Andrew Milligan, former head of strategy at Aberdeen Standard Investments, questions the notion that cryptocurrencies have a role in institutional portfolios – at least on the advice of crypto bulls.
So many articles from investment banks, asset managers and digital experts have extolled the virtues of investing in bitcoin. Before doing so, I will reflect on two lessons which I learned the hard way during my career.
Always consider: why are they telling me this? Are they truly independent or are they trying to sell me something? Then: do they have statistics to back up what they say or are the arguments self-serving platitudes?
Only after answering such questions can we decide whether bitcoin plays a useful role in a portfolio.
Names matter. I suggest that rather than using the term ‘digital currency’ the words ‘digital commodity’ would be better. Some central banks have issued digital currencies, say in China and the Bahamas, but these are very much government creations for the benefit of all citizens. Stable coins such as Facebook’s diem (libra) will necessarily be publicly regulated to protect the banking system. Bitcoin, dogecoin, ethereum and the like are privately issued; indeed mined would be a better expression. They are created using a massive amount of computer power, not only equivalent to the energy consumption of a mid-sized economy but also highly polluting as most of the miners are based in China and Russia. What are your ESG credentials as a potential holder?
The classic portfolio
Let us approach digital commodities from the perspective of creating a portfolio. The classic 60-40 type portfolio is designed to minimise drawdowns while generating a positive return. It would include an array of risk-facing assets (equity, real estate, etc) which benefit from a range of cash flows (profits, rents, etc). These asset would stand alongside a range of defensive assets (bonds, cash) which provide both income and hedging characteristics.
More sophisticated multi-asset portfolios include a broader array of assets and dynamic asset allocation techniques – but the principles are the same: which risk premia do I wish to benefit from (equity, illiquidity, credit, etc)?
I can improve a portfolio by seeking assets with different characteristics, preferably not moving in line with traditional markets. An example might be infrastructure, benefitting from steady cash flows and long maturities.
On that basis, how might bitcoin fit into a portfolio? Many argue that ‘Digital Gold’ will necessarily have different risk/return characteristics; indeed some say that bitcoin represents the most uncorrelated asset in the market. At this point, we move from words to statistics, and discover that bitcoin is merely a highly leveraged risk-facing commodity.
Examining charts clearly shows that bitcoin is correlated with movements in such assets as Tesla, the Nasdaq, or risk-on/risk-off market moves. Bitcoin does not provide protection against an equity market sell-off.
Using Morningstar data, in Q4 2018, bitcoin lost about 44% of its value compared with about 14% for the broader market. In February/March 2020, bitcoin lost about 38%, compared with 35% for the US market.
Moving to correlations, in 2020, bitcoin had a correlation coefficient of 0.68 with the S&P 500, versus 0.32 for the trailing three-year period. However, bitcoin has a negative correlation with the US dollar, suggesting that – like gold and emerging market equities – it would assist a portfolio if the ‘house view’ were that the US currency will depreciate over time. A final point is the degree of volatility for bitcoin: daily moves of 5-10%, monthly moves of 25-30%, have clear implications for anyone wanting to control drawdowns in any portfolio.
Traders, criminals, governments
It is no surprise that we find such results from statistical analysis. After all the main drivers of bitcoin are either hedge funds, or day traders with US stimulus cheques, or criminals and certain governments seeking to manipulate the market. Self-evidently, bitcoin and its compatriots are not yet a major part of any institutional portfolio. That is why the recent statements from the likes of Musk have attracted front page news.
If we compare bitcoin with another commodity, gold, the following words from a World Gold Council report are worth considering: “Gold benefits from diverse sources of demand, as an investment, a reserve asset, jewellery, and a technology component. It is highly liquid, no one’s liability, carries no credit risk, and is scarce, historically preserving its value over time”.
On that basis, bitcoin only has one source of demand: as an investment. And unlike gold it is not scarce. As and when Bitcoin 1 reaches 21 million units, what is to stop Bitcoin 2 and 3 being launched? Unlike gold, investors also need to be aware of regulatory risks when investing in digital commodities. The FCA in the UK has delivered very strong warnings, India is considering banning bitcoin outright.
In conclusion, although bitcoin is positioned as a decentralised and alternative asset, statistical analysis indicates high correlations with traditional markets, reflecting common drivers such as central bank liquidity and capital flows. Portfolio constructors should consider its role carefully – all that glitters is not gold.
*Andrew Milligan is an independent investment adviser and economist. He spent over 20 years as head of strategy at Standard Life Investments and Aberdeen Standard Investments.
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