It is difficult to believe that before 2000, most traditional institutional investment portfolios did not allocate to commodities. Balanced portfolios of stocks (60 percent) and bonds (40 percent) were the norm. Alternatives were no where to be seen, and often shunned.
Though Nobel Prize laureate Harry Markowitz said in 1952, “diversification is the only free lunch in investing,” it wasn’t until the millennia that portfolios really started greater diversification into alternatives. The argument for diversification was grounded in some straightforward math – earn higher risk adjusted returns through diversification to include alternatives such as commodities and managed futures.
We’ve Seen This Movie Before
Chris Tyrer, the Head of Fidelity Digital Assets Europe argues in a new paper that many of the barriers that financial institutions face allocating to bitcoin and other digital assets, are similar to those faced accessing the commodities markets in the early millennia – we have seen this movie before.
Says Tyrer “The stock market underperformance (1Q20-4Q02) created an environment in which investors were open to exploring other sources of return. Indeed, this proclivity has persisted and grown stronger over time as can be demonstrated by alternative investment allocations, which according to estimates published by the CAIA Association were 6 percent of global investable markets in 2003 and as high as 12 percent in 2018.”
It is now accepted that commodities are a separate asset class for traditional investment purposes, and many advised portfolios have some exposure to commodities as an asset class. Fidelity’s 2021 Institutional Investor Digital Asset Study of more than 1,000 institutions found that 23 percent believe digital assets belong in an independent asset class.
Tyrer highlights the similarities in the development of the nascent commodities markets with the current maturing digital assets markets and points to several shared characteristics including a developing product suite, market access, an improved regulatory environment, and a transforming market infrastructure. From the launch of regulator approved bitcoin ETFs to the development of institutional custody of digital assets, through to the development of digital assets futures, the “suite” has now matured and is ready for institutions to access, as witnessed with the commodities markets.
Bitcoin’s 10 Year Outstanding Performance
The most compelling case, however, is the outstanding performance of the asset class. Bitcoin’s 10-year performance to the end of 2020 significantly outperformed every other asset class with only two drawdown years, in one of the years where the S&P was also down. It is this performance that is largely uncorrelated to other asset classes that is attracting investors, across the board. The Fidelity Study found that 52 percent of surveyed (institutional) investors in Asia, Europe, and the U.S. have an allocation to digital assets.
Adds Tyrer, “Recent global monetary policy, and increasingly fiscal policy, have created a positive macro backdrop for future bitcoin investment allocations and many investors remain concerned at the rate of central bank balance sheet expansion, the scale of the budget deficits being run in many developed economies, and the potential for inflation as a result.
“Bitcoin is seen by many as being an asset that will have a leveraged return profile in an inflationary environment and see it therefore as a portfolio hedge against this outcome.”
Investors like Greg Foss, the career high-yield bond trader turned bitcoin bull, agree. He would also point out that we went through a similar period of market adoption of high yield debt in the 80s. Michael Milken, the architect of the junk bond, was a pariah in the eyes of institutional investors on Wall Street in his early days, until his approach to risk adjusted junk bond yields (relative to equities) was embraced.
Foss co-created the Fulcrum Index, an index that “calculates the cumulative value of Credit Default Swap (CDS) Insurance on a basket of G-20 sovereign nations multiplied by their respective funded and unfunded obligations.” According to the ex-bond trader, the Index could form the basis of a current valuation for bitcoin, which he calls “the best asymmetric trade I have seen in 32 years.”
Tyrer points to his colleague, Fidelity Investments’ Director of Global Macro Jurrien Timmer’s research, and the analysis of the S-Curve correlation between mobile phone subscriptions and bitcoin addresses, observing “it appears that the bitcoin growth curve may still be in its early phase and could remain so for a number of years.”
“Thus the bullish case for bitcoin: Price is at the intersection of supply and demand, and demand is growing exponentially while supply (per BTC stock-to-flow) approaches its limit. Bitcoin can act as a store of value because of its scarcity, but it’s also an integral part of a technological revolution (blockchain encryption) with potentially explosive demand growth,” wrote Timmer.
A Compelling Macro Backdrop
Whilst there are many similarities between the digital asset markets of today and the commodities markets of the early 2000s, Tyrer points to the significant advances in enablers of institutional participation and as importantly that as with commodities in the early 2000s, these developments are occurring at a time when the investment narrative and macro backdrop is compelling.
The growth of the cryptoassets markets, now $2 trillion, has been driven largely by the retail market and private capital since the financial crisis in 2008. Governments and the traditional financial services sector have not really played a significant role, to date. This has been one of the most historically interesting and socially beneficial incubators for the development of an asset class ever witnessed. Against a backdrop of low interest rates, historic government and personal debt levels, and rising inflation, digital assets have to date, proven their utility.
In commodities, the conditions in the early 2000s resulted in a significant volume of institutional capital flowing into the asset class in the years immediately succeeding, seeking asset class diversification through greater risk adjusted returns. Whether bitcoin and other digital assets will attract similar volumes remains to be seen, but the case for asset class diversification through greater risk adjusted returns can most certainly be made, and the current direction of travel has certainly confirmed the trend that institutional investors have arrived.