Cryptocurrencies as alternative assets

Against a background of flat or negative yields for most conventional cash investments, rises in the price of Bitcoin and increasing public awareness of the potential of blockchain to reshape financial markets have prompted investors to look to cryptocurrency markets for returns.

But how should investors regard cryptocurrencies in the context of constructing a multi-asset portfolio?

Associate Professor of Finance at the Queen Mary University of London, Daniele Bianchi, PhD, has looked at this question in a recent paper.*

Above and beyond the promise of large returns, she says, investors are attracted to the idea that cryptocurrencies represent a novel, innovative asset class which is potentially segmented away – i.e., driven by alternative economic forces and factors – from other, traditional asset classes. While segmentation from traditional asset classes may ultimately indicate that we still do not fully understand the pricing mechanisms behind cryptocurrencies, practically, cryptocurrency markets may offer large and persistent diversification opportunities.

Empirically, at least in reduced-form, such segmentation can be investigated by looking at the cross-correlations between cryptocurrencies and more conventional investment vehicles, and between crypto and macroeconomic variables. The rationale is simple; if cryptocurrencies exhibit uncorrelated returns to either standard asset classes or macroeconomic variables, they may represent significant diversification instruments against typical financial and/or economic risk factors.

In her research, Professor Bianchi studied the returns and market activity of the top 300 cryptocurrencies. Her conclusion was that, except for a mild correlation with the returns on precious metals, there is no significant relationship between returns on cryptocurrencies and global proxies of traditional asset classes. The absence of cross-assets correlation holds true for both returns and volatility, with the latter indicating that there are no significant spill-over effects in terms of risk between cryptos and more traditional investments. Similarly, empirical evidence suggests little evidence of prices and volumes being driven by macroeconomic activity on a global scale.

More specifically, delving further into the dynamics of market activity provides evidence that trading volume is primarily influenced by past returns and volatility. Additionally, macroeconomic variables such as shocks to inflation expectations, interest rates, and aggregate market risk aversion (proxied by the VIX index) do not influence short-term trading activity in cryptocurrency markets.

As a whole, macroeconomic activity on a global scale does not seem to influence the short-term dynamics of cryptocurrency prices and volume.

That would seem to suggest investments in cryptocurrencies could serve as hedges against traditional asset classes but Professor Bianchi cautions against taking that at face value.

Long-term dynamics may differ whereby macroeconomic fundamentals, aggregate risk attitudes, and global imbalances may well influence trading activity in cryptocurrency markets, she says.

Therefore, she says, the perceived absence of correlation could be a naïve interpretation of the dynamics of returns and trading activity in cryptocurrency markets based on the returns on other more traditional asset classes and/or changes in aggregate macroeconomic conditions.

The fact that the return dynamics in traditional markets and cryptocurrencies do not have many commonalities represents a source of difficulty that should warn investors to be cautious if cryptocurrencies enter their portfolios, she says.

There is still a considerable debate as to whether and how cryptocurrencies may be segmented from traditional asset classes, and how this can possibly translate to economic gains for the average investor, she concludes.

SEEK.com (ASX: SEK) co-founder Matt Rockman, now chair of 1010 Capital and a board member of Genesis Capital is one individual high net-worth individual who is seeking to use crypto currencies as a hedge. However, he makes it clear he regards this strategy as an experiment and one that should only be tried by investors who can afford to lose their entire allocation to the strategy.

Rockman first purchased Bitcoin in May 2020 when it was priced at $10,000 and later diversified into Ethereum when that crypto was trading in the range $500-$$700. His crypto portfolio mix is now 50:50 Bitcoin Ethereum and makes up about 3% of his investment portfolio, although this can obviously change as asset values alter.

He says his investments in cryptocurrencies are primarily a hedge against the debt burden and fragility of the global financial system.

“I’m in the camp that has lost some faith in the current system and is looking to invest outside the system,” he says. Central bank aggressive actions have undermined fiat currency. My crypto investments are there as a hedge.”

Rockman regards his crypto investment hedging strategy as somewhat similar to holding gold but says the risk profile of the asset class is more like venture capital. “It feels like a hybrid asset class,” he says. “Crypto has venture attributes while also having equity and currency attributes – its characteristics are quite new.”

Cryptocurrency is more a store of value rather than a means of exchange for Rockman. He describes himself as a strategic long-term crypto holder rather than a trader. He did, however, sell a small proportion of his Bitcoin holding when it hit $65,000 and moved that into Ethereum.

“So far, I got part of that trade right as I bought low and sold a little at the high point,” he said.

Rockman says his choice of trading platform was an important part of his crypto investment strategy. He makes his crypto investments through the Gemini (gemini.com) platform that launched in Australia in 2020.

“It’s important to have trading and storage security,” he said. “The bigger and better platforms like Gemini will have high functionality and production innovation and security has to be a consideration.”

Rockman began using Gemini in December 2020 after he had contacted the company’s APAC managing director Jeremy Ng on LinkedIn. He said he chose Gemini because he respected the vision and capability of the founders, the Winklevoss twins, the high-level expertise of the platform and the good support levels offered for the “semi-institutional” high net-worth market.

Gemini currently holds around $39 billion in cryptocurrency under custody.

Headquartered in Singapore, the business plans to set up satellite offices elsewhere in the APAC region including in Australia.

Australian users of the Gemini platform can buy, sell and hold capital from more than 40 cryptocurrencies with their funds secured by proprietary cold storage systems or held in insured hot wallets. Users also have access to crypto products including the ActiveTrader platform which provides advanced traders with tools to implement sophisticated trading strategies.

Rockman offers these tips:

• If you want to understand crypto, dip your toe in with a very small amount that you can afford to lose. Investing will increase the level of engagement – you will learn a lot quickly.
   
• Go into crypto investing with your eyes open, understanding that it is a highly volatile asset, and you should be willing to lose it all. It is not beyond the realm of possibility that the price will go to zero if legislation is introduced or a big hack occurs.
   
• Form your own views, educate yourself as an investor, and push through the noise. There are super credible bulls and credible bears in the market, but you need to form your own view on whether you think there’s risk in the financial system and if this asset solves that – in part.
   
• Try to avoid following a ‘quick buck’ mentality. Even though some people have bought large assets with crypto, that’s generally not sensible investing.
   
• For anyone who asks me if it is too late to begin investing in bitcoin, I think the price will continue to grow over the long term. This is the reason I am holding.
   
• It is important to find the right exchange platform, with strong trading and storage security.
  
  *Cyptocurrencies As An Asset Class? An Empirical Assessment, Fall 2020 edition, The Journal of Alternative Investments (freely available.)