Case for Allocating to Crypto
Crypto has historically been ostracised by business leaders, including Warren Buffett, who has infamously called Bitcoin “rat poison squared.” Such a strong resistance to crypto from the incumbent financial community has influenced many others (including yours truly for a long time) to dismiss the asset class without properly looking into it.
Crypto ignorance has been costly. Since Bitcoin’s inception over 13 years ago, crypto has become the best performing asset class in modern finance. This is despite the fact that global ownership of crypto still remains relatively low and we are in the midst of a crypto bear market (this is #3 since 2009). The concept of digital economies powered by digital assets, though still nascent, is not going away.
To initiate a discourse on whether crypto should have a place in individual or institutional portfolios, we first examine historic data.
Crypto’s Asymmetric Returns
Source: YCharts
The table shows the long-term returns and drawdowns of asset classes commonly found in multi-asset portfolios. Despite the significant de-rating of the crypto market in 2022, Bitcoin’s performance has been more than 26x that of the best performing traditional asset, US equities, since 2014.
Hindsight is 20/20 but let us continue.
A traditional 60/40 portfolio allocated to global equities/bonds would have produced 5.6% p.a. return from 2005.
Scenario 1: Traditional 60/40 portfolio in equities/bonds
What if the portfolio was tweaked slightly to include bitcoin? Rotating 5% out of bonds into bitcoin would have produced, on a cumulative basis, 2x the returns of a traditional portfolio.
Scenario 2: 60/35/5 in equities/bonds/bitcoin
At first glance, a 5% allocation to a relatively unproven asset class may seem aggressive. However, the same math shows us that had bitcoin gone to 0, the portfolio’s overall returns would have been barely affected.
Scenario 3: 60/35/5 in equities/bonds/bitcoin but bitcoin goes to 0
The point of this exercise is not to dwell on the precision of the numbers, but to illustrate the power of asymmetric returns in portfolio context. Reallocating a small amount out of an asset class that has structurally low returns into another with positively skewed returns can have an outsized impact on the portfolio with capped downside risk.
Markowitz’s Diversification Dream
Crypto’s additional point of attraction is that historically it has exhibited low correlations with traditional markets.
The matrix by Morningstar shows Bitcoin would have provided greater diversification benefits to a US market investor (60% equities, 40% bonds) than US real estate, emerging market equities, or even global investment-grade bonds. The data is based on a 5-year historic period to end of 2021, but different time horizons tell a similar story.
In a world of increasing interconnectivity, a lowly-correlated asset that has structural growth drivers is unique.
Source: Morningstar (2022 Diversification Landscape)
Crypto’s Structural Growth Opportunity
One of the most dominant narratives against crypto is the excess liquidity argument. This cohort of the population associates crypto’s meteoric rise with the world’s loose monetary policy post the GFC. Following on from this logic is a dim view on long-term valuations of not only crypto, but also other long duration assets as central banks raise rates to fend off inflation. We think this mental model over-indexes on the influence of interest rates on human innovation and creativity and fails to consider other important variables at play, such as:
Crypto is tackling a global, large total addressable market: Public blockchains enable global flow of value over the internet. This is done without the help of trusted intermediaries like banks, payment companies or social media platforms.
Imagine being able to send money securely to anyone anywhere with just internet connection - without using a bank, at a fraction of the cost of wire transfer. Or as a merchant, being able to sell goods and services without incurring credit card fees. Or as a creator, being able to monetise directly from your fans rather than having to go through distribution platforms that profit from your content. Blockchains, powered by cryptoassets, provide more efficient infrastructure to enable such solutions. Some of this is already a reality, though mainstream adoption has yet to occur.
While cryptoassets have been the mechanism through which tech-savvy individuals explore more efficient architecture for enabling digital commerce, for others, they are fulfilling the function of an alternative monetary system.
Currently over 70% of the global population reside in countries with inflation greater than 5%. Included in this group are citizens of countries with enduring socioeconomic and political crises (e.g. Zimbabwe, Venezuela, Sudan, Turkey and Argentina), but also those in the West who suddenly find themselves under the threat of inflation and the resultant devaluation of their savings. Eroding trust in the local government-backed currency incentivises savings in other assets, which could catalyse greater capital flow into state-free, digital money – supply of which is secured by code.
Source: Tradingeconomics.com, Fiatmarketcap.com
Whether cryptoassets gain value from their wide ranging utility within digital commerce, or simply from more wealth being stored in them, the runway for growth seems significant. Crypto’s <$1 trillion market cap, for example, compares to:
$2 trillion dollar per annum global payments market. Capitalising this at a (relatively non-controversial?) 8% discount rate would suggest a $25 trillion market value.
$6.5 trillion market cap of publicly listed global banks.
$11 trillion market cap of gold.
$17 trillion market cap of publicly listed global big tech.
$109 trillion global fiat money supply excluding “hard currency” namely USD, CNY, EUR, JPY and GBP.
Simply put, crypto is a big global idea and its current size is small compared to the wide-ranging use cases.
Source: 1. 2021 McKinsey Global Payment Report; 2. Companiesmarketcap.com; 3. Fiatmarketcap.com
Liquid tokens offer exposure to early-stage tech: One of the guiding principles of crypto is that people who contribute value to the protocols should benefit from the success of those protocols through a stake in the system (note that such a value accrual mechanism was unavailable to the early users and contributors of the big social media companies like Facebook). To enable this, crypto projects go “public” at the bottom of the innovation S-curve. Consequently, tokens trading in the secondary market provide the upside potential of venture investing.
Contrast this with the stock market, which has evolved to be the destination for companies closer to the top of the S-curve. Onerous public market disclosure requirements and availability of capital in the private market have led to tech companies staying private for longer. The result has been that retail investors over the last twenty years have been largely deprived of the opportunity to gain early-stage tech exposure.
Engineering talent is moving to Web3: Because value in tech is generated by intellectual capital, flow of talent is likely the single most reliable leading indicator of long-term returns. Behind the chaotic crypto market cycles is the accelerating growth of human capital entering the space.
According to the comprehensive study conducted by Electric Capital, monthly active Web3 developers reached an all-time high of >18,000 in 2021. This is a significant number in the context of 36,000 developers at Amazon and 9,000 at Goldman Sachs.
The study further observed that developer participation in crypto has historically seen boosts during periods of market excitement (e.g. 2017 and 2021), but overall number of developers stayed flat even when prices fell (e.g. 2018-2020). In fact, many of the big winners of the 2021 bull run (e.g. Solana, Avalanche, NEAR) were projects that got started in the “crypto winter” of 2018.
The synergistic interplay between market exuberance and developer interest has become a familiar dynamic: high crypto prices beget developer participation, which in turn produces new innovation that catalyses the next market cycle. With a record number of developers joining the Web3 movement in 2021, it seems reasonable to expect significant advances over the coming years.
An additional factor that foreshadows crypto’s long-term growth potential is its young, skilled demographic of software engineers. Go to any developer-focused crypto conference, and one will notice the average age of attendees to be somewhere in their mid-twenties. Such a demographic profile ought to be an enormous advantage in the world of aging workforce and declining productivity. This point becomes more concrete when expressing an industry’s value as a sum of the present value of a) benefits of financial capital and b) benefits of human capital (we often disregard b) in a standard DCF because the variables are intangibles which are difficult, if not impossible to quantify). That is,
All else equal, the influx of young talent 1) increases absolute R&D value, 2) at a higher N (longer working life) and 3) at a lower individual risk premium (age tends to be negatively correlated with tolerance for experimentation and risk-taking). All three variables have a positive impact on the present value of human capital and should increase industry value.
Conclusion
Despite the phenomenal historic performance, crypto’s addressable market remains large and the industry’s intellectual capital employed is rising. Crypto exposure is certainly not for all. But a modest allocation may be suitable for those with a long-term time horizon and willingness to accept volatility (and even permanent loss) for potential asymmetric returns.
DISCLAIMER: IMPORTANT NOTICE INFORMATION IN THIS POST IS INTENDED FOR USE ONLY BY PROFESSIONAL INVESTORS AS DEFINED BY MIFID II. ANY INFORMATION IN THIS POST DOES NOT CONSTITUTE AN OFFER OR SOLICITATION FOR INVESTMENT. THE DISTRIBUTION OF THE INFORMATION CONTAINED IN THIS POST IN CERTAIN COUNTRIES MAY BE RESTRICTED BY LAW AND ACCORDINGLY, PERSONS WHO READ IT ARE REQUIRED TO INFORM THEMSELVES AND TO COMPLY WITH ANY SUCH RESTRICTIONS. THE FIGURES SHOWN IN THIS POST REFER TO THE PAST. PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE RESULTS. CRYPTO ASSETS ARE FAIRLY RECENT AND ARE AT A DEVELOPMENTAL STAGE WITH VARIATION IN ITS REGULATION IN DIFFERENT JURISDICTIONS. INVESTORS SHOULD BE CAUTIOUS OF THE RISKS ASSOCIATED WITH CRYPTO ASSETS INCLUDING (WITHOUT LIMITATION) VOLATILITY, TOTAL CAPITAL LOSS, AND LACK OF REGULATION OVER CERTAIN MARKET PARTICIPANTS.
THIS IS A MARKETING COMMUNICATION. PLEASE REFER TO THE OFFERING SUPPLEMENT TO THE FUND BEFORE MAKING ANY INVESTMENT DECISIONS.