Solomon Wong explains alternative investments and investigates the competitive advantages and risks of Bitcoin investments.
2020 was a good year for Bitcoin investors. As of December 24, 2020, Bitcoin’s price has reached USD 22950, representing a 380% return compared to its trough in March 12, 2020. As Bitcoin garners more attention, many investors are spurred to allocate a higher proportion of this novel cryptocurrency asset class to their portfolio. Is Bitcoin a fad, or is it here to stay? This article will seek to address three questions: Firstly, what is Bitcoin’s role as an alternative investing instrument? Secondly, why invest in Bitcoin? Thirdly, what are the risks associated with Bitcoin investments?
(i) What is Bitcoin? What are alternative investments?
Let's begin by defining two key terms: Bitcoin and alternative investing. Bitcoin belongs to the family of cryptocurrencies (other cryptocurrencies include Ethereum, Litecoin and so on) and is the most developed out of the category, with a market cap of $462 billion and 18.582 million BTC units in circulation. Bitcoins are transacted, stored and governed by an open, decentralised system, called Blockchain. (For more information on Blockchain, see Myra’s article Cryptocurrency 101). Bitcoin has its own issuance policy that is independent of central bank’s monetary policies (see: Mining)
Alternative investing is a catch-all term for any investments that are not cash or do not belong to any traditional asset classes like equities and fixed income. Examples of alternative investing can include private equity, private credit, hedge fund, etc. Typically, investors invest in alternative instruments to achieve three objectives:
Offsetting foreseeable losses by increasing exposure to returns that are uncorrelated with traditional stocks and bonds
Risk diversification, that is diversifying risk exposures to assets that are not covered in traditional investing instruments (e.g. middle market credit, venture capital)
Generating stable cash flow from non-traditional sources (e.g. collateralised debt obligations)
Perceptions on Bitcoin are starting to change. Many high-profile institutional investors, such as Blackrock, Fidelity, Morgan Stanley and JP Morgan, have taken actual steps to increase exposure in the asset, setting up Bitcoin-only funds for qualified clients.
(ii) Why invest in Bitcoin?
The rationale behind investing in Bitcoin can be separated into three parts: its competitive advantages against shares and bonds, its competitive advantage against other alternative investments and its growth potential.
1. Bitcoin’s competitive advantage against traditional shares and bonds
Bitcoin’s performance as an asset class has been outstanding during 2014–2020. When we use the Sharpe Ratio as a metric, we can see that Bitcoin has delivered the highest amount of risk-adjusted return compared to other major asset classes, and the performance is consistent. What does this mean? It means that investors’ return on Bitcoin investment far exceeds the corresponding degree of risks they had to carry.
Illustrated in the experiment result below, As investors increased their exposure to Bitcoin from 0% to 3% in a traditional portfolio composed of 60% stock and 40% bond, risk-adjusted return increased by 32.2% while the maximum drawdown experienced a slight drop. The statistics yield one important insight: Adding Bitcoin exposure in a traditional portfolio will result in a significant improvement in capital efficiency and lower downside risks for investors.
Another important insight is that Bitcoin is an efficient ‘safe-haven asset’ against declining market fundamentals. Despite bullish sentiment in the financial markets worldwide, the underlying market condition has actually worsened by as much as 15%, due to the disruptions in retail, manufacture and logistics sector brought by COVID-19. In other words, the rally in share prices was created artificially by inflated expectations and higher money supply, supported by expansionary economic policies.
With no underlying assets linked to the real economy, Bitcoin is an ideal store of value for investors who fear that the stock market might crash when expectations fall. Moreover, there is only a fixed amount of Bitcoin available in the economy, which means that no entities can control the value of Bitcoin except the ‘invisible hand’ of the market. This makes Bitcoin an attractive hedging instrument for people who worry the effect of quantitative easing might diminish the value of fiat currencies they hold.
2. Bitcoin’s competitive advantage against other alternative investments
There are two reasons why Bitcoin is superior to traditional alternative investment products available to investors:
Higher liquidity
Bitcoins are traded 24/7 in the exchange platform with high volume, which provides investors with the flexibility to pull their money out and rebalance their portfolio at any time.
In comparison, traditional alternative investments such as private equity and real estate funds, which may lock up investors’ capital for a prolonged period before they can liquidate their positions.
Ease of trading
Bitcoin can be traded through online and mobile crypto exchanges such as Coinbase, with a low transaction fee. In contrast, traditional alternative investment products transactions are conducted through fund managers or investment banks, which are only accessible to wealthy individuals.
3. Bitcoin’s Growth potential
As Bitcoin increases its market capitalisation, the ability for one mega market participant to move the market price has gone down. As seen in the graph below, from June 2020 to December 2020, Bitcoin’s volatility has dropped gradually, which is reflected in the decreasing value of the Bitcoin Volatility Token (BVOL)
Narratives are fundamental to investment decision-making, according to behavioural finance theories, and Bitcoin is not short of stories.
Covid-19 has accelerated the trend of digitalisation in the economy and people are increasingly buying into concepts such as IOT (Internet of Things) and De-Fi (Decentralised Finance). As more individuals have confidence in Bitcoin playing an important role in the future economy, the more willing they will be in investing in the digital asset.
(iii) What are the investment risks involved?
Despite the upside potential, the risks associated with Bitcoin investment cannot be overlooked. Here are the two risks that are most relevant to Bitcoin investing:
Regulatory risks: The crypto nature of Bitcoin has been a perennial problem for regulators as it may be used as a conduit for illicit activities. For example, it was estimated that $2.8 billion in Bitcoin was sent to currency exchanges from criminal entities in 2019 alone, which poses severe questions about the safety of Bitcoins. Although Bitcoin was not included in the FCA’s new ban on the retail sale of crypto-assets (see Khadra’s article on the FCA ban), it does not preclude the possibility that government agencies will impose more stringent rules on Bitcoin transactions.
Absence of intrinsic value: This is an argument often advanced by Bitcoin sceptics. As economist Paul Krugman explained in this article, Bitcoin’s value has no tether to any real-world entity; its value is solely dependent on self-fulfilling expectations. Indeed, Bitcoin’s value does not have any exposure to the real-world economy, making it vulnerable to any exogenous shocks caused by unanticipated events or a shift in expectations.
In conclusion, Bitcoin has grown from a niche asset to one of the hottest investment asset classes in recent months. The investment benefits it provides is immense: higher risk-adjusted returns, no correlation from real world assets, higher liquidity and ease of access compared to other alternative investments. Given the momentum it has over the past few months, it is not surprising to see Bitcoin’s value rising above the USD 30000 mark by early 2021. However, investors do need to take stock of the Bitcoin’s extreme volatility, its regulatory risks, and be wary of any market corrections that can occur anytime.
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