The challenges of digital assets investment have forced advisors to adapt in real-time with the emergence of new and unfamiliar products in the global investments landscape. Fortunately, the struggle requires quite familiar tools: supply, demand, and modern portfolio theory.
Below we discuss two key reasons for introducing digital assets into an investment management portfolio: diversification on the one hand and the periodic dangers posed by inflation on the other.
Crypto Assets Diversify a Portfolio
Diversification is defined by the presence of assets that are either not correlated or are negatively correlated, one with another.
To review: correlation is measured on a scale from 1 to -1. A correlation of 1 means that any price move in one asset corresponds to the same price move in the other. If one asset has a correlation of 0 to another, on the other hand, a price move for one asset tells us nothing about what the other one is doing. Intuitively, one would expect crypto assets to add diversification, especially in contrast to publicly listed equities. Cryptos and equities have very different sellers/issuers. But one needs to measure that intuition against facts.
For ease of discussion, we will treat Bitcoin (still the flagship of crypto currencies) and its correlation with listed equities here. According to Fidelity, in 2020 the correlation between U.S. equities and BTC was very low (0.15).
Yet as capital markets worldwide came under pressure from the pandemic and then from the Ukraine war and other destabilizers, the correlation between BTC and equities rose. By implication, BTC’s value as a diversifier fell through 2021 and the spring of 2022. Still: the most recent trend is back toward low correlation.
Beyond diversification, the most cited reason for expanding a client’s portfolio into digital assets is that they help hedge against inflation. Again, Bitcoin is the natural standard bearer within digital currency. Bitcoin has a built-in quantitative limit. Only 21 million Bitcoins will ever be mined. That is where the metaphorical use of “mining” derives. Like gold, bitcoin is scarce, and so long as demand keeps up, this scarcity should preserve its value.
This is not true of fiat currency. It isn’t true of all digital assets, either. It isn’t even true of all cryptocurrencies. The proper way to state this point is that many crypto assets can work as hedges against the fiat, really the fickleness, of a central bank.
These two reasons for including the digital asset ecosystem in an investment portfolio pull in different directions. As the crypto asset class becomes more generally seen as an inflation hedge, that fact may increase its correlation to equities and reduce its value as diversification.
After all, a central bank’s pro-inflation policy is often adopted precisely to assist lagging equity values. That inflation may increase the need for hedges, increase demand for cryptos, aligning crypto and equity value moves.
The More Speculative Part of the Ecosystem
The analysis thus far has addressed chiefly investing in cryptocurrency, which is now the best-known part of the broader digital asset ecosystem, especially for institutional investors.
Another (newly) important investment product in this ecosystem consists of non-fungible tokens (NFTs). These are assets that employ the infrastructure of cryptocurrencies and blockchain technology, though in a very different way.
Currencies are fungible: an NFT is not. An NFT is a token built upon an artwork, an in-game item, or some other content presented or represented in digital form. Each NFT is a unique digital signature added to that underlying content. The unique signature (not the content) makes the NFT, as the ‘NF’ implies, non-fungible.
NFTs are highly speculative. They will fit some investment strategies, but they are not an investable asset that one needs to add to the portfolio of someone saving for a comfortable retirement.
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Safe Harbors and OpenSea
For example, consider one NFT available at OpenSea. The underlying image is a three-panel cartoon about the branded character “Dilbert.” In the cartoon, Dilbert’s dog (Dogbert) buys and sells an NFT for a quick profit. Naturally, this distresses Dilbert, who uses the F-word in response.
Someone with the OpenSea account F86393 has owned this NFT for months. It is possible that F86393 is happy to own this NFT for status and is not disappointed that no one is bidding for it. But it is also possible that he is trying to emulate Dogbert’s success as portrayed in the underlying art. F86393 may want to sell high. If that is so, the wait continues.
The “Dilbert NFT Comic F-Word” and other similar crypto assets are no one’s safe harbors. Those working in financial services should see to it that buyers understand this.
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