A new kid on the block(chain)

By Simon Finch | 27 January 2021

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Do cryptocurrencies have a place in a modern diversified portfolio?

2020 was a memorable year in many ways. We have observed the market going on a roller coaster ride; reaching new highs early in the year, before a dumbfounding retreat in March, only to be followed by a spectacular recovery. A market of two tales was the dominant theme, where Growth stocks kept grinding higher, and Value companies firmly in the dump. However, in November when COVID-19 vaccinations were being approved, a reversal of fortunes happened almost overnight and equity markets ended the year with new all-time highs. The bull market that started in March 2009, despite a few minor setbacks, remains possibly the most debated and detested bull market of all time. Investors have become accustomed to equities trending upwards year-on-year and are now finding themselves wondering how to maximise the chance of maintaining the returns going forward. Should they begin to consider other assets to diversify from equity? And, if so, what might those be?

Fixed Income is arguably not the best source of return. Gold has been a diversifier over the years but has itself reached all-time highs in 2020 (in USD terms). Real estate traditionally has also been an option, although no doubt this sector will experience significant restructuring following COVID-19- induced work and lifestyle changes. Hedge funds have not done themselves much of a favour in the past decade either. Infrastructure, especially the “green” type, is receiving renewed funding from both investors and governmental bodies, but has its own challenges none-the-less.

Some market commentators have been pondering that perhaps there is a new diversifier emerging that can provide returns that are not correlated to equity. This new kid on the block (pardon the pun) is digital assets or cryptocurrency assets. No doubt you will have heard of Bitcoin, the leading protagonist in the brief history of digital asset investing. While it is certainly very volatile, with FUD (the “digital” way of saying Fear, Uncertainty and Doubt) resulting in wild swings, it was one of the best-performing assets in 2020, while being the standout investment over the past 3, 5, and 10 years (302%, 105%, 6,627%, and 9,664,567%). These performance credentials are at least one reason we are seeing greater uptake now, with investment managers and financial institutions such as BlackRock, Fidelity and JP Morgan embracing digital assets. Ruffer Investment recently announced that it had purchased $745mn, representing 2.5% of its $27bn portfolio, into Bitcoin and Ethereum. The question many are now asking is: has this institutional investment added the final missing ingredient to cryptocurrencies, which is some form of legitimacy? Slowly but surely, they are certainly going mainstream, with the likes of the Chinese State announcing its own digital currency DECP, Paypal accepting cryptocurrency spending and the IRS having increasingly comprehensive rules around owing these digital assets. The relatively low correlation between them and equity (0.19, 0.14 and 0.07 over 3y, 5y and 10y) is also a rare and much-needed feature from a portfolio construction perspective.

The excitement in Bitcoin in late 2017, with investment bankers and taxi-drivers alike investing in this new asset, was reminiscent of the original “gold rush” and comparable to the Wild West. However, just over three years on, the landscape has changed dramatically for digital assets. Safe custody solutions, crypto funds, an evolving derivatives market, and the aforementioned institutional investments are very strong arguments why this new kid on the block(chain) might be here to stay.

So, while we continue to believe there are many good reasons to maintain a traditional diversified portfolio, it is important to consider if there are ways to achieve better risk-adjusted returns through allocations to non-correlated assets.

The Enhance team is working with a variety of cryptocurrency providers to better understand the complexities of investing in blockchain solutions and digital assets to ensure the most suitable approaches for all our trusted clients. We would welcome the opportunity to discuss our thoughts on the evolution of digital assets and their place in a modern diversified portfolio.