by Krystal Daibes Higgins, CFA
Vice President, Equity Research
"Speculators buy the trend; investors are in for the long haul; 'they are a different breed of cats.' One reason that people lose money today is that they have lost sight of this distinction; they profess to have the long term in mind and yet cannot resist following where the hot money has led."
― Edwin Lefèvre, Reminiscences of a Stock Operator
The explosion of cryptocurrencies and their meteoric returns over the last several years is causing some investors to experience a fear of missing out (FOMO). While cryptocurrencies, mostly Bitcoin, are in the news every day, very few investors understand their potential and the technologies that enable them. Rather, many are attracted to the highly-publicized returns they have generated in a very short amount of time. This has created something of a flywheel effect -- some may call it a bubble -- in which more investors are chasing these returns, which then drives returns higher, which then attracts more investors.
We would be remiss to ignore this emerging space and dismiss it as purely speculative; however, it is critical to understand the benefits and risks of investing in cryptocurrencies before including it in our clients’ portfolios. Here we address some of the frequently asked client questions on Bitcoin and blockchain.
Source: investing.com
What is Bitcoin and Blockchain? What’s the Difference?
The concept of Bitcoin and blockchain are often confused. In fact, the creator of Bitcoin invented the first blockchain. However, Bitcoin and blockchain are two separate functions. Blockchain is the technology that enables the transactions of cryptocurrencies, as well as other asset transactions. It is effectively a global record-keeping system that tracks past, present and future transactions. It can have different use cases, such as the purchase of a home, tracking music royalties, monitoring supply chain and logistics, or simply purchasing goods. These different uses require different types of blockchains. Once a transaction is encoded, it can’t be erased or modified. Additionally, depending on the blockchain, it can take significant computing power and time to verify transactions, making it difficult for bad actors to modify or steal assets (though not impossible). There are now thousands of blockchains, all of which are based on some form of the original Bitcoin blockchain.
Bitcoin is a digital currency and is another form of value that consumers can exchange for the purchase of goods. Created in 2009, it is a relatively new financial system that does not rely on government backing or banking institutions to transact. Instead, Bitcoin was created to rewards users that took the effort to verify transactions with newly minted Bitcoins. Thus, it is a digital currency based on decentralized finance. Today, there are thousands of different digital currencies that employ variations of blockchain technology that have different sets of rules. Bitcoin has a finite supply of 22 million bitcoins, while others allow for an infinite amount. Bitcoin, however, remains the leader with more than 60% market share and is the most recognizable brand.
Why Hasn’t Ferguson Wellman Added Cryptocurrencies to Portfolios?
We have yet to see cryptocurrencies serve as a diversifying asset class. As fiduciaries, we seek to not only grow clients’ wealth, but also to take effective measures to mitigate volatility and risk. The most effective method to reduce portfolio risk is by diversifying portfolios across asset classes with low or negative correlation. In the case of Bitcoin, we have generally seen reduced diversification benefits over time. Many compare Bitcoin to “digital gold.” However, while gold is seen as safe haven during turbulent market periods, we have witnessed the opposite with Bitcoin as its volatility and correlation is higher. We would be merely chasing returns of assets that are speculative, extremely volatile and provide lower diversification benefits.
In addition, most investment professionals and institutions have been on the sidelines as the industry is still in its infancy and lacks the level of governance and infrastructure required to support institutional investor requirements. However, we are beginning to see large institutions build their strategy in adopting digital currencies.
Is Bitcoin a Bubble? What Are the Risks of Cryptocurrency?
That is the $64,000 dollar question (Bitcoin recently surpassed $64,000[LSO1] [KH2] ).1 It is only in retrospect after a bubble has burst that we realize it was one, but it certainly is worrisome that it has the characteristics of a bubble. Namely, a bubble is when an asset’s value exceeds its fundamental value, often driven by speculation and market participants chasing returns. A good proportion of investors are flocking to Bitcoin as a way to “get rich quick.” Bitcoin’s fundamental value will largely depend on the degree of its adoption globally. The value of Bitcoin is propped up on people’s acceptance of the digital currency as well as the supply and demand dynamics. If people or businesses begin to believe in another cryptocurrency and demand vanishes, Bitcoin’s value will collapse.
Another major risk is regulation. Regulation eventually catches up to new technologies, and we expect to see more information in the near term from the U.S. government. Once again, it is too early and speculative at this point to confidently understand the regulatory risks, which is one of our chief concerns.
What Will Happen over the Long Term?
We remain in the very early innings of blockchain technology, despite the extraordinary returns we’ve seen within the space. Some of the most innovative and cutting-edge technologies take decades to develop before they become commercially viable. Whether that may be in the healthcare sector, astronomical engineering and science, electric vehicles, or blockchain and cryptocurrencies. Often times, these new technologies allow for a new wave of innovation and invention that plays out over many years. For example, the internet was first formed more than 60 years ago, but we have only just begun to see some of the most influential and impactful businesses on our society in the last 15-20 years, such as ecommerce, social media, smartphone, cybersecurity—and more recently—blockchain-based companies. None of these businesses would exist if the internet was never invented. We believe the same is true for blockchain technology. We are likely to see new companies pioneer new applications. It will be a bumpy road with many bull and bear markets until this asset space matures over the next several decades.
How Can I Invest in Cryptocurrency?
Investors can gain exposure to Bitcoin or other cryptocurrencies through three methods. One method is to invest in a fund that invests in Bitcoin such as Grayscale cryptocurrency funds. These funds charge high fees and may not produce the same returns as the underlying digital currencies. Another method is to invest directly by creating an account on Coinbase or PayPal. These platforms also offer a cryptocurrency wallet feature or facilitate transactions. Finally, a third method is to use an exchange-traded fund (ETF) that invests in bitcoin futures contracts. While we would expect to see a decent correlation between futures and the underlying securities, the ETF does not have a long-track record to determine the level of correlation.
Investors should carefully do their research before investing in cryptocurrency. Investors should also be prepared for volatility and be sure that they are comfortable with the potential of a permanent loss of capital. We continue to monitor the crypto-asset space to assess its appropriateness in client portfolios.
Our Takeaways for the Week:
Blockchain technology is an exciting emerging technology that will have lasting impacts on cryptocurrencies as well as new business technologies
Investing in cryptocurrencies involve a great deal of risk and investors should conduct thorough research before investing - currently, Ferguson Wellman does not recommend cryptocurrencies as an asset for client portfolios
1. Coinbase.com, as of 11/12/2021.