Investing in Bitcoin
By: Brian Seay, CFA
The recent launchof new Bitcoin ETFs has re-ignited conversations around cryptocurrency for investors. I hear clients and investors share a variety of perspectives on Bitcoin, from those using it as “digital gold” in case of major geopolitical and financial disruption to those hoping that Web 3 and crypto will be the next great technology revolution.
Our overarching view on cryptocurrencies is that they are an investment tool, and like other investment tools and asset classes, they should be well understood and used appropriately.
In this article we examine some of the perspectives around Bitcoin so that you can make informed decisions about whether to include Crypto as part of your investment strategy.
We discuss:
Bitcoin (and other Cryptocurrencies) and Blockchain Technology
Investing in Bitcoin as a Currency
Investing In Bitcoin as an Inflation Hedge
Investing in Bitcoin as a Safety-Net
Recent Bitcoin ETF Launches vs. Investing Directly in Crypto Wallets.
Is Cryptocurrency Investable? Is it “Good or Bad?”
Want the video version? -> https://www.youtube.com/watch?v=xLB5sSWgc84
Bitcoin (and other Cryptocurrencies) and Blockchain Technology
Investors often want economic exposure to the future of Blockchain technology and they use cryptocurrencies to achieve this goal. In our view, it’s important to understand blockchain’s distributed ledge technology and to separate the underlying technology from the individual coins. Distributed ledger technology removes many of the existing intermediaries from financial transactions. That allows for faster and cheaper processing. I have no doubt that the adoption of distributed ledger technology will continue to increase over time, the benefits to the financial sector are potentially quite large.
However, there is no reason why the distributed ledger network that may ultimately be used to trade stocks or real estate must be an existing cryptocurrency network. In fact, I think the most likely scenario is that the Federal Reserve, another government agency, or a private sector exchange creates ledgers to be used for transactions. Remember, the stock exchanges are private businesses and are incentivized to adopt new technology.
The U.S. government and other agencies monitor transactions today for criminal and terrorist activity. Yes, they may impose unpopular sanctions. But there is a significant public interest in money not falling into the hands of those that wish to do harm. For this reason alone, the idea of a truly unmonitored, “free” U.S. currency seems fanciful. It’s more likely that the underlying technology of blockchain is used with some sensible regulation to prevent abuse and nefarious activity. Even today, you cannot trade Bitcoin on the actual Ethereum blockchain and vice-versa. There are different ledgers today and the future may contain multiple ledgers.
Regardless of whether you share this view or not, investing in Bitcoin to gain exposure to the economic benefits of future technology is akin to venture capital or investing in high-growth technology stocks. You are attempting to pick the winning technology for years down the road. Even venture capital funds struggle to do this effectively. They typically own 5-15 companies in a fund and hope to hit on one or two, the remainders will be write-offs. If you are investing in Cryptocurrency as a high-risk, high-reward strategy, consider diversifying within the basket of available currencies and investing a small portion of your assets.
2. Investing in Bitcoin as a Currency
Currencies are stores of value that can be exchanged for goods and services. When was the last time you paid for a real, physical good or service with crypto?
Proponents of Bitcoin will suggest that Bitcoin usage is growing, and that is true. But news stories around crypto transaction values exceeding Visa and Mastercard are misleading. Bitcoin did “settle more value” than either Visa or Mastercard in 2022, but most of those Bitcoin transactions were financial trades, not point-of-purchase transactions in the real economy. A better comparison would be comparing the $8 trillion in Bitcoin settled value against the total value of stock transactions. In 2022, in the U.S. alone, there were over $44 trillion in stock transactions according to the World Bank. Spherical Insights and a consortium of Bitcoin research providers pined 2022 Bitcoin purchase payment volume closer to $1.1 trillion. I would personally be surprised if it was even that high. So, Bitcoin has a ways to go before being close to any of the major payment networks volumes.
Our view is that Bitcoin is not best considered as a currency. Currencies can easily be used for transactions, which creates demand for them in circulation. Additionally, currencies can be deposited at banks to earn interest. Bitcoin has some staking capabilities, but your bitcoin holdings do not generally earn interest simply by sitting in an account.
So, is Bitcoin a viable currency today? Not currently, and I have serious doubts that it will eventually replace the U.S. dollar or any other major global currency for the reasons I mentioned above around transaction monitoring.
3. Investing In Bitcoin as an Inflation Hedge
I understand the argument that many countries, especially emerging markets, struggle with inflation. The idea of a global currency could help people in those countries have a dependable store of value. However, this is not a new problem. Most people can (and do) solve their concerns about inflation uncertainity today by transacting in U.S. dollars. Dollars can be used for large and small purchases around the world. There is a reason why most oil and other commodity trading occurs in U.S. dollars.
What about as an investment asset? We looked at the correlation between Bitcoin prices and the Consumer Price Index (CPI). If investors were buying bitcoin to hedge against rising inflation, we should see a positive correlation between Bitcoin prices and the change in inflation. Indeed, there is a positive correlation, but it tends to be small. Except for 2022’s peak inflation, Bitcoin prices tend to be slightly positively correlated to inflation as measured by CPI.
S&P Global researched the correlation between the money supply (M2) and Bitcoin prices and found a strong positive correlation. That means that as money is printed, Bitcoin prices increase. This relationship is also true of other risk assets like stocks. Increasing the money supply increases investment in speculative assets across the economy. When you look at Bitcoin against the S&P 500 Growth Index, you see a much stronger correlation. In fact, most of the time the relationship is very positive. Meaning that when growth stocks go up, Bitcoin goes up, and vice-versa.
In total, our view is that Bitcoin is correlated with inflation, and, like other risk assets, is a good hedge against rising inflation. But it’s a one-way hedge…
4. Investing in Bitcoin as a Safety-Net
The challenge with using risk assets as an inflation hedge is that the relationship is one-way, meaning that Bitcoin might hedge against inflation over the long-term while inflation is rising, it does not protect against deflation during bust cycles. Like all other risk assets, the price of Bitcoin would likely fall substantially if the economy fell into a deep recession and the stock market tanked.
As risk taking declines, the most volatile assets usually fare the worst. That is a very different kind of hedge than say other commodities or Gold, which would maintain some or all their value during a sharp downturn. So while Bitcoin may protect against inflation risk, that doesn’t not mean that it should be thought of as a safety-net for worst-case economic or geopolitical scenarios.
Cryptocurrencies Make Stocks Look Calm.
Finally, when we look at the level of price changes for Bitcoin, it appears to be in a category of risky assets all by itself. Historically, we have thought of stocks as relatively risky compared to bonds and money market funds. You can see on the chart that while the S&P 500 grows over the long term, it moves up and down significantly over shorter time periods. Bitcoin makes the S&P 500 look like a calm walk in the park. On the next chart you can see the extreme levels of volatility of Bitcoin vs. the S&P 500.
5. Recent Bitcoin ETF Launches vs. Investing Directly in Crypto Wallets
Crypto has been in the news and seen significant price increases with the launch of several new ETFs at major investment houses. Investors buy shares of the ETF, which in-turn works with a custodian like Coinbase to purchase and hold actual crypto tokens. Investing through ETFs provides easier administration and more security than the existing crypto wallets. Trading can be easily done through your brokerage account and your funds remain with well-known custodians that can reset your password if you forget it! For all those privileges, the ETFs charge a management fee. The crypto exchanges come without the management fee of an ETF but require you to keep your own digital wallet. If you lose your wallet credentials, your tokens may be lost forever. Additionally, while the exchanges may not charge management fees, crypto exchange transaction fees tend to be high relative to standard brokerage account transactions. In my view, the trade-off is really your penchant for easy administration through a large financial institution vs. the anonymity and special features, like staking, of direct crypto wallets.
The ETF, or any other structure, is simply a legal structure for an investment. The investment needs to be worthwhile on its own, regardless of the structure. In other words, the advent of ETFs does not change the fundamentals of Crypto we laid out in prior sections. Not every ETF is a good one to own 😊.
6. Is Cryptocurrency Investable? Is it “Good or Bad?”
The point of this article isn’t to pass judgement on Crypto one way or the other. Bitcoin is neither good or bad for investors. But it should be used in the right circumstances. You should not use a hammer to hit in a screw and you cannot use a screwdriver to screw in a nail. Bitcoin is a tool, and it should be used by investors appropriately. So, what is that “right” circumstance?
I like to compare Bitcoin to a high-risk, venture capital like commodity or collectable. It does not have cash flow or economic value outside of investor demand to own the asset. Much like gold. However, given its volatility and correlation with other high-risk assets, Crypto shouldn’t be thought of as a safe-haven asset. Instead, Bitcoin should be used by investors with a very high tolerance for risk in a small portion of their portfolio. In fact, I would suggest investing no more than you are prepared to write-off as a total loss.
Some will argue that Crypto makes sense as part of a portfolio because it is not highly correlated with other common assets like stocks and bonds. However, an investment with the high volatility of Bitcoin will naturally have a low correlation to any other financial asset. Nothing else is that volatile. Just because it moves up and down wildly, reducing its correlation with other assets, doesn’t make Crypto a worthwhile investment.
For most long-term investors seeking consistent mid to high single digit returns, the risk – reward profile of Bitcoin seems unnecessary to me. However, for some investors that want to take large risks, Bitcoin may have a place in a portfolio. For full disclosure, we do not recommend cryptocurrency investments to clients. But if you choose to invest, I hope you invest wisely based on the history Bitcoin’s performance.
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