It is no longer prudent to ignore the potential of crypto assets.
The investment industry can be sceptical about crypto assets. Investors can certainly choose not allocate to them, but few can afford to ignore them.
Why? Not just because Bitcoin’s dizzying ascent – the most recognised crypto asset has risen eight-fold over the past 12 months and 140 times in five years (as of 19 April 2021) – has captured the popular imagination but the more persuasive reasons why the investment industry should be paying attention.
First, as a CFA Institute Research Foundation paper notes, investment in crypto assets and crypto-asset infrastructure is increasingly undertaken by market players, not just mavericks. Substantial financial institutions, such as Fidelity Investments and the CME Group, are involved. Large endowments, including those managed by Harvard, Yale and Stanford have invested, in tandem with hedge fund stalwarts such as Paul Tudor Jones II. Facebook, PayPal, Visa and Square are all considering crypto-asset strategies. In response, central banks including the US Federal Reserve, Bank of England, and the People’s Bank of China are discussing whether to develop their own central bank digital currencies.
Second, consultants and pension schemes are asked by their clients and members to examine the case for investing in crypto assets. Given that crypto currencies now have a market capitalisation in excess of $2trn (€1.6trn) these requests no longer seem outlandish.
Third, there is (early and limited) evidence that adding crypto to portfolios increases long-term absolute and risk-adjusted returns. Analysis in the CFA Institute Research Foundation paper shows that adding Bitcoin to a traditional 60/40 stock/bond portfolio has a positive impact on long-term portfolio returns on both an absolute and a risk-adjusted basis. For the period January 2014 to September 2020, a quarterly rebalanced 2.5% allocation to Bitcoin increased a traditional portfolio’s returns by 23.9 percentage points. Importantly, volatility would have remained almost constant (10.5% versus 10.3%). As a result, the portfolio’s Sharpe ratio grew from 0.54 to 0.75.
Last, given the lack of obvious correlation with other assets, crypto assets are potentially a portfolio diversifier.
In short, whatever your personal view on crypto assets, anyone with a fiduciary duty cannot afford to ignore them.
Let’s be clear, CFA Institute is not endorsing Bitcoin.
Indeed, there are many reasons to be sceptical. Chief among these is that crypto assets defy conventional analysis. Basic tasks such as obtaining daily trading volumes are fraught with difficulty.
Then there is the challenge of identifying fundamental drivers of valuation: valuation models do exist, but all are flawed. Model inputs are often incomplete or unreliable. Crypto assets are more akin to commodities or currencies than to cashflow-producing instruments, and even valuation frameworks for these established assets are challenging.
Furthermore, there is no consensus about the role (if any) that crypto assets should have in a professionally-managed portfolio. Consultants’ due diligence efforts are still in their infancy, and broker-led research is thin.
None of these challenges would matter much if it were clear that crypto-asset valuations would carry on rising over the long term. To date, Bitcoin has proved itself a rare asset – combining the return characteristics of a classic alternative asset with the liquidity of a publicly-traded security. The key question is whether it will retain these characteristics in the future.
The Research Foundation paper contends that the answer lies with the three core characteristics of crypto assets: high volatility; low correlation with traditional assets; and high potential returns.
Volatility seems to be improving: Bitcoin’s standard deviation of daily returns was 5.4% between 2013 and 2015, 4.1% between 2015 and 2018, and 3.7% between 2019 and September 2020. The paper argues that this pattern of declining volatility should continue.
Meanwhile, the low correlation between crypto assets and traditional ones will likely persist because the drivers of crypto are unrelated to fundamental value (see panel).
The outlook for valuations is more nuanced. Crypto bulls paint a picture of a future where crypto assets are as familiar as cash, and crypto-powered blockchains are used for lending, remittances, escrow, title transfer, and automated market making. They argue that even the most established crypto asset (Bitcoin) has a capitalisation of less than 2% of its most obvious comparable (gold), suggesting that valuations could go far higher.
Crypto bears, however, note that the valuations of some crypto assets are already measured in the hundreds of billions of dollars – comparable to the valuations of the largest corporations in America. Crypto assets are over-valued, say the bears, prone to scams and hacks, and destined to be remembered as the cyber-equivalent of tulip mania in 1636-37.
Investors also have to factor some practicalities into their thinking. Custody is one such: the ownership of a crypto asset is secured by a password, or ‘private key’. If that private key is lost or stolen, the asset is lost forever.
Other challenges include no accepted taxation structure for crypto assets. Tax on crypto, where it exists, varies enormously in type and amplitude between countries. Meanwhile, the regulatory treatment of crypto assets is evolving with regulators’ pronouncements swinging alarmingly from positive to negative, and back again.
For early adopters, the experience has been overwhelmingly positive, providing a rare combination of high returns, low correlations with other assets, and intraday liquidity. At the same time, their introduction has been messy, exposing some investors to huge volatility, fraud and scams.
Time will tell whether the substantial investment in crypto infrastructure – including the development of regulated custodians, the launch of regulated futures contracts, and the creation of crypto-asset funds – will make crypto a staple of institutional portfolios.
Until then, investors and consultants should keep a watching brief. Few in the investment industry can afford to put their head in the sand and say “I don’t get it, so I’ll ignore it and hope it goes away”.
Rhodri Preece is senior head of industry research at the CFA Institute