Should cryptocurrencies be treated as an asset class in a diversified portfolio intended for retirement savings?
By Nic du Toit, Regional Head: Investment Consulting
In 2020, the value of Bitcoin increased from just under USD9,000 to around USD40,000. This occurred amid record-low real interest rates and continued accommodative monetary policies. Given this rife environment for speculative investments, it is not surprising that investors are grappling with the question whether cryptocurrencies should find their way into retirement fund portfolios.
In 2008, an online posting of a pseudonymous white paper envisioned a new way to transfer value over the internet in an instant and a transparent way, without using the banking system. This peer-to-peer electronic payment system, explained by a “Satoshi Nakamoto” (who is yet to be identified), set the scene for Bitcoin to lead the way for cryptocurrencies to be a worldwide accepted medium of transacting. The payment system was made possible through an encryption methodology known as blockchain. Now, 13 years later, at the start of 2021, a single Bitcoin had a market value of around USD40,000 (roughly R600 000) and according to the initial white paper there will be no more than 21 million Bitcoins in circulation. Of these, an estimated 19 million have already been made available for trade after being “mined”. At today’s market value, the 21 million coins represent a total market cap potential of USD0.84 trillion (R12.6 trillion), which is more than double the South African GDP of roughly USD0.35 trillion (R5.2 trillion).
The question remains, though: Does Bitcoin or any other cryptocurrency have a place in a well-diversified portfolio, and can it be considered a sustainable asset class?
In 1997, Robert J. Greer published an article in the Journal of Portfolio Management where he identified the following three criteria to be used to specify asset classes for the purpose of asset allocation:
- Assets within an asset class should be relatively homogeneous or similar – the assets that make up an asset class should exhibit similar characteristics.
- Asset classes should be mutually exclusive – an asset should only be able to be categorised into one asset class (i.e. no overlap between asset classes).
- Asset classes should be diversifying – have a low correlation to other asset classes.
In order to make sense of these asset classes within portfolio theory, asset classes can then be categorised as either being local or offshore, public or private, as well as traditional or alternative in nature. While classifying asset classes into either local or offshore, public or private markets may be easier to comprehend, the other asset classifications are more elaborate. In layman’s terms, alternative assets represent real assets which are more sensitive to inflation and can represent a store of value, whereas traditional assets like equities and fixed income securities are more sensitive to market conditions.
Let’s see how Bitcoin compares to these criteria:
Homogenous attributes?
Deemed a cryptocurrency, Bitcoin paved the way for various other cryptocurrencies to follow in its wake, such as Ethereum, Ripple, Litecoin, etc. Although these competing currencies differ somewhat in purpose and construction, they all use blockchain encryption as a method of transacting or storing value. Therefore, cryptocurrencies can be considered a homogenous asset class.
Are cryptocurrencies mutually exclusive?
Considering Bitcoin and other crypto assets we can argue that they are more closely aligned to alternative assets, in the form of real assets rather than traditional assets. A cryptocurrency is perhaps the most comparable to investments in commodities or hard currencies, as it serves as a means of payment or to preserve purchasing power of money. However, unlike commodities, cryptocurrencies do not offer any value derived from an underlying tangible asset whatsoever, as they don’t offer returns in the form of utility, dividends or interest payments. The only available return is derived from the fluctuation of the capital value per unit once realised. Although Bitcoin has been themed a currency it also has no link to any jurisdiction or authority, and therefore does not offer any protection from a legislative perspective. Cryptocurrencies’ value drivers are somewhat unclear and more aligned to sentiment and the intentions of their accountholders. Whether this asset class is therefore mutually exclusive remains to be seen, especially when compared to other commodities like gold.
Are Bitcoin and cryptocurrencies diversifying?
In a CFA Research Institute paper issued by Matt Hougan and David Lawant in January 2021, they point out that Bitcoin’s historical performance characteristics exhibit three main attributes which prove, at least for now, it exhibits diversification benefits: high returns, high volatility and low correlations with traditional assets. The research indicates the cryptocurrency was the best performing investment of the past decade, although it had a bumpy ride. Over this period, Bitcoin underwent six different peak-to-trough drawdowns of more than 70%. Lastly, although Bitcoin did indicate low correlations to traditional asset classes, this might be temporary as Bitcoin remains an early-stage investment opportunity.
It therefore seems one could qualify cryptocurrencies as an asset class given some leeway in its interpretation of being mutually exclusive and assuming the current diversifying benefits will remain, but would it be prudent to invest in such an option when considering retirement savings?
It is imperative to understand that, when investing into such an asset class, there are other factors to consider, including:
- applicable legislative environment;
- tax considerations (applicable to taxable entities);
- selecting the appropriate investment vehicle;
- valuations and marketability;
- operational liquidity issues; and
- expense and fee considerations.
After considering the factors listed above, it becomes clear that cryptocurrencies do not yet qualify as sustainable investments for institutional investors. At this stage, the cryptocurrency market is not sufficiently developed and regulated for this asset class to be seriously considered by institutional investors. To address this concern in South Africa, the Financial Sector Conduct Authority (FSCA) recently published a draft declaration of crypto assets as a financial product under the Financial Advisory and Intermediary Services Act (FAIS) which is a step in the right direction to protect vulnerable investors in the interim. The selection of the investment vehicle is also an issue, as it enabled the rise of unscrupulous market participants as evidenced by recent cryptocurrency fraud. There are examples of investors who invested in Bitcoin early, only to find a hacker managed to get hold of their valuable information to enrich themselves, which reflects positively on the asset but not the intended investor. Furthermore, valuing these assets is one of the most complex, challenging and disagreed-on aspects of the crypto market. Regarding liquidity, another big concern is that research showed about 2% of the anonymous Bitcoin ownership accounts that can be tracked on the cryptocurrency’s blockchain control 95% of this digital asset. This can significantly distort prior statistical findings since correlations to traditional asset classes could therefore simply be spurious, or worse, market manipulation. When liquidity becomes a concern transaction costs can be high, eroding value.
We canvassed a number of asset managers to get their view on investing in cryptocurrencies. Many asset managers agree on the importance of monitoring developments in this space but agree that the market is not mature enough to consider allocating assets into a retirement fund portfolio.
In summary, the cryptocurrency environment is still new and evolving with a somewhat uncertain future. The rise of cryptocurrencies can pave the way for technological improvements due to the underlying blockchain encryption it uses, and its applications in the financial industry. However, as with any new technology, early-stage adopters could make a handsome profit but must be aware that substantial losses are also possible. When saving for retirement such risks are not prudent to accept.