How Does Cryptocurrency Fit Into A Portfolio?

How Does Cryptocurrency Fit Into A Portfolio?

How should investors think about cryptocurrency as part of a broader diversified portfolio? I spent most of the past four years working for the University of Chicago endowment where we had to consider into which "bucket" investments would fall. 

Is cryptocurrency best thought of as venture capital? Absolute return? 

A potential inflation hedge like gold or real estate?

An average investor may not be bound by the buckets above, but should still carefully consider the role cryptocurrency plays in the context of a complete portfolio.

Some investors view cryptocurrencies primarily as currencies or commodities that may appreciate in value as they compete with fiat currencies or gold. For these investors, a passive investment or an index hugging manager may provide an attractive investment that is best thought of as similar to a commodity allocation. 

A more active manager may add alpha to this approach by identifying those cryptocurrencies most likely to win the competition to become censorship resistant money or “digital gold."

In addition to hoping for both a positive return and a low correlation to the existing portfolio, these investors may also anticipate that the investment will act as an inflation hedge, or at least a currency depreciation hedge similar to gold.

Other cryptocurrencies are best thought of as equity in an open-source software project. 

For example, to compete with Amazon Web Services, developers have created open-source decentralized file storage systems that incorporate a cryptocurrency to pay for storage space. 

The value of these cryptocurrencies are ultimately connected to the usage value of the network, and a successful network may produce an attractive return to the holders of the cryptoasset. 

Accessing this opportunity set can be done via investment managers that invest in exchange-listed cryptoassets, or in venture capital style funds that try to identify successful projects earlier in their life cycle with lower entry prices.

Lastly, as in all other asset classes, opportunities exist for market makers, arbitrageurs, and quantitative traders. 

While cryptocurrencies bring many unique challenges and risks, short-term trading strategies from traditional asset classes can generally be applied to cryptocurrency.

All of these investment approaches share one major similarity – unusually high barriers to entry that may explain the exceptional returns of the past seven years to both active and passive investment. Storing cryptocurrency is currently difficult from both a technological and regulatory perspective. 

Exchanges present unusual levels of counterparty risk. The newness of most investment managers in the space makes due diligence difficult. 

And the relatively small total market capitalization and lack of scale available to some of these strategies makes them unattractive to many existing traditional investment managers and large institutional investors.

For many investors, underwriting these unusual risks is difficult. 

The risks are real - high volatility, counterparty risk, complexity, operational and security challenges - but they are idiosyncratic and can be diversified away by sizing cryptocurrency investments to a small percentage of the total portfolio, or by diversifying across cryptocurrency investment managers.

Cryptocurrency markets are capturing tremendous value creation from technological innovation and disintermediation of existing financial services. The nascency of these markets provides active managers with an unusual level of inefficiency to exploit.

Popular

More Articles

Popular