Cryptocurrencies and Asset Class Destruction
The death of the 60/40 allocation has lead many investors to have an effectively equity-only portfolio.
This is the first post in a series on Bitcoin and cryptocurrencies. In these posts, I make general comments on about owning cryptocurrencies. These comments are NOT individual investment recommendations. You should consult with your investment advisor about owning cryptocurrencies or any other investment.
Owning and Sizing Cryptocurrency Investments
Every investor should have some exposure to cryptocurrencies. The only question is how much.
For most investors, the answer is very little, and it should be confined to a percentage of their risk assets. That is, if an investor decides to allocate funds to cryptocurrencies, it should be a percentage their risk assets, not a percent of their total investment assets. For most investors, this will imply a small exposure. For example, if an investor is allocated 50/50 between risk assets and conservative assets, a one percent allocation in their risk assets would be one-half of a percent of their total assets.
The reason cryptocurrency allocations should be small is that they are speculative investments. “Speculative” is a term of art in the investment industry, it means that investors can lose all or substantially all of their investment.
While I believe a total loss in established cryptocurrencies such as Bitcoin is a highly remote possibility, they are volatile. For instance, Bitcoin was trading around $200 in mid-2015 and rose to almost $20,000 in December 2017. It then fell to around $3,200, rose again to about $12,700, fell to around $4,900, and now trades at $9,488.
Chart 1: Bitcoin Log Chart
The trend is decidedly up, but it has been a volatile ride.
But Cryptocurrencies Aren’t Backed by Anything!
Cryptocurrencies are not “backed” by anything in a strict sense, but neither is the U.S. dollar. All currencies are faith-based. You accept wages or payment for goods and services in a currency because of your belief that others will accept wages or payment for goods and services in the same currency. There’s nothing else to it.
If you want to test this theory, try paying your staff in Venezuelan Bolívares.
The ability to agree to a shared belief is one of the great advantages of humanity. This is the basic premise of Yuval Harari’s Sapiens. Humanity has agreed on many beliefs, such as gods, nations, human rights, and laws, to name a few.
The belief in money is just like any other. If it is believed (and most of humanity’s shared beliefs are tacit), it works. Many goods have occupied the special place of currency, including: animal pelts, colored sea shells, salt, grain, silver, gold, paper money, and now cryptocurrencies.
I’m sure that, at the time, it seemed radical to move away from colored sea shells, but the transition was made and humanity was better off for it. This example seems absurd, but isn’t physical cash just an easily stackable form of sea shells?
After the belief in a currency is accepted, the believers can move on to the traditional traits of money, including being a:
- Store of value;
- Medium of exchange, and;
- Unit of account.
Bitcoin, and other cryptocurrencies have all of these traits. (I'll admit that most vendors don't accept payment in cryptocurrencies, but that is steadily changing.)
Asset Class Destruction
U.S. Treasuries, as an asset class, are disappearing from the face of the earth. Why? Because after one of the most epic secular trends in history, they now offer return-free risk.
Chart 2: 10-Year U.S. Treasury Yields – Log Chart
On September 30, 1981, the 10-year U.S. Treasury (“10-year”) yielded 15.84 percent. It now yields 0.73 percent. While it is possible that 10-year yields go to zero, or even below zero, the returns to be had from such a move are low.
If the 10-year were to go to zero, the bond price would increase by about 6.3 percent. However, if the 10-year yield were to rise to two percent, roughly where it was at the end of 2019, the price would decline by about 11.5 percent. Of course, if it just stays where it is, an investor would earn the 0.73 percent yield.
This means the 10-year has effectively turned into a zero-coupon bond, with very high duration (aka interest rate risk).
The risk/reward tradeoff is decidedly unappealing and the 0.73 percent yield doesn’t pay anywhere near enough to justify waiting around to see what happens.
This is what return-free risk looks like: large asymmetric downside risk and no carry.
The Death of 60/40
Return-free risk in 10-year Treasuries puts investors in a bind. Treasuries have served as high-quality ballast in portfolios since the advent of Modern Portfolio Theory in 1952, if not earlier. Indeed, they have been a big part of the “60/40” portfolio (60 percent equities/40 percent bonds), the default asset allocation for most investors.
The 60/40 portfolio has long been reported to have died. Those reports were greatly exaggerated, but now with the 10-year well under one percent, the death would appear to have come to pass.
Where will investors shift their bond allocations? The first option is to shift down the yield curve to shorter duration bonds. This eliminates the price volatility, but if you thought a 73 basis point yield was low, how do you feel about the 19 basis points the 2-year Treasury is paying?
Option number two is to shift some of the fixed income allocation out of bonds and into bond proxies such as utilities or REITs, or into higher risk bonds such a junk bonds, and leveraged loans. This is also fraught with risk, as many found out during the market route in March which punished low quality bonds just as much as equities.
Option three, which has been in play for many years, is to shift out of bonds and into “alternative assets” such as private equity. This greatly increases the risk of the portfolio, but keeps the expected returns high. These alternative assets are carried at cost with prices being sporadically updated and thus appear to be low volatility (like U.S. Treasuries!). In reality, almost all private equity is the equivalent of a microcap stock portfolio and would have high volatility if marked to market every day.
Another Way Forward?
The wholesale shifting out of conservative fixed income will continue because of the Federal Reserve’s interest rate policy, which has forced retirees, pensions, and anyone needing yield to look elsewhere.
Thus far, all three of the options above have boiled down to a shift out of bonds and into equities.
This is highly sub-optimal because such a portfolio basically has one exposure: equities.
Only two remaining assets offer truly differentiated returns from equities: gold and cryptocurrencies. Ironically, I believe cryptocurrencies, while being speculative, may offer a much better risk/reward tradeoff and would enable investors to avoid the trap of having most of their assets being equity or equity-like.
In subsequent posts, I will be exploring these options and sharing insights I’ve gathered from conversations with a number of cryptocurrency experts.