Where are the Institutional Investors in Crypto? Demystifying the ever-elusive wall of capital
Disclaimer: opinions are my own. None of this should be construed as investment advice. This was written in its current form last Fall when I was still at the pension fund, and does not incorporate any new information since I joined Coinbase.
Intro
As far as I know, I am one of the few crypto enthusiasts that has also happened to work on the investment team at a large US public pension fund. Over the past few years this has afforded the privilege of seeing the space through multiple lenses — wanting pension funds to gain exposure to the asset class while also continuing to adhere to the fiduciary oath taken by institutional allocators. Whether reading as a fund manager, institutional investor, or just a crypto enthusiast, it’s my intent that this piece be useful in pushing forward much needed dialogue. For some time there has existed this macro tailwind of “institutions are coming” yet the actual flow of capital has hardly occurred (particularly with pensions). Why is it taking so long? What more is needed than a $250 billion market cap, CFTC approval of regulated futures, and the best track record of any asset, period, for the last 10 years?
What I will not be doing is making the case for the asset class. This has already been expressed far more eloquently by others, and I don’t expect to bring any novel arguments to the table. Rather, I would like to share perspective from straddling both sides of the tracks, and further, explain why it’s taking so long for pension funds to allocate to the space. Spoiler alert, there is nothing unique about this timeline.
The simple fact is the largest ships take the longest to turn.
Institutional investors are far from homogenous — see the appendix for why some have already allocated while others may never. To stay in my lane of experience I will focus on pensions alone from here on out. At a high level this piece isn’t so much geared towards proposing answers as it is posing the right questions the real people inside pension funds are asking (and the obstacles they grapple with). I hope this helps bridge the gap that currently exists so that resources can be optimally allocated by pension funds and crypto managers alike.
Who Needs to be Convinced?
We must first unpack the people in the room that drive investment-making decisions at these funds — investment staff, consultants, and trustees (members of the fund’s Board). Think of investment staff as the quarterback, the investment managers as players, consultants as the talent scouts, and board members as coaches. Hierarchically speaking, trustees are the ultimate stewards of capital, who in turn hire a CEO/CIO, investment staff, and consultants to assist in their momentous task of responsibly investing billions of other people’s dollars.
Quarterback → Investment Staff
Let’s begin by breaking down the cohort I was once a part of — investment staff. Degree of investment delegation runs the spectrum from CIO having absolute signing authority, to only approving investments up to a certain threshold, to being required to bring all investment decisions to the Board for approval. Even in the extreme example where the CIO has signing authority, this power has been delegated by the Board and can be taken away just as easily. At all but the largest funds, pensions typically run lean teams and delegate individual security selection to managers, especially in the case of more esoteric assets — which crypto falls squarely into. This is a function of allocating time and resources in the most efficient manner. A nuanced but important flaw to our football analogy is that staff will never hold up the Vince Lombardi trophy and rake in life-changing pay. The compensation for staff comes from the fund itself, i.e. the beneficiary’s pool of retirement funds, so any expenses incurred by the fund must be judicious.
As a result, staff is not compensated for taking inordinate risk in the same way a Hedge Fund manager is. While the asymmetric return profile of BTC makes it attractive to an unconstrained investor, that same investment has asymmetric risk to the downside from the career risk perspective of investment staff.
To be first and right here means a pat on the back but not much personal gain, other than the “I told you so” rights that are often better left untapped. To be wrong could mean job loss and difficulty finding employment in a similar role. In short, one step forward at the risk of many steps back will not be worth it to many of these professionals who spend their lives maximizing return per unit of risk.
Understanding this impediment is crucial to the question of why pensions take so long to invest in a new asset class. It is the perceived risk of investing in the asset class, not the potential returns, that receive more weight in the decision-making process for the time being. Fortunately, progress is being made. Endowments and well-known service providers have entered the space. The increasingly constructive narrative in financial media towards crypto is also chipping away at this perceived risk. The overall amount by which one would be reaching their neck out to invest is decreasing gradually. To their credit, educational outreach on behalf of professionals in crypto is at an all-time high. This confluence of factors leads me to believe that pension funds are in fact coming, the market just needs to be patient and continue making its case.
Talent Scouts → Consultants
Consultants are often referred to as the gatekeepers of institutional capital. Investment managers have to get their nod to be awarded an allocation. The relationship between consultant and client is either discretionary (delegated full authority) or non-discretionary (limited to advising on actions). In either case, consultants take on the risk of recommending managers/strategies, and generally stand ahead of staff/trustees on the chopping block when portfolio underperformance becomes problematic. They bear responsibility for their recommendations and as a result perform extremely thorough due diligence on managers and investments, which requires significant resources in the form of time and money. This creates the incentive to focus on researching strategies/investments that can be sold across their client base while also offering the capacity to invest in at scale. Perhaps the biggest reason why consultants haven’t given crypto much of a look is the perception that the asset class is still too small. After all, the largest consultants are each advising on >$500B (collectively in the trillions) so deploying a meaningful amount into crypto would be difficult. Though to that I would say this:
The same argument could be applied to other verticals of early stage tech, but it’s commonly accepted that a non-zero exposure is sensible given the momentous potential of the investment.
Fortunately one consultant is bucking the trend. Cambridge Associates, one of the industry’s oldest and most well-respected names, appears to be a first mover here. In February of 2019, Marcos Veremis and team released a research paper on the space, and the importance of this cannot be overstated. The message was loud and clear: crypto has created an emergent asset class that at the very least deserves a look from institutional allocators. This publication effectively green-lit the use of time/resources from consultants and staff alike to begin researching the space. Keep in mind, behavioral bias often anchors people’s opinions to initial perception, and for crypto this was likely quite negative (e.g. Silk Road). What Marcos and team did was offer a rare opportunity for perception to be reset. In time we may look back at the Cambridge publication as a watershed moment where institutional investors collectively agreed that the digital asset space was worth a second look.
Coaches → Trustees
Returning to the football analogy, trustees of pension funds are coaching from the sidelines, surveying the field and making the biggest calls. Who then, owns the franchise? This would be the beneficiaries whose money is collectively managed. It is their equity that ultimately goes up and down based on the success of the team. To enforce that the team’s decisions are in the best interest of their assets, “fiduciary duty” is introduced to the coaches and players.
Citing Investopedia, “a fiduciary obligation exists whenever the relationship with the client involves a special trust, confidence, and reliance on the fiduciary to exercise his discretion or expertise in acting for the client. The fiduciary must knowingly accept that trust and confidence to exercise his expertise and discretion to act on the client’s behalf.”
All decisions made by trustees must satisfy these conditions. While private investors have the freedom to make speculative bets, the level of justification needed for trustees willing to do so is much higher.
On top of this, trustees aren’t necessarily professional investors by nature; some seats are held ex-officio and others are elected positions. Tenure on the board varies depending on terms served. Some trustees professionally advise retail and have to completely relearn many things since their career knowledge doesn’t frictionlessly carry over. Trustees want to learn but also have day jobs, and staying on top of crypto is a full time job. Compounding the task is the fact that Boards often only meet once a month or quarter.
Trustees face headline risk in their decisions. It is not all that uncommon for substandard practices of a portfolio company within a PE fund to make its way into a board meeting via a news article. As you can imagine this is something trustees attempt to avoid. These individuals are not in it for the money, and like staff, face asymmetric downside risk in making a decision like being a first mover in crypto. Just as with any board, there is the danger of groupthink and the tendency to have a pack mentality among peers. Remember that their fiduciary duty holds them to a higher standard, with the legal obligation to make prudent investments. Just think about how much deliberation an individual endures when making a small personal investment in BTC. Now imagine being accountable for Arthur and Eleanor’s livelihood in retirement, and the immense responsibility of ensuring funds persist indefinitely to deliver the pension benefit people worked their entire lives for. Explaining to Arthur and Eleanor why an investment in crypto is a bet on the future, not just magic internet money, is a real scenario trustees expect themselves to be in. So the calculus around potential returns alone is daunting. Now take into account that managing the portfolio also requires being mindful of volatility. Pension funds can’t just HODL due to the liquidity requirement of making regular benefit payments.
Critically, when it comes to funding pension benefits, the margin of error is tiny, and unfunded benefits are borderline unacceptable. To get the big picture, I must highlight that we are currently in the midst of a pension crisis, where investment returns on the present value of principal can’t possibly keep up with the benefits that have been guaranteed in the past. Funding gaps remain over 25% across many public plans even on the back of the longest economic expansion in US history. Some funds have even gone so far as issuing bonds to help bring up their funded ratios (like refinancing a mortgage as interest rates fall). The bonds provide a cash infusion, though this is immediately consumed by current liabilities (“leverage”) and the issuance adds a whole new component in the form of a new layer of liabilities that will need to get amortized over time. Thus pensions are in a precarious position of balancing the need to generate higher returns but in doing so taking on added risk that may widen the funding gap. This feedback loop of needing to take more risk, but becoming more unfunded as a function of that risk, is colloquially termed the death spiral.
Ironically a thoughtfully sized Bitcoin position could be the perfect Hail Mary, but put yourself in the situation of trustees and staff with the asymmetric risk described, and then you may begin to appreciate how the situation is far more complicated than whether or not to invest in the best performing asset of the last 10 years.
For the sake of advancing this discussion, let’s just take for granted that all parties involved arrive at the following conclusion: failing to gain exposure to this asset class may actually prove negligent in their performance of fiduciary duty (an extreme take, but one I’ve heard). In my estimation, an allocation would be sized anywhere from 10 to 300bps. Anything under 10bps wouldn’t have a material effect at the portfolio level, and anything over 300bps would likely be viewed as imprudent given the nascency of the asset class.
Now if you’ve made it this far, I applaud you, let’s get into the fun part of actually investing. All pension fund investment programs are governed by an investment policy statement (“IPS”), and within this document lives a fund’s asset allocation.
Asset Allocation
If crypto were to be formally adopted into a pension fund’s asset allocation, there are many forms it could take. The simplest would be a direct investment into liquid crypto (BTC, ETH etc), but a more likely scenario is an allocation to a hedge fund manager or VC specialist. Whatever is decided, the investment must be housed within a certain allocation bucket as defined by the IPS. The question then becomes: can these investments be made within the current investment guidelines, sitting alongside pre-existing HFs and VCs in the portfolio, or do digital assets constitute an entirely new asset class thus requiring their own asset allocation bucket? If the latter is true, a bespoke allocation is complicated by the fact that this requires an amendment to the IPS which might only be reviewed every few years. After all, it’s not every day that a new investable asset class becomes available. At the moment there doesn’t seem to be a clear answer to this dilemma, but to the credit of managers in the space, many have stepped up their game on educating institutional investors to be better equipped to make this decision (see here, here and here). There is no right or wrong answer here, and it will all be figured out in due time, so let’s move on.
Manager Selection
Nascent markets are a natural fit for active management because the inefficiencies provide a breeding ground for alpha, so for this reason I don’t expect crypto index funds to be the first choice for allocators — especially since a handful of names in the top 10 by market cap have no reason to accrue value in the long term (cue the XRP army), and owning a basket for the sake of diversification may only dilute the returns of the most promising assets like Bitcoin which boasts a clear value prop. To quote Warren Buffet,
“diversification is protection against ignorance. It makes little sense if you know what you are doing.” Ergo, I expect pensions that gain initial public crypto exposure to do so through Bitcoin.
This is not an uncommon opinion, so why hasn’t it happened? From conversations with people in the industry it’s apparent that the biggest hurdle to making this investment has been custody — until recently. It’s the industry standard to have fund assets entrusted with a custodian (the US marketplace is dominated by three players: BNY Mellon, State Street, and Northern Trust, none of which have made meaningful moves to custody digital assets). In their absence, industry natives like Coinbase have made a name for themselves by offering a flawless track record and deep understanding of the underlying technology. The custody conversation was further brought forward when a $7+ trillion asset manager — Fidelity Investments — began offering institutional grade trading and custody through their Fidelity Digital Assets arm. With this, they effectively ported over their reputation, and with it much needed validation to the crypto custody space.
Ok we want to invest and aren’t worried about theft — what now?
I don’t expect pension funds’ first move will be directly investing in liquid crypto since staff is not equipped to manage the risk involved. So assuming a decision was made by the fund to allocate, this will likely kick off a search for the right strategy and best manager to execute said strategy. When looking at Funds, the first step is making sure basic prerequisites are met: custody, insurance, and a third party administrator verifying NAV of the fund. These are essentially non-negotiables, and without a doubt, lack thereof has been a major impediment for institutions thus far. Fortunately the digital asset space has matured to where there are a handful of funds that check the required operational due diligence boxes. These prerequisites are costly though, and this burden is increased by the fact that these funds aren’t yet bringing in sizable management fees. Fund managers have to front these costs which from my seat actually speaks to their conviction and commitment around the investment opportunity. Let’s now get into the different types of active management available to allocators.
HF, VC and FoF
Hedge Funds, Venture Capital funds, and Fund of Funds all make their own case for deserving an allocation from pension funds. For simplicity I will be focused on the fund structures and experience of the teams, rather than opine on specific strategies in market.
While past returns are no guarantee of future performance, a track record of outperformance is certainly assigned a hefty weight in the manager selection process. Because crypto is still so young, every manager is basically classified as an emerging manager (no 5yr track record). The lack of performance data covering at least one market cycle, whether for an evergreen fund or first vintage of a closed end fund, makes the process of manager selection very difficult. Emerging managers in traditional asset classes struggle to raise assets for this same reason, which is only compounded in the crypto space. Not only are funds being deployed to a largely untested asset class, but they’re also being granted to unproven managers.
Another critical factor in the diligence process is examining the team. This is probably the most important consideration today. Fortunately, the potential of the opportunity set has successfully lured away a handful of accomplished investors from some of Wall Street’s most prestigious firms. Veterans of Tiger Global, Citadel, Point 72, and Jennison Associates now sit at Pantera Capital, Arca Fund, Ikigai Asset Management and CoinFund respectively, bringing their skill and equally if not more importantly — their reputations. These are seasoned professional investors taking career risk that adds unquantifiable yet real value to the space. That said, I would be remiss to say that former Wall Street experience is all that matters. The other cohort of talent sits on some of the best teams essentially born into professional investing via starting successful companies/projects within the crypto ecosystem, though this experience lends itself more to VC investing that active trading.
It should now be apparent that even determining what a “qualified” team looks like is complicated in this industry. One thing is for sure: whether they were the “crypto person” within an incumbent firm or founder of one of crypto’s earliest projects,
today’s market participants have been aged at an accelerated rate in crypto-land, awarding them a deep understanding few others have.
Ex-Wall Street vets and hardened crypto gurus alike are probably just as qualified and will be judged on the investment process that they employ today. Notably, and unique to VC firms, some well-known teams have raised dedicated crypto strategies. Their clear advantage is already having both an LP base and track record in early-stage tech. It is no coincidence that a16z and Sequoia-spinout Paradigm have raised some of the largest funds to date. Native funds like Pantera, Castle Island Ventures and Morgan Creek Digital are not far behind. The last of which impressively boasts the first investments from US public pension funds, who also followed on to the next vintage in size — a vote of confidence for both the fund and industry at large.
One final option is the Fund of Fund (FoF) route. FoFs provide expertise in manager selection, outsourcing the work which staff likely wouldn’t have the time or experience to do diligently. Given today’s landscape there is probably no better place to utilize a FoF to gain exposure to an asset class. While they impose an additional layer of fees, they provide access to funds, diversification across a basket of funds, and the level of diligence a pension fund would require to make an investment.
To make a long story short (too little too late), pension funds are grappling with many different ways to gain exposure to digital assets, and there is not yet a precedent for the best way to deploy assets into the space.
Regulation
Regulatory uncertainty is real, and has (for the most part) previously given allocators an easy out in ignoring the asset class. I see this beginning to change though. We are seeing major efforts being made at the state level. Ohio now allows individuals and businesses to pay their taxes with crypto. Caitlin Long from Wyoming is leading the charge in recognizing digital assets as property, well aware of the potential it could bring to the future of the state’s economy. Within the SEC we have champions like Hester Pierce (“Crypto Mom”), and we’ve already witnessed the first SEC approved token sale under regulation A+ framework. In the CFTC we have a recently departed chairman, Giancarlo (“Crypto Dad”) that not only oversaw the approval of regulated futures but also wrote a glowing open letter to the crypto community. In this he encouraged the work being done and recognized the potential for positive change that is being so vehemently fought for. Even Chairman Powell recently referred to Bitcoin as a “speculative store of value” and showed no indication of believing it warrants a blanket ban.
Overall the market is cleaning up its act. Exchanges are being pressured to report legitimate volumes and showing a willingness to be regulated and follow KYC/AML. Market participants are calling out bad actors in what is the purest form of self-regulation and monitoring. All in all, people are stepping up. The parent company to the NYSE now offers physically settled bitcoin futures and a regulated warehouse. The OTC market is maturing too. Managers are using risk controls. In sum, there are compliant ways for a pension fund to invest in crypto today.
Wrap Up
Underneath a testy macro backdrop the world is slowly experiencing a paradigm shift. Spreads have compressed globally, negative yielding debt now stands around $16 trillion, and fiscal deficits have ballooned. We’re also witnessing coordinated action from central banks racing to cut rates more aggressively and restart QE. To hit their assumed rate of return pension funds will need to be more elaborate in their investments and find truly differentiated, uncorrelated sources of return. Those that break from the pack are at least giving themselves the chance of weathering the storm.
To crypto folks, pension funds appear to be moving slowly if at all. Keep everything in perspective: just as driving at 80mph on a road trip makes slowing through a town feel like coming to a standstill, pension funds operate in one of these 30mph zones. So what feels like slow motion to the fast-paced crypto traveler is actually just the speed they’re used to. It’s all relative. Appreciate this reality and continue to build, disrupt, and educate.
Pensions will come, as they always do.
Afterword
In the spirit of democratizing what has previously been held by the few, I want this knowledge — basically what pensions need to see to invest — to be accessible. Guessing what they’re looking for should not be the hard part and I hope this alleviates the mystery by pulling the curtain back on discussions happening about crypto today within pension funds. If you would like to help amplify this signal please share with others in the community.
Special thanks to Nic Carter, Jeff Dorman, Anthony Pompliano, Ria Bhutoria and Anthony Emtman for providing valuable feedback on this piece.
Appendix: Types of Institutional Investors (in order of likelihood to invest)
Broadly speaking one may think of institutional capital in 5 different buckets: banks / insurance companies, Sovereign Wealth Funds (SWFs), endowments / foundations, family offices and pension funds.
Family Offices
Family Offices essentially manage the wealth of one or more individuals or families. These investment teams are subject to the least amount of public oversight of the aforementioned groups because they are simply employed by retail investors with millions (or billions) of AUM. With both the willingness and ability to invest in crypto, this group is a logical early entrant into crypto investing. Because of their wealth these investors are awarded an accredited or qualified classification, just as other institutions, which allows them to invest in private markets that regulators like the SEC forbid retail from entering. The SEC argues this protects retail, but this is a subject of increasing debate, with the counterargument being that the regulation bars retail from accessing many of the best investments. This dilemma has been exacerbated by the fact that massive institutional inflows to alts have created a paradigm shift where companies no longer have to tap public markets for funding to reach scale, and as a result an increasing amount of returns are accruing to private investments.
Endowments and Foundations
Endowments and foundations manage funds for organizations like universities and charities. These assets are designated for various expenditures, but in general exist to help meet the spending needs of their respective organizations. Unlike banks, these liabilities are not necessarily legal obligations, which allow their investment programs to take on more risk. Additionally, since the assets/liabilities are not being managed in a 1:1 fashion like that of a bank or insurance company, portfolio managers have more latitude in what they can invest in. The program also typically has a long time horizon, meaning it can earn an illiquidity premium because the fund can afford to hold onto an investment for longer and ride out market fluctuations before realizing the gain. These factors have allowed endowments and foundations to adopt more alternative assets into their investment policies over time.
Taking the Yale endowment fund as an example, whose pool of assets is expected to continue funding scholarships and new buildings in perpetuity. I won’t go into detail here but it’s worth reading about David Swensen (Yale endowment CIO) and how he engineered what’s known today as the endowment model — creating a portfolio heavily weighted in alternative investments (PE, VC etc) rather than traditional assets (public equity/bonds). The same characteristics that allowed these investors to be the first ones to wade into PE and VC (realizing incredible returns over time) have also enabled them to be early movers into digital assets, as evidenced by Yale, Harvard and other notable endowments all making allocations to crypto funds (Harvard even invested directly into a token sale).
Pension Funds
The mythical unicorn of institutional investors. The proverbial pot at the end of the rainbow for HODLers. Pension funds come in all different shapes and sizes; the sponsor may be a private corporation or it may be a public entity (municipality, city, county, state). For the purposes of this piece, we assumed “pension fund” referred to defined benefit plans (DBs) rather than defined contribution plans (think 401k). The important distinction here is that DB plans owe a vested benefit to plan participants (employees and retirees) which creates a legal liability for the fund. Corporate pension funds have become increasingly rare (too expensive and onerous from an actuarial perspective) but are the standard in the public sector. It is reasonable to expect pension funds to invest meaningfully into this asset class before banks, insurance companies and SWFs, but after FOs and Endowments.
Sovereign Wealth Funds
A SWF is a reserve pool set aside by a government for investment. SWFs are primarily found in countries rich in natural resources, funded by oil revenue etc. The idea is that as finite resources are extracted and sold today, permanent capital will be set aside to benefit future generations. These funds are prevalent in the Middle East, though not exclusively. Another variation of this is the Permanent Fund in the state of Alaska (paid into by oil companies operating in the state). Generally SWF’s tend to be idiosyncratic in nature since governments come in many flavors. On the aggregate we are talking about over $7 trillion (per Preqin) of permanent capital looking for a home. Given their extended time horizon, I expect this money will eventually allocate to crypto just as it has to PE and VC, though today’s market is still too small for these behemoths to meaningfully deploy capital.
Banks/Insurance Companies
Don’t hold your breath on banks/insurance companies putting Bitcoin in their portfolios. To be clear, with banks I am referring to the assets on their balance sheets (not projects like JPM Coin and other services like trading/market making). These organizations employ a strategy called liability driven investing (LDI); in short, they have liabilities on their balance sheets (customer deposits, insurance policies etc). These are legal obligations — as such the stewards of this capital manage the assets to match the fluctuations in the value and duration of their liabilities as closely as possible. The chief goal is to keep the value of the assets paired with liabilities, aka “immunizing” the portfolio liabilities. This is achieved by investing in assets with return drivers highly correlated to that of the liabilities (think duration with interest rates). Since the value of bank deposits and insurance claims are not likely to move in lockstep with that of Bitcoin, not only would these institutions not be interested in investing, they actually have strict investment policy constraints that forbid investment in something like Bitcoin. Compatible investments like tokenized credit and other decentralized debt instruments may eventually be originated, but for now let’s keep the conversation focused on crypto assets where price appreciation is the main consideration being underwritten in the investment process.
