Take small bites
The meteoric rise of crypto assets like Bitcoin and Ethereum saw thousands of retail investors flocking to virtual crypto exchanges to get their fix; most of them just in time to suffer though one of the asset classes many ‘50% or greater’ corrections. Despite staggering volatility across the asset class, financial advisers now find themselves inundated with requestions from clients who want to know whether they can include crypto assets in their investment and savings portfolios, and if so, how much?
It is not all about Bitcoin
The Financial Planning Institute of Southern Africa (FPI) invited Hugo van Veen, an investment specialist at SwissOne Capital AG, to share his thoughts on the emerging asset class during the institution’s 2023 Retirement and Investment Conference. Van Veen kicked-off his “Crypto as an Asset Class” presentation with two introductory remarks. The first was to remind the audience not to become emotionally involved when considering investment opportunities, and the second served to dispel the notion that Bitcoin represented the entire crypto asset universe. “Bitcoin can be seen as a currency, a store of value, and a medium of exchange; but there are multiple other sub classes within the crypto universe,” he said.
The first of four focus points during his hour-long discussion was whether crypto assets made sense from an investment perspective. Van Veen observed that an investment portfolio’s overarching objective was to include the optimal blend of assets and asset classes to deliver the highest probability of return, at the lowest risk. Turning the spotlight on volatile crypto assets, he said: “A single asset [or asset class] might represent a very high risk, but that does not necessarily mean that it should not be included in a portfolio”. He added that assets with great risk-to-return ratios were well-liked; but that the inclusion of uncorrelated assets and portfolio diversification were also important constructs. “A well-constructed portfolio does not necessarily omit assets with the highest risk of capital loss,” he said.
Some more of that asymmetric return, please
Crypto assets can be thought of as high-risk, high return portfolio diversifiers that offer an asymmetric return profile, and are uncorrelated with traditional assets. “The upside return versus downside risk are generally equal; for every unit of risk, you have an extra unit of possible upside return,” Van Veen said. A graph of annual returns from Bitcoin between 2014-2023 showed that investors had suffered a capital loss 25% of the time. However, for the remaining period, the cryptocurrency delivered on average 175% per annum, with a one-in-10 chance of 1000% plus. PS, this is an opportune moment for our “this is not financial advice” disclaimer. This is not a call to you or your clients to rush out to your nearest Bitcoin ‘store’ and go ‘all in’ on the digital token!
Getting somewhat more technical, Van Veen suggested switching from the risk-versus-return-focused Sharpe Ratio for another popular portfolio management tool, the Sortino ratio, when assessing cryptos. Wikipedia.org describes the latter as ‘a ratio that measures the risk-adjusted return of an investment asset, portfolio or strategy’. In layperson’s terms, the Sortino ratio defines the return possible for each unit of risk. “When one looks at things like Sharpe and Sortino ratios [you will find that] crypto assets return far higher values than traditional assets, and that is a very desirable attribute for portfolios,” he explained. Having offered a sensible basis for including crypto assets in an investment portfolio, the discussion turned to future risks and reward.
Use case adoption remains low
It is quite difficult to predict the adoption and longer-term use cases for disruptive technologies. Case in point, nobody would have foreseen the stellar growth in smartphone penetration, nor the evolution of services consumed by users of said devices. In the early days, smartphone users spent 90% of their time making and receiving voice calls whereas nowadays this function accounts for less than 5% of usage. Similar adoption and utilisation evolutions occurred around the Internet and, more recently, any of a dozen-or-more social media platforms. The point is that the use case for cryptos that we know today will be unrecognisable a decade hence. Even so, Van Veen was a bit concerned about the adoption of use cases in the crypto asset space.
Assuming the use case issue is addressed, there is plenty of room for crypto assets to grow. In 2023, the global market capitalisation of crypto assets was around USD1 trillion compared to the so-called FAANG stocks at USD7 trillion; gold at USD10 trillion; and global equities at around USD110 trillion. “Crypto is still in its infancy, and that means it has massive potential for growth … purely based on the [relative] size of the asset class there are possibilities for outsized returns,” Van Veen said. The caveat is that selecting the crypto asset most likely to go on a 1000% or better ‘tear’ is incredibly difficult. The top 10 crypto asset market capitalisations all exceed USD6 billion, with hundreds of coins occupying the USD100 million and higher space.
The massive potential for growth in crypto assets can be tempered by a number of risks. Regulatory risks seem to have abated slightly in recent years, but there could be another hiccup if central banks decide to intervene in global cryptocurrency trade. The risk of technology failure has dissipated too, based on a decades-long history of near bullet-proof distributed ledger activity. From Van Veen’s perspective the major risk to crypto assets centres on use case adoption. “There needs to be real use case adoption on a larger scale for crypto to offer real [rather than speculative] value,” he said.
Limit exposure to drawdown tolerance
The conclusion was that crypto was worth considering in an investment portfolio, with the caveat that the exposure should not exceed the worst drawdown the investor and / or portfolio can tolerate. “A broad-based approach is best; you will cut across all the different crypto sub-categories to have good representation in the overarching asset class,” Van Veen said. This approach allows your clients to lock in the return potential of the many outliers that occur in this space.
As for active versus passive crypto asset exposures, Van Veen said the difficulty in predicting disruptive technology made it unlikely that an active strategy would outperform a passive strategy. The presentation then turned to modelling sensible position sizing. “The message here is that one does not need a large allocation to crypto for it to be relevant in terms of what it can add to one’s portfolio,” Van Veen said. He added that exposures of between 1% and 4% would have a significant impact on overall portfolio returns, but warned against a buy-and-hold approach: “If there is a big run, you need to pare [your crypto assets exposures] and take profits”.
The detailed assessment of crypto assets ended on a high note, with the presenter announcing a high probability that the crypto assets’ historic asymmetrical return profile would persist over the next decade. In addition, there is plenty of outsized return potential in smaller crypto assets. Clients who are keen to consider this asset class might consider a broad-based, passive exposure totalling about 1% to 4% which will be adequate to have a significant impact on portfolio returns.
Writer’s thoughts:
The crypto assets presentation to the 2023 FPI Retirement and Investment Conference earned top marks for stripping out emotion, and instead assessing the emerging asset class on its risk and return merits. Do you think it is time to start adding crypto assets to your clients’ portfolios? Or is it still too risky? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za
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