Despite its volatility, Bitcoin makes for a compelling alternative asset, argue Fred Pye and Jack Tatar
AS WE WRITE, the price of Bitcoin has just corrected below $10,000, and the topic has moved away from fringe discussion boards to become daily fodder for conversation on 24-hour finance channels and nightly news.
To put its current price in perspective, back in January 2017, Bitcoin was trading at $1,000. Clearly, anyone who put money into it back then would now have huge profits, even with the recent correction. But the question remains for many investors and investment managers: Is it an investment?
Perhaps the first question should be: What the heck is Bitcoin? Bitcoin grew out of the 2008 financial crisis. It was created by an anonymous entity known as Satoshi Nakamoto. In October 2008, six and a half weeks after Lehman Brothers declared bankruptcy and Merrill Lynch was sold to Bank of America to save it, Satoshi released the
Bitcoin white paper. The document, which outlined a new method for electronic transactions, is the genesis for every single blockchain implementation deployed since.
Satoshi summed up the white paper by saying, “We have proposed a system for electronic transactions without relying on trust.” For those of us in North America, it may be disconcerting to think that we cannot trust our governments or our banks, but we must remember that the concept of Bitcoin as a potential global currency or store of wealth is bigger than just North America. Accordingly, investors and advisors must be prepared to discuss the concept of money changing form in our lifetime.
Bitcoin is currently traded on numerous exchanges throughout the world on a 24-hour basis. Anyone can trade fiat currency for Bitcoin through exchanges such as Coinbase (in which the New York Stock Exchange is an investor). At any time, traders can recognize a price for Bitcoin and many other cryptoassets, including Ethereum and Litecoin. Currently there are more than 1,800 cryptoassets trading on exchanges around the world.
Over the past year, Bitcoin has been on a wild price ride, but a look at its historic volatility shows that this volatility has been significantly decreasing since its inception. That may not bring a lot of comfort to volatility-averse investors; however, an asset class with a volatility of zero usually has a similar rate of return.
Also, Bitcoin’s volatility must be measured against its return profile and against other more conventional assets such as stock in Facebook, Amazon, Netflix and Google. To effectively address asset allocation in clients’ portfolios, advisors are always on the quest for non-correlated assets. All of these assets have seen absolute returns over the last few years; however, Bitcoin shows very little correlation to any of them.
Second, although returns and volatility are important, those of us who study assets recognize that putting the two together provides us with the Sharpe ratio, which helps to calibrate the returns against the risk taken. The higher the Sharpe ratio, the more the asset is compensating investors for the risk.
Evaluating the Sharpe ratio for Bitcoin and equities from Facebook, Amazon, Netflix and Google over this same time period shows that not only did Bitcoin exhibit the highest volatility and highest returns over this time, but it also had the highest Sharpe ratio of these assets by a significant level. Bitcoin compensated investors twice as well for the risk they took as the aforementioned equities.
As investors and investment managers, we always have the need to implement effective risk/reward holdings into our portfolios. Using the Sharpe ratio helps to identify those assets that can provide significant returns while balancing the risk profiles of our funds and investors.
The significant returns exhibited by Bitcoin over the last couple of years are nudging investors of all levels to explore it and other cryptoassets within the context of their investment portfolios. Could Bitcoin fit the model of being an alternative asset? One of
the major functions of an alternative asset is to provide a level of non-correlation to other assets, which would then provide a lower level of risk in a portfolio.
As responsible investment professionals, it is vital for us to become educated on this new asset class and consider how these assets should be appropriately recommended and positioned for investors. Dismissing Bitcoin and ignoring the entire cryptoasset space is something investors and investment managers do at their peril.
Fred Pye is president and CEO of 3iQ Corp. Jack Tatar is an advisor with 3iQ and co-author of the book Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond.