A current investment approach
June 1, 2018
This excerpt, taken from Balentine’s 2018 Capital Markets Forecast, addresses cryptocurrencies and digital assets in the context of Balentine’s investment process. In addition to reviewing where cryptocurrencies fit within the investment universe, Balentine’s Investment Strategy Team explains why we caution against investing in cryptocurrencies for the foreseeable future. Want to learn more? Don’t miss Balentine’s full 2018 Capital Markets Forecast, our signature research piece that serves as the foundation of our investment process.
When phenomena reach a certain level of public recognition, Balentine feels compelled to address the hysteria. Cryptocurrencies and other digital assets should not be completely dismissed; to do so would be a miscategorization of this movement as a fad rather than a force of creative destruction. However, it is important to address cryptocurrencies and digital assets in the context of the Balentine investment process and explain why we caution against investing in Bitcoin, et al., for the foreseeable future.
What is the investable universe?
Asset classes generally represent a collection of risk premia—what might be thought of as the underlying “return drivers” of investment returns. The return on an investment exposed to a certain risk premium should be commensurate with the degree of riskiness (typically proxied by volatility) inherent in that premium. Balentine recognizes a particular risk premium if it is: a) intuitive (i.e., is the reason for return obvious?), b) pervasive (i.e., has this premium been consistent through time and is it found in multiple instruments?), and c) accessible (i.e., can this premium be readily accessed in a cheap and liquid fashion?). Examples include inflation, interest rate, credit, and equity risk premia. Some asset classes may not contain an embedded risk premium but serve some other useful portfolio function such as inflation hedging, portfolio diversification, or alpha generation.
Additionally, asset classes must be sizeable. While we do not have an explicit market capitalization threshold before we consider investment inclusion, cryptocurrencies and other digital assets are only a small percentage relative to broader capital markets:
- Private real estate: $136 trillion
- Global bonds: $57 trillion
- Global equities: $42 trillion
- Commodities: $16 trillion
- Cryptocurrencies and digital assets: $700 billion
We also need sufficient data that suggest that the expected return and risk of the asset class are persistent through time. For example, we can predict with reasonable certainty that global stocks will return somewhere around inflation +4% over the long run. As a relatively new phenomenon, cryptocurrencies do not yet have a track record through multiple cycles or different market environments.
Assigning an asset class to cryptocurrencies
Where do cryptocurrencies fit in the investment universe? It’s not an easy question to answer, as cryptocurrencies force investors to consider with more scrutiny their investment philosophy and risk tolerance.
Cryptocurrencies as commodities. Commodities generally serve a utilitarian function (i.e., an input in the production of another good or service). By this simple measure, cryptocurrencies are not commodities. However, certain cryptocurrencies do exhibit inflation-hedging properties, which likens them to commodities and other real assets such as real estate. Cryptocurrencies may function as hedges and/or “safe haven” assets (though few would assign the “safe” label today), mimicking the role of precious metals as a sort of “digital gold.” There is a certain amount of mining terminology inherent in the protocol of Bitcoin and a few other cryptocurrencies that makes them analogous to precious metals, particularly the deflationary concept behind placing a hard cap on new coin “issuance.” We have yet to see how Bitcoin will behave in a severe recession, but the evidence we do have suggests that it may behave similarly to, if not better than, gold in periods of market duress. Though highly volatile, Bitcoin will likely exhibit shock-absorber properties during periods of widespread skepticism about the stability of economic institutions, as experienced during the 2013 Cypriot “bail-in”, and will likely serve as a hedge against stocks and bonds generally.
Cryptocurrencies as currencies. Cryptocurrencies pass the test of what is typically considered “money”: they can and do function as mediums of exchange, stores of value, and units of account, though these functions are hampered by excessive volatility. But do more traditional fiat currencies exhibit a risk premium that warrants asset class designation, thereby securing their place as an investable asset class and opening the door for cryptocurrency investment? Theoretically, no, because the return on currencies should be zero in the long term; currency risk can be hedged away. But practically speaking, yes, because interest rate parity does not hold in actuality (i.e., investors can profit from the carry trade). Furthermore, cross-currency relationships may experience long periods of deviation from the mean in excess of what is suggested by macro fundamentals, thereby allowing investors to profit from certain currency positions. It is this potential generation of alpha by an investor that leads us to conclude that cryptocurrencies are an asset class.
Cryptocurrencies as venture capital. If initial coin offerings (ICOs) are analogous to early-stage private equity investing, we might expect to find something closely resembling the VC-like equity risk premium. However, digital assets are not backed by the prospect of future earnings. Rather, they are supported by the prospect of mass adoption of some network and the future value of the services underlying that network. That is, they represent a claim on future services rather than on earnings. This difference does not preclude, and in fact may support, the existence of an equity risk premium with both high upside and tail risk in certain cryptocurrency “tokens,” similar to the equity risk premium we observe in private equity markets.
Looking to regulatory bodies for asset class guidance is of little value. Both central banks and statutory authorities have provided loose guidelines as to the proper classification of cryptocurrencies, but these guidelines suffer from a great deal of bias since the bodies are opining through a selfish lens. There is, obviously, a natural tendency to label an emergent asset class as something that falls within your regulatory purview or to dismiss innovation entirely until it is more readily understood and widely used. The SEC asserts that tokens are equity-like securities and will likely treat ICOs as such in the future, the Commodity Futures Trading Commission (CFTC) says cryptocurrencies are commodities, the IRS claims that they are property like gold or real estate (assigning them to the real assets and commodities category), and the U.S. Treasury, unsurprisingly, labels cryptocurrencies as a form of currency. The European Central Bank (ECB) has called Bitcoin a virtual currency, and ECB President Mario Draghi publicly denounced Estonia’s recent attempt to introduce a cryptocurrency as a potential rival to the euro. Many Federal Reserve members, including new chairman Jerome Powell, have dismissed cryptocurrencies as posing no imminent threat to central-bank issued money.
Cryptocurrencies and digital assets are constantly evolving, and there remains the possibility for cryptocurrencies to fall into one or more of the aforementioned asset classes. Investors may well see digital assets within these networks develop along traditional financial asset lines and witness an ecosystem of market-like instruments develop around cryptocurrencies in the future. These instruments, such as loans, could be seen as assets structured in a particular currency, thereby fitting into the current labeling scheme. Though a tall order, we could even see the birth of an entirely new asset class, one with properties different from anything in the history of global capital markets.
The developing role of cryptocurrencies in portfolios
Seeking to optimize and properly design strategic portfolios with cryptocurrency is difficult, as we quickly find that we have an input failure: we cannot derive reliable estimations of expected return and expected volatility, nor can we adequately assess portfolio drawdown using some other tested measure. There is not enough data to assess correlations between cryptocurrencies and other asset classes, so there are difficulties surrounding risk management efforts that attempt to dampen volatility while satisfying drawdown constraints.
Difficulties in assigning intrinsic value and the absence of an observable yield (typically) mean that we cannot derive reliable estimations of expected return. Courageous investors may try, perhaps, to arrive at an expected return given estimates of intrinsic value, using asset class valuation methods as a framework.
- As commodities: assess the role of cryptocurrencies as a new inflation hedge or as digital gold, and calculate the current market value of the “outdated” commodity and the effects of, say, a 2% shift of all gold holders to Bitcoin
- As currencies: use the quantity theory of money and assess payment markets penetration
- As equity-like securities: use traditional equity valuation methods and solve for a terminal value derived from the eventual value of the underlying services network
Balentine will continue to monitor cryptocurrency and digital asset developments, but we do not currently recommend either for inclusion in client portfolios. Cryptocurrencies fail to satisfy our risk premium test; while the risk premia inherent in cryptocurrencies and digital assets may be intuitive, it is neither pervasive nor accessible. Furthermore, cryptocurrencies and digital assets are difficult to trade, and private key storage is complex. The introduction of Bitcoin futures could open the door for the proliferation of liquid, futures-based products such as ETFs, however.
Cryptocurrencies and digital assets also fail to satisfy other criteria for asset class designation. Despite rapid expansion, the market remains both undersized and immature. We do not know how cryptocurrencies will behave in certain periods given their short track record. Since it is an evolving arena, the data is distorted by excessive and speculative inflows and outflows. Until maturation, buying cryptocurrencies is more speculation than prudent asset allocation. Investors hoping to preemptively capture budding risk premia before widespread adoption and recognition of cryptocurrencies as an asset class should not only hold multiple currencies and digital assets in small proportions, but should own only those coins and tokens that appear to have reached some level of critical mass. With cryptocurrencies, there remain many idiosyncratic risks—regulatory, technological, etc.—for which investors are not currently compensated.
Cryptocurrencies and digital assets therefore fail to withstand the Balentine portfolio construction process. However, we are not completely dismissing cryptocurrencies, as we are likely experiencing a period of creative destruction and a “fattening” of the protocol layer that could produce significant societal and investor value in the long run. Cryptocurrencies are simply too new, and we are content to let them evolve into a mature asset class—whether as commodities, new forms of venture capital, or maturing currencies and methods of payment—before we seriously weigh the investment merits of ownership.
 For the purposes of this article, we use the terms “cryptocurrency,” “crypto,” and “digital assets” interchangeably.