From the layman investor to bulge bracket banks, no one can escape the buzz for cryptocurrencies. The COVID-19 pandemic has accelerated this interest in digital finance, and a potential new inflation hedge. Governments are getting increasingly involved as regulation catches up with technology. And for economists, the future of digital assets being used as a mainstream form of exchange is hotly debated.

Perhaps most importantly, it’s difficult to ignore crypto’s performance relative to other asset classes since its inception. Throughout this piece, we use Bitcoin, currently the most common cryptocurrency, as a benchmark:  

Figure 1: Historical Performance of Bitcoin vs. Other Asset Classes

* logarithmic scale

Sources: New York Life Investments Multi-Asset Solutions team, Bloomberg Finance LP, 6/08/21. Past performance is not indicative of future results. An investment cannot be made in an index.

 

Why are cryptocurrencies valuable?

A primary draw to cryptocurrencies is that they are decentralized, essentially bypassing the bureaucracy of central banks and governments controlling the currency supply. Elaborating on these benefits:  

  • Cryptocurrency enables near-instantaneous payments and eliminates concerns about defaults or cancellations
  • No foreign exchange rates
  • Bypass traditional payment systems, which rely on commercial banking
  • Increased financial inclusion with censorship resistance, particularly for developing countries. Nobody can be denied access for any reason.

 

Risks to crypto uptake

We see potential for digital assets in the future of economic and financial market transactions, but their format has not yet stabilized. This presents some risks:

  • Less regulation also means less user protection from economic crises, hacking, or other threats
  • Governments are discussing how to regulate cryptocurrency, which may impact current operations
  • Central bank and private alternatives to cryptocurrency, such as central bank digital currencies (CBDCs) and Stable coins are also in development. While these alternatives may use different technologies and protocol than cryptocurrency, they may reduce the relative benefit of cryptocurrency in some areas (i.e. ease of digital transaction).
  • Environmental impact: A single Bitcoin transaction consumes more than 4x the energy as 100,000 Visa transactions.1 While there are reasonable counterarguments to this structure (i.e. improving energy efficiency; infrastructure required to power credit card transactions), it could present a risk for uptake.

 

Is cryptocurrency money?

The history of money is complex, but there are traditionally three functions required to meet the definition: it must serve as a medium of exchange, a store of value, and a unit of account. Fiat money (e.g. the U.S. Dollar) fulfills all those requirements.

There is much debate about how cryptocurrencies fit into these three requirements. We’ll use Bitcoin (BTC), currently the most common cryptocurrency, as a benchmark:  

-          Currently, BTC cannot act as a unit of account. Anything priced in BTC today is also priced in USD – if BTC were to be a unit of account, the number of coins must be independent of the dollar price of BTC.

-          BTC is also not a reliable store of value. Now, BTC price is based on speculation that the cryptocurrency might become mainstream money in the future.

-          Finally, because there is mass speculation around BTC and much volatility in its performance, it is not yet a mainstream medium of exchange.

 

If not money, then what is crypto worth?

Underlying “value” is always difficult to determine and often subjective, but if cryptocurrency doesn’t yet check the boxes as “money,” then investors may instead be focused on its role in the future of technology and process.

Remember, crypto isn’t just a currency—it is a technology, a network, and a means of transaction. As such, we have witnessed the rapid emergence of development platforms and enabling technologies. These underlying technological benefits have inspired an explosion of innovation, an entire ecosystem of altcoins, and new business models. The investment space could be impacted not just by cryptocurrency, but also by these new platforms for investment strategies and customer acquisition.

 

How to invest

There are three things investors should consider when implementing crypto into a portfolio.

1. Understand the risk profile of the asset class.

When thinking about investor outcomes, it is important to consider the risk potential of any asset class. Investors have several options, but across all of them Bitcoin showed the most potential risk over the 10 years since its inception.  

Sources: New York Life Multi-Asset Solutions team, Bloomberg Finance LP, 6/08/21. Weekly historical value at risk measures, with 95% statistical confidence, the worst drawdown for a single week in an asset class. Historical conditional value at risk is a risk assessment measure that quantifies the amount of tail risk an investment portfolio has. Past performance is no guarantee of future results. An investment cannot be made in an index.

 

Figure 2 indicates a cyclical drawdown of approximately -80% every 3 years—a significant risk that Bitcoin investors should be wary of. For many investors, this level of volatility is unsuitable. For those with higher risk tolerance, often only a small allocation is appropriate.

 

Figure 2: Portfolio historical drawdown: Bitcoin, stocks, and bonds
$100 invested 10 years ago

Sources: New York Life Investments Multi-Asset Solutions team, Bloomberg Finance LP, 6/08/21. This assumes $100 invested in Bitcoin in June 2011, no withdrawals or additional deposits were made. Past performance is no guarantee of future results. An investment cannot be made into an index. Index definitions can be found at the end of this article. Analysis does not consider fees or transaction costs. However investors should be cognizant of costs to investing in cryptocurrency which may depend on strategy, platform, or exchange.

 

2. Identify your use case for the asset class.

There are two schools of thought when it comes to investing in cryptocurrency. The first is comprised of those who believe in the technological case for a viable mainstream cryptocurrency and disrupting traditional finance, discussed above. The second is those who are interested in diversifying their investments with a high-volatility asset class. While our broad recommendations for allocation are similar for both groups (see below), the distinction may impact the size or specificity of allocation.

 

3. Consider where it fits in a portfolio.

Because cryptocurrency is often referred to as a potential inflation hedge, it can be tempting to allocate to crypto from the core equity or fixed-income portion of a portfolio, as some investors do with gold. This is not our recommended approach. In our view, Bitcoin is inherently different than gold as its intrinsic value is ill-defined, and subsequently the price is much more volatile. Figure 3 below illustrates non-stationarity, as well as the lack of consistent correlation between Bitcoin’s performance in relation to equities, bonds, and gold.

 

Figure 3: Bitcoin’s correlation to other asset classes

Rolling 6-month average

Sources: New York Life Investments Multi-Asset Solutions team, Bloomberg Finance LP, 6/08/21. This chart illustrates the correlation coefficient (linear dependence between two variables) between Bitcoin and various asset classes (S&P 500 index, Barclays Aggregate bond index, and gold). Perfect correlation = 100%. Past performance is no guarantee of future results. An investment cannot be made in an index.

 

Instead, cryptocurrencies should be considered as an alternative asset class. A diversified alternative portfolio can vary in its composition: private credit, private equity, real assets, venture capital, and hedged strategies. Portfolios that include alternative asset classes can vary widely depending on investor goals and risk tolerance, and will make up anywhere from 5% - 30% of assets. However, the similarities are in client type: accredited investors (high net worth individuals), investors seeking growth (risk takers), and investors who are willing to lock their money up for a significant period of time (5-15 years).

 

Conclusion

Ultimately, how optimistic or skeptical one should feel about Bitcoin or cryptocurrencies in general is highly subjective. And as soon as you feel like you have achieved a good understanding of the landscape, a new coin or a technicality comes into play. However, with all the information provided above, the takeaways are:

1. Stay open minded about innovations in digital and decentralized finance as they can improve market efficiency.  

2.  Learn to separate hype from reality. What are extreme runups based on? Do you agree with the fundamental assumptions made? Once you’ve answered these questions, let that inform your investing.

1. Source: BCA Research, Bitcoin: A Solution in Search of a Problem, 2/26/21.

INDEX DEFINITIONS

The S&P 500 Index is a free-float weighted measurement stock market index of 500 of the largest companies listed on stock exchanges in the United States.

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate-term investment-grade bonds traded in the United States.

DEFINITIONS

A cryptocurrency, broadly defined, is currency that takes the form of tokens or “coins” and exists on a distributed and decentralized ledger.

Central bank digital currencies (CBDCs) utilizes technology to represent a country's official currency in digital form.

Stable coins are cryptocurrencies that attempt to peg their market value to some external reference.

Altcoins are an alternative to bitcoin – the crypto that started it all. Most of the altcoins that've been released are built on the blockchain technology that spawned bitcoin, and this technology is already supporting more secure and efficient ways of transacting business and transferring assets.

Correlation is a statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management, computed as the correlation coefficient, which has a value that must fall between -1.0 and +1.0.

Accredited investors are investors with a special status under financial regulation laws.

All investments are subject to risk including loss of principal.

The opinions expressed are those of the Multi-Asset Solutions team, an investment team within New York Life Investment Management LLC and not necessarily those of other investment boutiques affiliated with New York Life Investments.

This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any funds or any particular issuer/security.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

Any forward-looking statements are based on a number of assumptions concerning future events and although we believe the sources used are reliable, the information contained in these materials has not been independently verified and its accuracy is not guaranteed. In addition, there is no guarantee that market expectations will be achieved.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company.

1904169