“Dear Advisor – what’s your view on Cryptoassets?”

Summary

With Cryptocurrencies displaying tremendous performance last year, it is just a matter of time before clients start asking for your informed view on these potential investment opportunities. We provide pertinent background on the rise of Cryptoassets, share the main findings from a recent publication on Cryptoassets by the CFA Institute and suggest a model answer to the dreaded question: “Mr/Mrs Advisor, what’s your view on Cryptoassets?”

Introduction

A few years ago when asked about Cryptoassets, we used to produce only two slides – the first slide showing various price bubbles of assets;  and the next slide overlaying the price of Bitcoin on top of the various bubbles. The conclusion was quite clear – invest at your own peril…

So what has changed?

  • After last year’s phenomenal performance, Cryptoassets are popular discussion points in the media. Your clients are bound to ask you your view on Cryptoassets, sooner or later.
  • Bitcoin and Cryptoassets used to be very popular amongst specifically Retail investors and Hedge Funds. In 2020 we have seen signs of acceptance by institutional players, such as Paypal, Visa and recently also Mastercard; and the launching of various Crypto indices or ETF’s could accelerate adoption by institutional investors.
  • The CFA Institute released a publication on the role of Cryptoassets in an investment portfolio.

The aim of this article is three-fold:

  • We want you to gain a basic understanding of the Crypto world – be it to gain new clients or to protect your current client base.
  • We want to share the main findings of the CFA Institute’s publication with you –benefits, risks and whether you should hold some percentage of Crypto in your investment portfolio.
  • Lastly, we want to provide you with a simple Excel tool you may use to drive the point home that if you embrace the huge performance potential of Cryptoassets, you must also be ready and willing to embrace the potential of huge volatility and drawdowns.

The dreaded question: “Mr/Mrs Advisor, what’s your view on Cryptoassets?”

When faced with the above question, which of the following options would you lean towards:

  • Option A: Ummm…
  • Option B: It’s not regulated in South Africa – no comment…
  • Option C: I believe in Blockchain, but most Cryptoassets are in bubble territory…
  • Option D: They are highly speculative assets, and very difficult to value…
  • Option E: Other (Extraordinary) response…

We would suggest Option A may not be the best response; Option B is trying to avoid answering and Options C and D are closer to the truth, but not comprehensive or helpful enough. What you need is Option E – an extraordinary response that shows you have a fair idea of the Crypto landscape and have sound reasons for your views on Cryptoassets.

Before volunteering a robust response to the question, let’s first provide some background on Cryptoassets.

Rise of Cryptoassets

The interest in Cryptoassets is increasing at a rapid pace.

Consider the following:

  • Paypal, operating as one of the largest global online payment systems, announced on 21 October 2020 that users would be able to buy, hold and sell cryptocurrencies.
  • In 2019, Visa partnered with Coinbase to create a crypto-backed debit card that allowed user's cryptocurrencies to convert to fiat currency when spending. On 1 December 2020 Visa announced that it was partnering with BlockFi, a crypto financial service, to create a credit card that rewards its users in Bitcoins - instead of traditional point credit card rewards.
  • On 10 February 2021, MasterCard announced that it would begin supporting select cryptocurrencies on its payment network.

In addition, access to Cryptoassets is becoming easier:

  • On 3 December 2020, S&P DJI confirmed that it is partnering with Lukka, a blockchain data provider, to launch crypto indexes with 550 coins in 2021.
  • On 25 February 2021, Purpose Investments launched the first Bitcoin ETF, backed by physically settled Bitcoin, on the Toronto Stock Exchange. The management fee is 1% per annum.
  • In October 2020, EasyEquities announced their intention of acquiring a controlling interest in DCX Capital - the Crypto start-up by venture capitalist Michael Jordaan and entrepreneur Earle Loxton. The DCX10 Index of Top 10 Cryptocurrencies will be rebranded as the EC10 (“EasyCrypto10”) Index. The EC10 token is a crypto token linked to the value of the EC10 Index. Priced within the token is an annual 2% fee levied by EasyCrypto.

The CFA Institute weighs in on Cryptoassets

According to the authors of the CFA Institute Brief entitled Cryptoassets: The Guide to Bitcoin, Blockchain and Cryptocurrency for Investment Professionals the main benefits of Blockchain and Cryptoassets are cost-effective and fast settlement;  creation of property rights and the possibility of digital contracts.

The risks to Cryptoassets are many and varied, including:

  • Technical risks: Blockchains are potentially susceptible to bugs that could expose unknown security flaws.
  • Competitive risks: Rising competition from other technological solutions - for example the Fed announced plans in August 2019 to launch a real-time gross settlement program called “FedNow” that would significantly speed up financial transactions in the US.
  • Regulatory threats:
  • - Asset seizure or bans.
  • - Enhanced KYC requirements.
  • - Cryptoassets are not deemed as securities– this could change in future.
  • Investment-related threats: Extremely high levels of volatility, including multiple instances of substantial drawdowns.
  • Additional threats: Market manipulation and Fraudulent entities.

Given the fact that the valuation of Cryptoassets ranges from very difficult to impossible to value – is it feasible to explore whether an investor could hold some percentage of Crypto in an investment portfolio? The authors of the CFA Institute Brief contend that as long as the low to negative correlation of Cryptoassets relative to other mainstream asset classes persist, you could contemplate the possibility of adding a small exposure to your offshore investment portfolio. The caveats are that this small exposure to Cryptoassets typically needs to be in the order of 0% to 4%, if the intention is to try and harvest the return potential without increasing the drawdown risk in the overall portfolio; and the small exposure will need to be rebalanced on a quarterly basis.

“Buy and Hold” or “Buy and Hold On for Dear Life”?

We have developed a client-friendly Excel spreadsheet to illustrate the return and risk profile of Bitcoin relative to our Offshore Benchmark (50% global equity, 10% global property, 20% global bonds and 20% global cash).

We will use the spreadsheet to compare the following three scenario’s:

  • The return and risk profile of Bitcoin.
  • The return and risk profile of the Offshore Benchmark.
  • The effect on returns and risk when adding 0%, 5% and 10% of Bitcoin to the Offshore Benchmark portfolio.

Top left shows that if you had invested $100 in Bitcoin 7 years ago, you would be smiling from ear to ear – your $100 would have turned into $3865 at the end of December 2020! Top right we show annualised returns in USD – Bitcoin returned almost 300% in the last year and 132% per annum for the last 5 years.

Fantastic returns, but unfortunately there’s no free lunch… The bottom graphs show that you would have experienced an 80% volatility on average per year (bottom left) and multiple drawdowns in excess of 73% over the last 7 years (bottom right).

Next consider Figure 2 below – these are the returns (and volatility)that we would typically expect from an offshore portfolio…

If you had invested $100 in the Offshore Benchmark 7 years ago, it would have turned into $151 at the end of December 2020. Top right we show annualised returns in USD – the Benchmark portfolio returned almost 10% in the last year and 8% per annum for the last 5 years –seems rather pedestrian compared to Bitcoin…

But the volatility and drawdowns are also very palatable - the volatility was 8% on average and drawdowns of -6% and -13% in Mar 2020 were experienced in the last 7 years.

Lastly, we compare the Benchmark Portfolio to two other portfolios – where we add 5%and then 10% Bitcoin to the Benchmark Portfolio.

Consider Figure 3 below. Notice that the return potential was enhanced as we added more and more Bitcoin exposure, and on the top right the 1-year return increased from 10% to 18% to 27%. Below notice that the volatility also increased markedly, and on the bottom right you’ll notice that an allocation of 5% had slightly worse drawdowns than that of the benchmark portfolio, while a 10% allocation impacted drawdowns markedly.

Revisiting:“Mr/Mrs Advisor, what’s your view on Cryptoassets?”

When faced with the above question, we suggest the following “Extraordinary”response:

“Mr/MrsClient, the designer of the first blockchain created the ability to have a distributed database that is controlled by no individual party but maintains a verifiable public record of “the truth”. This breakthrough created the possibility of digital scarcity, digital contracts and the rapid settlement of financial transactions between any two parties without the need for any intermediary.

Of the Cryptoassets, Bitcoin is the oldest and has the largest market share at approximately 70%. Cryptoassets are difficult to value and we know they offer very high returns, coupled with high levels of volatility and substantial drawdowns.

The CFA Institute Research Foundation recently released a document which outlined the benefits, risks and investment characteristics of Cryptoassets and also Bitcoin specifically. Their research found that an exposure of between 0% to 4% represented an optimal allocation to Bitcoin in an offshore portfolio, rebalanced at least quarterly.  

Let me walk you through some interesting results using a simple Excel tool developed by Analytics, our investment partner…”

In Summary

With Cryptocurrencies displaying tremendous performance in 2020, it is just a matter of time before clients start asking for your informed view on these potential investment opportunities.  

This article provided pertinent background on the rise of Cryptoassets and shared the main findings from a recent publication on Cryptoassets by the CFA Institute where the authors outlined the benefits and risks and suggested an optimal allocation of Cryptoassets of between 0% and 4%, rebalanced at least quarterly.

We introduced a simple and client-friendly Excel tool, to enable you to drive the point home that if you embrace the huge performance potential of Cryptoassets, you must also be ready and willing to embrace the potential of huge volatility and drawdowns.

Lastly we suggested a model answer to the dreaded question: “Mr/Mrs Advisor, what’s your view on Cryptoassets?”.

If you would like to have access to the CFA Institute publication and the user-friendly Excel-based system, please contact us at dfm@analytics.co.za.
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Daniel Schoeman
Daniel Schoeman is currently CIO of the Analytics multi-manager funds of funds. He has more than 19 years investment and portfolio management experience, and has previously worked at three of the largest multi-managers in South Africa, first at Investment Solutions, then joined Momentum MultiManagers which later merged with MCubed to form Advantage Asset Managers.‍His main responsibilities include economic research, tactical asset allocation, investment manager research, portfolio construction, monitoring and risk management, system development and innovative investment research.‍He is also a member of Investment Committees of some of the largest advisor networks in South Africa, providing investment consulting services to these groups on an on-going basis.

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