in over a year. In rising markets, bitcoin leads and the others tend to follow. In declining markets others lead and bitcoin tends to follow. The smaller more aggressive and speculative assets are a place where significant wealth can be created or destroyed. As my friend Corey Hoffstein likes to say, “no pain no premium.”

Digital Gold
The idea of treating digital assets and bitcoin specifically as a separate asset class has been debated by many, but the concept of bitcoin as “Digital Gold” will not and should not go away. We encourage everyone to listen to the unexpected podcast between Jim Cramer and Anthony Pompliano that took place in September. Jim Cramer may seem slightly over the top if you have seen his antics on CNBC, and like anyone who is forced to make financial projections on a television show, he makes some bad calls from time to time. However, when you take him out of the short-form medium like TV or Radio and sit down to talk with him, he is thoughtful, he clearly understands markets and trends, and he isn’t afraid to try on new ideas. A long-form podcast interview was the perfect setting to hear his thoughts on inflation and this emerging trend of people considering bitcoin as a form of digital gold. If you haven’t yet had a chance to catch this interview it was fantastic. If you are not familiar with Anthony Pompliano — he is a partner at Morgan Creek, an alternative asset manager, in addition to that, he is one of the most prominent figures in the blockchain/crypto community due to his high-quality educational podcast “The Pomp Podcast”. In addition, Pompliano’s creativity uses his Twitter account to educate If that signals in your mind, soundbites, and flash, I assure you, this interview was anything but. Like so many of his interviews, it was mellow, thoughtful, and probing as the two discussed the ideas behind wealth transfer, inflation protection, and the possibility of bitcoin taking the place of gold for a younger generation of investors as an inflation hedge. Jim Cramer is known to have some incredibly strong opinions and as a long time investor in gold, I was expecting this conversation to be a bit adversarial. Instead, I was pleasantly surprised, and we believe you will be as well. Check it out here.
Global Central Banks are keeping interest rates artificially low, and due to COVID, they pumped trillions of new dollars into the economy. There is plenty of debate over whether or not we will see the velocity of money come down enough to offset that stimulus, but the potential for inflation now is high, and fear of inflation, whether it’s true or not, can be self-fulfilling. We have seen this in the past with other markets as the fear spreads from one person to the next and asset prices begin to move, markets are reflexive, so sometimes the idea of asset inflation actually sparks asset inflation which then starts a FOMO effect and so on. In the podcast they further discuss the point that Paul Tudor Jones made about inflation hedged assets doing great in this macro environment but bitcoin will be the most amplified due to the supply constraints and the relatively small global market capitalization.
Like gold, bitcoin supply increases as new bitcoins are mined each day, but unlike gold, bitcoin supply goes through a process called “halving” where the reward for every mined block gets reduced by one half every four years. As Pomp points out, “Now imagine if gold mines went through the same process every four years. [cutting their output in half]” The price of gold would explode. “I feel like it’s logical to add crypto to the menu” — Jim Cramer replied. Pompliano also ventured that If gold makes up 10% of your portfolio and you allocate 1% to bitcoin, “that one percent will outperform the remaining 9% of gold in the next 18 months.” Regardless of Pomp’s prediction, the idea of inheritance came up and the utility of gold versus the utility of bitcoin. As the two pondered the idea of Jim passing gold on to his younger children who grew up in a digital age, they discussed how a digital asset makes so much more sense than the analog version. At one point, later in the interview Jim really gets it when he says, “I’m being reckless” (by not allocating to crypto). This podcast was a huge step for the asset class. Like every network that grows in value as participants join, there are certain moments when the idea “crosses the chasm” from early adopters to mainstream. Thoughtful conversations like this one are not to be overlooked.

Active vs Passive Investing
More and more people are entering the asset class. Bitcoin wallet addresses and active daily users just hit all-time highs.

This train has no intention of slowing down anytime soon, so we once again remind you to consider a small allocation of your portfolio to bitcoin and other digital assets. See the chart below.

Because the asset class is still maturing, we always try to encourage our investors to gain exposure in two ways: passive and active. There are a number of ways to gain passive exposure to digital assets. If you are unsure how, please reach out, I will personally take the time to teach you how to purchase and store your assets directly or, if you are uncomfortable with that approach, I can direct you to a number of passively managed funds that allow access to the asset class. These passive funds like Galaxy Digital, Grayscale, Bitwise, and others handle all of the custody and acquisition on your behalf, all you have to do is buy the fund. They take care of the rest. However, because the asset class is still maturing, we feel that there is a great deal of opportunity justifying the case for an allocation to actively managed solutions as well.

This is by no means, an efficient asset class yet. In inefficient asset classes, the opportunity to generate alpha is high. There are plenty of opportunities for actively managed strategies to deliver superior, uncorrelated, risk-adjusted returns. Conversely, in highly efficient mature markets, it is difficult to create superior, risk-adjusted returns. With mature asset classes and markets, it makes a lot of sense to take a cap-weighted passive indexing approach. However, in less mature and highly inefficient asset classes the passive approach is sometimes the riskier bet. Consider the Chinese A-share stock market vs the US Stock market. In the US, almost 90% of actively managed large-cap money managers fail to outperform the S&P 500, yet in China, that statistic is flipped. Nearly 90% of all active managers in China outperform their benchmark index.

“This view is very much aligned to initial research from our Members which suggests that up to 90 percent of China ‘A-Share’ managers outperformed their index — so the hit rate for generating alpha is exceptionally high. If you look at the US — in a good year, it is 30 to 40 percent — whereas in China it is the exception for active managers not to outperform”.
We often talk about the idea of alpha, the risk-adjusted outperformance over a given passive investment, in this case, the passive investment represents the beta. For the most part, in a given market the beta is free. All you have to pay for is acquisition and storage. For the S&P 500, the cheapest ETF is about 0.03%. For digital assets, that number is much higher, the average passive fund for bitcoin charges close to 2% for their service. Two percent fee per year for a passive index fund holding a single asset may sound like a lot, but on a relative basis, that’s not bad considering that the annualized return over the past five years is approximately 215% for bitcoin vs. about 7% for the S&P 500. In cryptocurrency, acquisition, storage, and handling large sums of capital require more customization for security. As the asset class matures, the passive fees will come down but again, that’s just beta.

So, if allocating to the beta is practically free, then why wouldn’t everyone want to just allocate blindly to a passive cap-weighted index fund of the top 10 cryptocurrencies? In theory, shouldn’t diversification be your friend in a novel uncertain asset category? The answer is “yes…sort of.” A capitalization-weighted strategy where passive managers allocate more to the largest digital assets and less to the smaller digital assets would have foolishly invested in a number of cryptocurrencies that were artificially bid up on small closely held circulating supply in order to trick those passive strategies into investing. This isn’t the S&P 500 where earnings and other fundamentals are able to ultimately drive M&A activity and for price discovery. This is crypto, where prices can stay irrational longer than short sellers can stay solvent. So beware, many of the investing principles from the traditional world hold true in this world, but not all of them. Currently, in traditional assets, approximately 45% of the capital is invested in passive funds and the remainder is in actively managed investments or directly held. In crypto, that number is closer to 85% self-managed or passively invested, and only 15% actively managed. We believe it should be closer to 50/50.

In other developments
A major announcement hit the market in September, one of the largest cryptocurrency exchanges Kraken was cleared to start the first-ever US banking charter owned by a cryptocurrency firm. This development only highlights the work being put in behind the scenes of the crypto/blockchain world for mass adoption.

Business Insider published in September that bitcoin and blockchain will be important aspects of Twitter’s future through a new decentralized internet platform. Chief Executive Jack Dorsey of Twitter believes that blockchain and bitcoin will help shape twitter’s future of becoming a “content hosting” platform. Bluesky team is tasked with developing the open protocol, which would advance Twitter as a social media platform.

Israel is proposing a new bill that will recognize bitcoin as a currency rather than an asset. On September 22, the Israeli government body amended previous tax regulations which would allow digital currencies, specifically bitcoin to be taxed at a lower rate. Regulatory barriers are the main reason for the lag in the development of Israel’s crypto sector. In addition, the European Commission is planning to create a new trading platform that would benefit businesses by allowing them to raise funds by releasing their own coins to generate money from the blockchain network. A new single market for digital currency would provide a clear set of rules, resulting in multiple doors opening for investment and digital marketing.

The Fund Update:
As a reminder, our Achilles heel is not the raging sustained bull market or the deadly sustained bear market, but the more likely periods where we will struggle to keep up are those that lack direction when volatility is low. When we get into sideways markets with random spikes of volatility the fund tends to underperform as a clear trend is not established yet. So in the shorter term, we built the fund to be respectable in bull markets to preserve capital in down markets, and with the magic of compounding, we believe this has the power to deliver superior adjusted returns with a little bit less stomach acid.

The exposure levels for October are shown below. The average exposure was 74% for the month.

Bitcoin was up around 27.7% in October, while the fund was up 9%. The sharp rally and meaningful outperformance of BTC compared to all of the other assets left our fund trailing BTC. This is perfectly within our band of tolerance for any given short-term period. During rallies such as this, it is difficult for the fund to capture as much of the upside. Our specialty revolves around risk management, as we live and breathe risk reduction.
We do this in three ways:
First, we never fully expose the fund — we always limit our exposure to the market no matter how optimistic the market might seem, and even when “FOMO” kicks in. As the market matures and volatility comes down, we may look to re-evaluate this strategy, but there is plenty of volatility with 80% gross exposure.

Second, we engage in market-neutral strategies such as lending to offset some of the beta risks and provide additional return on the stable assets.

Third, we are constantly evaluating our algorithms based on new research and new markets. Even the best algorithms eventually get crowded out as other asset managers identify similar signals. The key is to never stop learning. This is truly the most interesting asset class I have ever been involved with. There are so many nuanced pockets of brilliant minds innovating in the space.

While our fund does not have a venture component, as the newer protocols go live, they become amazing sources of information to identify trends and signals in other protocols.

We were honored to see that cryptofundresearch.com included us in the Top 10 Best Crypto Hedge funds in the World list that was out of the 800 funds in their database.

As I end everyone of my notes:

As a reminder, we continue to steer our fund towards our core objectives. Our mission remains:

1. 80% of the upside of the crypto markets with 40% of the downside.
2. Half of the volatility of a long-only cryptocurrency portfolio, and
3. Little to no correlation to other asset classes.

These objectives are bold, but we continue to believe that with hard work, discipline, and patience, we will deliver on what we set out to accomplish.

As we stated in our previous letters, we are no longer waiving the minimum qualifications to invest in the fund as the demand is growing on a daily basis and we have to be selective due to a limited number of spots.

Please contact us today if you have any questions regarding the minimum qualifications to get started.

Sincerely,

Eric Ervin, CEO

Blockforce Capital — a quantitative cryptocurrency hedge fund.

*Blockforce Capital Management, LLC and its affiliates are furnishing this publication (this “Article”) to sophisticated current and prospective investors for informational purposes only in relation to existing or potential subscription in the Blockforce Multi-Strategy Fund. This is neither an offer to sell nor a solicitation to buy units or shares in any fund. Any such offer or solicitation will be made solely through definitive offering documents, identified as such, which will contain information about each fund’s investment objectives and terms and conditions of an investment and may also describe risks and tax information related to an investment therein and which qualifies in its entirety the information set forth in this Article. Interests in the Fund are exempt from registration under the Securities Act of 1933, as amended, and Regulation D promulgated thereunder, in accordance with the definitive offering materials. Investors should conduct their own assessment prior to making any investment and consult their own investment, legal, accounting and tax advisors in order to make an independent determination of the suitability of an investment. An investment in the Blockforce Multi-Strategy Fund involves significant risks, including entire loss of investment, and is suitable only for sophisticated accredited investors. Past performance does not guarantee future results.