In my conversations with clients over the years I’ve found that the term cryptocurrency elicits a broad range of reactions. I’ve seen everything from deep disdain to enthusiastic fervor and everything in between. Whether we like it or not, cryptocurrency is here to stay. For this month’s Insights, I’d like to explore what cryptocurrency is, where it is currently at, and whether or not it is a real asset class that should be considered as part of a portfolio.
What is Cryptocurrency?
Cryptocurrency is exactly what the name suggests. It is a currency (medium of exchange and store of value) whose record of ownership is recorded and protected by sophisticated cryptography.
As a currency it is digital (does not have physical coinage or paper). It is also “fiat” which means that there is no asset backing the currency and its value is predicated on trust.
The technology that underpins cryptocurrency is something called “blockchain”. This basic diagram shows how blockchain works in practice:
Blockchain technology has applications and potential uses in a variety of industries, but for purposes of this discussion, we’ll focus on how blockchain works within the cryptocurrency ecosystem. As the above diagram suggests, when a cryptocurrency changes hands, that discrete transaction becomes a “block” and once the veracity of the transaction is authenticated, the new “block” gets added to the historical “chain” of transactions. Cryptography comes into play in both the creation of new currencies and the validation of transactions. The nature of the sophisticated cryptography means that the blockchain of transaction history is accurate and more or less immutable.
There are hundreds of different cryptocurrencies and most share this common construct.
If at the end of the day cryptocurrency is just another medium of exchange (like Dollars, Pesos, Euros, Yen, and other currencies), why is there so much interest and action in this space? A few possible answers:
- It is novel. Like any new technology, it elicits curiosity
- It is decentralized and not tied to a specific government. As such, it is less susceptible to government intervention
- Unfortunately, it is sometimes used as a transactional medium for illicit activity (tax evasion, payment of ransom, money laundering, etc.)
- Related to the 2nd bullet, as trust in mainstream currencies erode due to inflation, loss of central bank independence, and soaring debt burdens, people are very interested in alternative means of storing wealth
- It is speculative. Its high volatility makes it a prime candidate for speculators
The complex supply and demand driven by the above factors leads to a cryptocurrency market that is both volatile and continually expanding in overall breadth.
How has Cryptocurrency been Performing?
The last six months have been challenging in the cryptocurrency space. This is not unusual, however, and the nature of cryptocurrencies is that there have been seasons of boom and bust. The two largest cryptocurrencies are Bitcoin and Ethereum and observe how they have performed over the past six months:
While these are off their February lows, they are still materially down over the past six months. When we zoom out, however, we see that this is pretty typical cryptocurrency behavior over the past 10 years. We have periods of dramatic rises followed by massive collapse, but the net movement upward has been staggering. If we look at the below chart (yes, those percentage increases are in 1000s), we see both the breathtaking rises along with the subsequent drops:
The periods of decline are called “crypto winter” and the $100,000 question is how long will this current winter last. Some fear that it will be long in duration, while others are optimistic that we’ll have a quick bounce back.
Should Cryptocurrency be Part of an Investment Portfolio?
There isn’t a clear answer to this, but there are several risks and opportunities here to consider. I’ll start with the risks first:
- Cryptocurrency is extremely speculative and volatile. It can and will fluctuate in value and one can lose a substantial portfolio of their initial investment
- While unlikely, we may look back and view the cryptocurrency craze at least to some degree the way we view the Dutch Tulip Bulb craze (see https://guides.loc.gov/business-booms-busts/tulip-mania) and other historical bubbles driven by the mania of crowds
- Technology continually evolves and cryptocurrency faces technological threats (better alternatives, more sophisticated hacking, etc.). This could radically alter the current cryptocurrency value proposition
- Alternative digital assets. Many governments either have or are developing their own digital assets. These may lessen the demand for cryptocurrencies generally depending on the quality/convenience of these offerings
In terms of opportunity there is much to consider here as well. One of the primary benefits of cryptocurrency is that the advent of cryptocurrency ETFs has made these currencies much more accessible for investment portfolios and these currencies can represent a less-correlated asset in a portfolio. The below chart shows correlations (how much things move together) between Bitcoin and Ethereum and other asset classes:
Green means high degrees of negative correlation (moves in the opposite direction), gray means no correlation (no real defined relationship), while red shows varying degrees of positive correlation (the darker the red, the more things move in lockstep). While this data covers approximately the last two years and is heavily influenced by the recent crypto pullback, there is often benefit to be had by having some non-correlated assets in your portfolio.
Other opportunities in cryptocurrencies center around how mainstream they have become. The current administration is a strong proponent of cryptocurrencies and have adopted many pro-cryptocurrency policies. The longer cryptocurrency is around and the more support that government lends, the more it becomes a bona fide asset class.
Lastly, as mentioned earlier on, as we see significant pressure on mainstream currencies (because of excessive debt and distrust), the more people seek alternative stores of value. We have seen this with gold and precious metals and may see cryptocurrency become a more and more viable alternative to mismanaged national currencies.
To the extent one weighs these and other risks and opportunities and decides to include cryptocurrencies in their portfolio, we suggest considering the following:
- Expect to see large swings in value
- Sizing here is extremely important. A small holding can improve the risk/return characteristics of a portfolio while too much can be catastrophic. To the extent this is included in an investment portfolio, we suggest a very modest amount. Think of this as you would adding a risky spice to a recipe. A small amount might make the recipe better, but too much risks ruining the entire dish
- Your portfolio is the sum of its parts and excellent portfolios will always have some positions that are down in value. If all your positions are up simultaneously to a similar degree, that probably points to overly high degrees of correlation and potential pain if we see a market reversal
We hope this note finds you all well and wish the best. As always, please reach out to us as questions arise.
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