Courtesy of Matt Sauer, MWSWNB Investments:
Is it a derivative, an asset or a currency? Look at its effect on the efficient frontier. Confidence is the key in any currency.
The advent of crypto assets and specifically cryptocurrency has garnered a significant amount of attention from investors. Is this the dawning of a new asset class or tulip bulbs? While there is diverse opinion on the subject, we observe cryptocurrency from three vantage points:
- The effect on long only portfolios utilizing Modern Portfolio Theory
- The emergence of a new asset class
- A global currency
Modern Portfolio Theory constitutes the prevailing wisdom on selecting assets based on forecasted returns of each asset together with the correlation to the others to determine the mix of the allocation. The risk measurement is introduced through the volatility of the returns and is utilized to determine the weights of the assets in the portfolio. The introduction of uncorrelated assets has been labeled a free lunch because of the potential of return not being solely driven by correlated risk. Investors have observed the traditional asset classes of bonds, stocks and cash increase in correlation especially since the correction that occurred in the early 2000’s.
The goal of asset allocation is to generate a return pattern for different risk profiles that minimize the drawdown. The more correlated the assets, the increase in difficulty of achieving the goal. The factor that MPT left out is how path dependent asset returns are. Additionally, because financial asset prices are lognormally distributed rather than normally distributed, the tails are fatter than occurs in normal distributions.
One of the fallacies that occurs in asset allocation is the belief that the investors are arbitraging time so short-term volatility is not a concern. This ignores the path dependency of the returns because geometric averages are non-ergodic. The result of the differences in return pattern is labeled the volatility tax which is simply the difference between arithmetic and geometric averages. While the arithmetic averages are simply the average of the returns the geometric returns are the average of the logarithms of the average price changes. A logarithm is a concave function so the bigger the loss the steeper the curve and the greater the penalty paid by the portfolio.
So how does an investor mitigate the volatility tax? We will explore the costs of hedging versus the introduction of non-traditional assets in the portfolio to obtain the objective of maximizing the compounded annual growth rate.
In a recent academic study (Harvey et al. 2019), the goal of crisis proofing portfolios was analyzed. Purchasing rolling S&P 500 puts was costly at 7.4% annualized cost (thus wiping out the expected performance) while also finding the strategy of utilizing 10-year US Treasuries as unreliable. The best solution found was a long/short strategy of quality minus junk utilizing Fama and French’s work. This leaves a long only portfolio manager with few options to avoid the impact on the geometric averages of swift downturns.
Introducing crypto assets as a low cost non-correlated asset will provide a different return pattern. After the original transaction costs, the carrying cost of 50-100 basis points per year of the asset only accrue 10-20 basis points overall to the cost of the portfolio for a 2% position. As a diversifying asset it is the cheapest form of owning the largest sigma of returns. This strategy does not require dynamic hedging by either rolling puts or simply buying the dip. These strategies both increase the size of drawdowns while rolling options becomes more expensive as implied volatility increases during swift downturns.
Research has established that the risk-return tradeoff is distinct from stocks, currencies and macroeconomic factors (Liu and Tsyvinski 2018). Additionally, factors specific to cryptocurrency markets (momentum and investor attention) drove returns.
The cost of dynamically hedging a portfolio is too expensive so the best alternative for the portfolio manager is to introduce assets that exhibit anti-fragility. Investments that benefit from chaos are extremely valuable to a portfolio manager and as cryptocurrency exhibits these characteristics once, no portfolio manager will sit on the sidelines the second time.
Portfolio managers must acknowledge that cryptocurrency does not act as a traditional hedge, but it does raise the efficient frontier. This becomes more important if bond prices become more correlated with stock prices and flatten the efficient frontier.
We suggest a new version of MPT that has a z axis that is defined by purchasing power of the portfolio in a basket of currencies. The efficient frontier becomes a plane that is advantaged by owning diversified currencies. This is another building block in crisis proofing portfolios as the debasement of a currency held as the primary currency can be a much greater tax than the volatility.
Critics of cryptocurrency have stated that the growth is not based on investment factors but derivative factors such as money laundering. These attempts to undermine an emerging asset class are not new and have always been part of the growth.
The recent volatility of prices may suggest to some pundits that cryptocurrency is not an asset class but a speculative game. This is the expected reaction to volatility as common stocks were treated with the same apprehension following the 1929-32 price movement. Lawrence Chamberlain’s 1931 quote in Investment and Speculation was that only bonds could be bought for investment. Obviously, this quote was a result of market movements at that time rather than an attempt to protect wealth against inflation in the long run but that is the point. Today’s fears over volatility are tomorrow’s missed returns.
High yield bonds have long been known by their pejorative title of junk bonds. Investors were lambasted in 1990 for being so foolhardy as to have invested in an asset class that was down 8.46% when high grade bonds were up 8.96%. There was a media frenzy over the death of junk bonds as an asset class. However, 1991 was a rebound year as junk was up 43.23% versus 16% for the high-grade bonds. Back to back 18% years in 1992-93 put “junk” back to asset class status and it has been “high yield” ever since.
Speculators are deemed to trade strictly on greed and fear. Invoking Keynes’ beauty contest analogy, they are evaluating what the other speculators will do and attempt to do it first. The coordination game they are playing involves looking for the Schelling point for the path of least resistance in the short run. Therefore, momentum and investor attention has driven the price, investors are trading short term momentum from the media coverage and have been utilizing investor attention to create liquidity both up and down. As the asset class matures, the Schelling point is not media opinion but focal point investors. This allows institutional investors to coordinate without communication. As the allocations of the new asset class are made “independently,” the coordination game played by market participants is utilizing their own Schelling point.
Asset classes become relevant because of recent superior performance whether it is quality stocks, gold or high-grade bonds. Institutionalization occurs after the speculator fallout as investors slowly migrate to the investment.
Currencies are the domain of countries because of taxing capability, regulation and the ability to affect supply. The idea that cryptocurrency is a true currency has been a question. The growth in government debts and obligations globally has not been perceived by the financial markets as an issue yet the risks are mounting. The dollar is no longer backed by gold or any liquid asset other than taxing ability. Bretton Woods is only a memory.
There is no risk that an investor in United States Treasury bonds will not be repaid principal. The question is what the purchasing power of that principal in terms of a basket of other currencies, oil and gold will be.
What are the experts thinking and writing about government policies and the effects on purchasing power?
International Monetary Fund viewpoint
A recent IMF working paper espoused the following thoughts on debt:“Sovereign debt is a Janus-faced asset class. In the best of times it relaxes the domestic constraint on savings, smooths consumption, and finances investment. Investors see it as a safe haven, as delivering “alpha,” and as a means of portfolio diversification. In the worst of times it is associated with debt overhangs, banking collapses, exchange-rate crises and inflationary explosions. Investors see it unenforceable, illiquid and prone to messy debt workouts. “
Currently global debt is about $244 trillion and about 318% of GDP. In January 2019, the International Monetary Fund warned governments to reign in debt and build buffers against risks. If a government can borrow at very low rates or in some cases negative rates, the path of least resistance is to increase the money supply and borrow more to keep the world economy rolling.
United States Congress viewpoint
Congressman Brad Sherman has proposed cryptocurrency be banned because it poses a threat to the dollar’s role as a reserve currency and the fact that the international settlement of oil is in dollars. As unworkable a policy that he suggests, there is a hint of fear among those responsible in the United States for debasing the dollar.
Developing countries have gold and currency reserves to underpin their currency. Developed countries utilize sovereign stability to create demand for their currency and then exploit the demand by increasing the amount of currency to maximize domestic asset values. As governments find it more difficult to sustain asset values necessary for tax receipts the debasement will continue. The global lack of the velocity of money supply has had governments pushing on a string since the last asset crisis of 2009. The next crisis will be led by asset price downturns but will morph into a crisis of currency value as governments try to flood the market with paper money to support asset prices. In this case the assets that rise in value will not be tied to a currency, be portable and not debasing.
What exactly is Cryptocurrency?
Cryptocurrency’s strength is that it can solve several fundamental problems in the global marketplace. Like having the transient properties of being a solid, liquid and gas; crypto assets can function in as a derivative, an asset and a currency. The investment holding that reconstitutes Modern Portfolio Theory and adds a z axis of currency risk also allows for a solution that is the new efficient frontier as it progresses into an asset class that is anti-fragile. Inflation protection is the tangible outcome of rethinking risk as defined by purchasing power across all currencies rather than the loss of it in one.
–Matt Sauer, MWSWNB Investments. Originally published here.