CryptoAssets: The New Investment Asset Class

Wondering what to consider bitcoin? We now have the answer!. Getty Images

A recent white paper by Chris Burniske of ARK Investment Management and Adam White of Coinbase firmly and eloquently lays down the gauntlet that it’s time for investors to view bitcoin and other cryptocurrencies as an asset class to consider for one’s investment portfolio.

How should an investor consider bitcoin?

It’s a case that I’ve been making for a few years now. Although I’ve viewed bitcoin and cryptocurrencies as an option in the alternative investment sleeve for investor asset allocation, Burniske and White make the case that they can stand on their own and be considered as their own asset class in the same manner that equities and bonds are.

 The paper makes a compelling case for this and does so with facts and data that is now available and can be evaluated properly given the history of bitcoin and its trading on exchanges.

The case they make for bitcoin and cryptocurrencies to be considered as a new asset class is driven home by their four prong evaluation.

The "investability" of bitcoin

The first point is to view the “investability” of bitcoin.  Given the price increases of bitcoin and the reality that trading volume of bitcoin on exchanges is averaging $1 billion a day, the point can clearly be made.  Add to this the liquidity of bitcoin on these markets and the ability to trade it worldwide on a 24-hour market compares favorably to other investments including GLD, which is only traded in the U.S. and Singapore

One of the more interesting observations made by the authors in the paper is their projection that “a larger percentage of the population may be inclined to hold a cryptocurrency than an equity in a public traded company.” This may not seem that difficult to recognize when you speak to many millennials who are negative towards the “stock market” and may be more inclined to consider “cryptos” as investments.

Using bitcoin throughout the world

The second evaluation is based on the ability for bitcoins and cryptocurrencies to be able to facilitate all kinds of transactions worldwide showing their ability to retain value due to what the authors term as its "politico-economic" profile.  The reality that bitcoin can address cross-border transactions (much cheaper than current options), provide banking capabilities to the unbanked and do so with an underlying structure that is distributed and not centralized, shows its ability to address multi-national transactions and solutions effectively and efficiently.

 

One of the most interesting aspects of the White Paper is how the authors point out the major difference between the capped (finite) amount of bitcoin creation to the ever expanding growth of fiat money as well as gold, and that “no asset in history has followed such a predictable supply trajectory” as bitcoin.

A "non-correlated" asset

The third aspect of their evaluation addresses what I perceive to be a major factor for considering bitcoin and cryptocurrencies as alternative investments – their ability to be a “non-correlated” asset.  The number of alternative investment options and subsequent allocation percentages have grown since the financial crisis of 2008 in order to provide investors with investment options that have low correlation to market conditions. 

By placing a small percentage into “non-correlated” assets, the thinking is that these assets will allow for a portfolio to better weather a storm created by market volatility.  In this way, these assets and their consideration as an “alternative investment” actually create less overall risk for a portfolio and the use of these investments have come to play a role in prudent portfolio asset allocation.

I’ve seen the numbers in the past that clearly indicate bitcoin’s “non-correlation” relationship to other assets, but in the White Paper, the authors provide a clear picture of this by highlighting their finding that “Strikingly, bitcoin’s price measurements have been separate and distinct from those of other asset classes during the last five years. Bitcoin is the only asset that maintains consistently low correlations with every other asset. Remarkably, the maximum correlation, positive or negative, that bitcoin exhibited with each of the other assets (S&P 500, US Bonds, Gold, US Real Estate, Oil and Emerging Market Currencies) is the minimum correlation that any of the other paired assets displayed with each other.”

The "Sharpe Ratio"

For an investor, putting together a proper portfolio and deciding upon investments demands that these decisions be based on a risk-reward analysis of assets. This is potentially where the authors make their strongest point of how bitcoin and cryptocurrencies should be classified as a new asset class. The fourth part of their evaluation includes the Sharpe Ratio (designed by Nobel Prize winner, William Sharpe), which is a basic and powerful portfolio decision tool that measures the amount of returns along with the risk taken.  Essentially it provides a way for an investor to understand the amount of reward (return) that they can get for the level of risk that they’re willing to take. 

This goes back to the discussions that many investors have (or should have) with their financial advisors about how much risk they are willing to take and still be able to sleep at night.

 Burniske points out that as an investor, “what you want to see are assets with high Sharpe ratios because that means you’re getting better compensated for the risk you’re taking on.

An investor should want to achieve returns that are correlated to the risk that they’re taking and the Sharpe Ratio can help to identify that correlation. What the authors found in their analysis over a five-year period is that for three out of the five years, bitcoins actually had superior Sharpe ratios compared to the other asset classes. They also show that the overall volatility of bitcoin has also lessened over the last few years, showing a maturation of the asset.

Will this convince investors?

I applaud the authors for their detailed work and constructive approach to the topic. As someone who recognizes the ability to consider bitcoin and cryptocurrencies as investment options, it may have been “preaching to the choir” to me but they’ve produced a report that’s well researched, richly detailed and yet highly readable, that provides a convincing case to even the most skeptical observer.

I believe that it will be received by the investment community as the impetus to recognize the reality of this “new asset class” and we'll soon see advisors and money managers addressing this by including them in their future portfolio allocation models. Many have told me that their clients and investors are demanding it given the recent returns on bitcoin and compelling investment options like The DAO and other blockchain related start-ups.

I also agree with the authors that considering bitcoin and cryptocurrencies strictly as “currencies” is limiting. I invite readers and investors to begin to refer to bitcoin and other cryptocurrencies as “cryptoassets”.  The authors have made a compelling case for them as a “new asset class” and they should be classified accordingly.