Bitcoin Mania Helps Fund’s Returns, But Crypto Push Leads to Downgrade

Morningstar’s decision to downgrade the fund, disclosed late last week, could have ripple effects for Emerald Advisers. Through its ratings system, Morningstar is the gate keeper for many investors around the world as they evaluate which funds in which to invest.

The firm’s portfolio managers say the downgrade is unwarranted. They say they are doing what they have done for decades. In addition, between Oct. 1 and March 31, the largest share class of the $240 million fund generated total returns of more than 90%, net of fees, beating a benchmark of financial stocks.

“Since this fund was founded, it seeks growth in the financial service sector—and it hasn’t changed,” said

Kenneth Mertz,

Emerald Advisers’ investment chief and the fund’s portfolio manager of 23 years.

Morningstar analyst

Eric Schultz

said that 23% of the fund was in cryptocurrencies and businesses exposed to them as of February 2021. He said cryptocurrency mania had boosted the results. “It could [easily] snap back the other way,” he said.

The fund’s managers dispute Morningstar’s analysis and the idea that they are trying to ride a cryptocurrency bubble. They argue that several of their investments are bets on a growing financial-technology ecosystem. They made investments in Voyager Digital and Galaxy Digital with the view that these companies could shift beyond cryptocurrency to mainstream financial services over time. They said they have followed the companies for years.

They said they took stakes in various bitcoin and cryptocurrency fund investments because they believed the assets were trading at attractive valuations.

The disagreement reflects a broader investment debate playing out as bitcoin prices are on a wild ride. Prices more than tripled in 2020 and doubled in early 2021 before faltering. In recent days, crypto traders have lost money as exchanges liquidated their bitcoin bets.

At Emerald, the stock pickers made the crypto bets as part a tilt away from bank stocks in 2020. Their prediction at that time was that the pandemic and Federal Reserve interventions would squeeze banks.

“We started reconfiguring and moving out of banks with heavy exposure to commercial real estate for fear of write-downs coming and interest rates headed to zero,” said fund portfolio manager

Steven Russell.

Now, the managers say they could put more money into banks again, given they are less concerned about the challenges facing financial firms.

Write to Dawn Lim at dawn.lim@wsj.com