Hedging Systematic Risk
Why Family Offices Should Invest in Bitcoin
The interest of institutional investors in Bitcoin is growing steadily. The digital asset ecosystem has grown and developed rapidly and now provides the required legal certainty that we have known from the traditional financial markets for decades. Many institutional actors are now beginning to manifest themselves within the ecosystem — mainly in the form of single and multi-family offices. But why are family offices in particular early entrants? Because they represent smart money and recognize the value of Bitcoin investments unaffected by the noise around the topic. Focussing on statistics and long-term implications, family offices have an eye on uncorrelated, scarce and asymmetric assets to generate the greatest returns for their clients. And they found such an asset with Bitcoin.
What was Bitcoin again?
Bitcoin was brought to life in response to the global financial crisis in 2008 and should bring about a lasting change to the error-prone financial system. With Bitcoin, payments can be made electronically and directly from one party to another without the need for a trusted intermediary (e.g. a bank). Although it was originally intended to become an alternative to fiat money controlled by central banks, Bitcoin remains a marginal phenomenon in daily payments. But this does not detract from Bitcoin’s right to exist. Bitcoin has bravely held its ground, against many forecasts and denigrations. Even if its use in daily payments will remain low, new perspectives on the value of Bitcoin have already opened up. And they might be even more powerful.
Bitcoin’s Uncorrelated Nature
Family offices have long been aware of the importance of portfolio diversification. Modern portfolio theory (MPT) suggests against the idea of keeping all eggs in one basket. It promises to reduce risk without sacrificing returns. However, there is a specific risk to which MPT is also relentlessly exposed: systematic risk. To withstand market-wide volatility, uncorrelated assets are sought. This is where Bitcoin comes in. For 11 years now, Bitcoin has demonstrated its uncorrelated nature with other asset classes such as stocks, fixed income, gold and oil. A correlation coefficient of about 0, combined with the idea that Bitcoin could be an effective hedge against the risks associated with global fiat and banking systems, makes it an attractive source of diversification for institutional portfolios. For family offices, the uncorrelated nature of Bitcoin is a key determinant of its appeal. Soon after the 2007 financial crisis, institutions found that their allocation within the stock market was too high and since then they have been pursuing uncorrelated assets.
Figure 1 shows that from January 2012 to July 2019 Bitcoin disjoint from developments in other markets. While other markets showed moderate correlations to one or more traditional asset classes, Bitcoin maintained a remarkably weak correlation to all other asset classes. In other words, Bitcoin could fit well into an investment portfolio and increase returns.
Asymmetric Risk Reward
Besides its eligibility as a portfolio diversification option, Bitcoin may also enhance the risk and return reward profile of institutional investment portfolios. Among others, VanEck investigated the asymmetric return of portfolios allocated to varying percentages of equities, bonds and Bitcoin from January 2012 to July 2019. They found that a small allocation to bitcoin significantly enhanced the cumulative return of a 60% equity and 40% bonds portfolio allocation mix while only minimally impacting its volatility. As shown in Figure 2, a portfolio with 58.5% of the fund distributed to equities, 38.5% to bonds and 0.5% to Bitcoin generated returns that surpassed that of a portfolio allocated solely to the S&P 500 by over 150% as of July 2019.
The ultimate idea behind Bitcoin has been that no nation-state, corporation, or third party has the power to control who can transact or store their wealth on the network. Censorship-resistance ensures that the laws that govern the network are set in advance and can’t be retroactively altered to fit a specific agenda. While traditional financial institutions are in the hands of intermediaries, the Bitcoin network isn’t owned by any single entity. As such, it’s virtually impossible to censor transactions on it — in contrast, this isn’t the case when it comes to traditional finance. For example, if a person is deemed an enemy of an authoritarian state, the ruling government might freeze their account and prevent them from moving their funds.
The New (Digital) Gold
Bitcoin presents a good opportunity to family offices which have gold in their portfolio. While gold has historically played a major role in economies based on material trade, today’s world is digital. This matters when it comes to portability and fungibility of the asset class. Unlike gold, Bitcoins can be sent quickly, securely, in almost any quantity, at low cost and with transparent, verifiable transaction data.
The reason for the often made comparison of Bitcoin and gold lies the inherent characteristics of Bitcoin, especially its scarcity. The production of new Bitcoins requires a lot of computing work in a process known as “mining”. With the release of Bitcoin, a fixed maximum circulation of 21 million Bitcoins was defined a reality. Today, there are already about 18 million Bitcoins in existence. Almost every ten minutes, when the miners process a new block, 12.5 new Bitcoins are mined. In May 2020, the output of new Bitcoins at the so-called “halving” has decreased to 6.25 new Bitcoins per processed block. Halvings are planned approximately every four years. The mining process distinguishes Bitcoin from gold in important ways. Despite best estimates, no one can name the gold stock with any conclusive certainty; there is no way to independently verify the entire gold supply. With Bitcoin, however, the entire existing Bitcoin inventory can be verified with a simple web-enabled device. Nevertheless, gold has a considerable advantage in terms of trust due to its long history. In the case of Bitcoin, comparatively few people recognize an electronically generated, dematerialized scarcity to date. Yet Bitcoin is the first successful demonstration that properties once reserved for physical assets such as gold can be reflected in digital assets.
Family offices are generally entrepreneurial and benefit from fast, agile decision-making processes. Many opportunities arising in the field of crypto assets require an open mind and access to capital. Hence, family offices are in a unique position to reap the benefits from crypto assets including Bitcoin into their portfolios. Through the lens of modern portfolio theory, this article has outlined the opportunities of allocating part of a portfolio to Bitcoin in particular. The main reason for this is 11 years of historical evidence that underpins the fact that Bitcoin offers investors the opportunity to further diversify their portfolio and maximize risk-adjusted returns. This is due to the incomparable dynamics of the crypto asset industry, which ensures that the key value drivers for a given crypto asset have little relationship to the value drivers of stocks, fixed income or alternative investments. What makes investing in Bitcoin particularly compelling is its potential to improve the risk profile of a traditional investor’s portfolio by significant levels. Therefore, the often volatile risk profile must be considered as only a part of an investor’s overall portfolio. When an investor intends to invest in Bitcoin in this way, the advantages are obvious.
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Simon Peters is the Managing Director of DECUS Network. We at DECUS open the doors for asset managers to new uncorrelated & uncensored asset class. Diversify your portfolio and Make Your Legacy Unshakeable!
Thomas Faber is research lead at Decus Network and research fellow at the Frankfurt School Blockchain Center. His areas of interest include distributed ledger technology (DLT), security tokens (STOs), crypto-assets as well as blockchain ethics and blockchain-related sustainability issues.
DECUS Network GmbH is a venture of BlockSize Capital.