Cryptoassets: Inflation Hedge, Portfolio Diversifier Or Return Enhancer?

What is an Inflation Hedge?

An asset that provides a hedge against inflation is one that has a positive correlation with the inflation rate, and in particular inflation surprises i.e., when the inflation rate is different to what the market expected. Historically gold has been considered the go to inflation hedge. In the 1970s and 1980s gold produced strong returns against the backdrop of high inflation, however, gold has otherwise shown weak correlation with inflation.

Is Bitcoin the new gold / safe haven asset?

There are three main arguments:

  1. Bitcoin is a currency similar to the old gold standard, with a fixed supply that cannot be debased. As with gold, it is engineered to be scarce and is deflationary by nature. However, scarcity and decentralisation do not guarantee protection from inflation, only that a central authority cannot debase bitcoin. Bitcoin’s value is also based entirely on people’s willingness to hold it. It is not tied to any other asset that rises in value along with consumer prices and historically private monies have been very fragile.
  2. Bitcoin has high returns in excess of the inflation rate and can be traded and stored with ease. Hence it offers protection against it. However, to be an inflation hedge an asset must correlate with inflation surprises, not just outperform. Cryptocurrencies also still have high associated volatility, not a desirable property for a hedge.
  3. Bitcoin will substitute gold as an inflation hedge as a store of value due to its lower storage and transaction costs. However, gold in general is not itself a reliable inflation hedge.

So far, there is limited empirical evidence that Bitcoin is a good inflation hedge. It is possible that a sharp rise of inflation will induce movement towards Bitcoin and increase correlation. It may, however, also have the opposite effect. If inflation is associated with a supply shock and a recession, investors might react by loading riskier assets such as cryptoassets and move into lower volatility assets. 

If Bitcoin is not a reliable inflation hedge, why invest in the DLT and Cryptoassets?

First and foremost, Distributed Ledger technology (DLT) and Cryptoassets offer an attractive long term growth opportunity. This is at a time when there is increased uncertainty amongst other asset classes, which have become increasingly detached from economic fundamentals and reliant on an expansionary monetary policy. 

Second, this technology has the potential to disrupt virtually every industry and has applications throughout many different value chains.

Third, this asset class has been the fastest growing, highest returning asset class, both on an absolute and risk-adjusted basis, and we believe that it still has a long way to go. In spite of their volatility, cryptoassets can offer superior risk-adjusted returns when compared to other asset classes.

Sharpe Ratios Since January 2015 to October 2021

Source: Aaro Capital Research Notes: Data as of: 31 st  December 2021. Net Returns, calculated in USD. Equities: iShares MSCI ACWI ETF; Corporate Bonds: iShares Global Corporate Bond UCITS; Commodities: S&P GSCI  Commodity; Real Estate: iShares Global REIT ETF; USD: US Nominal Dollar Broad Index; Crypto: MVIS CryptoCompare Digital Assets 100 
 

Fourth, cryptoassets are also uncorrelated with other asset classes, with correlations close to zero across the board and are low even during times of crisis in traditional markets.

Correlations Since Jan-15

Source: Aaro Capital Research Notes: Data as of: 31 st  December 2021. Net Returns, calculated in USD. Equities: iShares MSCI ACWI ETF; Corporate Bonds: iShares Global Corporate Bond UCITS; Commodities: S&P GSCI  Commodity; Real Estate: iShares Global REIT ETF; USD: US Nominal Dollar Broad Index; Crypto: MVIS CryptoCompare Digital Assets 100 


Fifth, well known industry names are embracing this new technology. Companies ranging from Meta (formerly called Facebook), IBM to JP Morgan are now involved. What makes the DLT story so powerful is the clear economic value that can be generated through its adoption. For cryptoassets, almost 90% of institutional investors now find something appealing about them.

The Appeal of Digital Assets

Source: Fidelity Digital Assets Notes: Data as of: September 2021 

Finally, established investment and operational risk management practices, can be applied, successfully to this asset class. The market is maturing and is becoming much more professional than in its earliest days.

So, what is the impact of adding DLT and cryptoassets to an investment portfolio?

The first key observation in this analysis is the outperformance of crypto funds relative to the crypto market overall. Secondly, and this may surprise many, is that there is empirical evidence that to get the most out of an allocation to this space. As the chart below indicates it may well prove to be beneficial for one to allocate up to 5% of their portfolio to DLT and cryptoassets. A 5% allocation to crypto funds in a traditional portfolio can improve returns substantially, but the volatility remains virtually the same.

Cumulative Performance of Different Portfolio Configurations


 

Source: Aaro Capital Research Notes: All data as of 31st December 2021. All returns are in USD and net of fees and have been calculated since 1st January 2015.The DLT & Cryptoasset market has been proxied by using the CCi30 Index. DLT & Cryptoasset funds have been proxied by using an equally weighted index of 283 funds since their inception. The Traditional Portfolio returns are based on: 40% = Equities: Vanguard Total International Stock Index Fund; 40% = Corporate Bonds: iShares Global Corporate Bond UCITS; 10% = Alternative Investment: HFRI; 10% = Cash 

How and why is crypto a valuable investment asset?

What is the value in holding crypto as an investment asset if it does not directly generate cash flows, like stocks, bonds or property? A similar debate has been between those for and against investment gold and other precious metals, as they developed to established alternative asset classes. How does crypto translate into real returns for investors, and not just a case of offloading onto the next buyer?

Firstly, Bitcoin and other cryptocurrencies can now be used to earn a yield via staking in decentralised finance (DeFi ) protocols, similar to interest earned in a bank account, although the yields in DeFi are far higher.
 

Available Annualised Yields


 

Source: Coingecko Notes: Date as of 13th December 2021. Gross returns, denominated in the underlying. 

Furthermore, cryptocurrencies are uncorrelated with other asset classes. The more uncorrelated assets one adds to a portfolio, the higher return one can get without taking additional risk. Studies by Yale and VanEck show empirically that even just buying and holding cryptocurrenies can do this.

Finally, and most importantly, many still view cryptocurrencies as just a currency, like fiat money, but in reality, it is much more. Crypto is a next-generation, value-based internet. As HTTP and HTML are the platform of the World Wide Web, Ethereum and other crypto networks are the platforms of Web 3.0. In the same way that the Web today enables many services, software built on Web 3.0 is already providing a wide range of valuable services to consumers.

Web 3.0 - The Internet of Distributed Ledgers
 

Source: Aaro Capital Research 

What is the best way to invest in DLT and Cryptoassets?

There are various ways for Professional Investors to access the DLT & cryptoasset growth story. The real challenge is being able to gain exposure in a properly risk-managed and dependable way. We are arguably at the same stage of market development as Hedge Funds were back in the 1990s.

On the DLT side, it can be difficult to access the top deals and VC funds and there are long lockups, while blockchain Exchange Traded Funds (ETFs) can give impure and concentrated exposures. Equally, on the crypto side, direct investment requires a lot of time, resources and expertise and there are operational challenges, whilst pure bitcoin funds and passive indices can carry concentration risk with little downside protection. Actively managed funds have their advantages, however, require thorough due diligence and have widely dispersed results. 

The potential for outsized risk-adjusted returns from effective active management is an order of magnitude larger than in traditional asset classes. One can see this when comparing the outperformance of crypto funds relative to passive benchmarks. However, there is a large dispersion in crypto manager performance.

Crypto Fund Outperformance
 


 

Source: Aaro Capital Research, 273 DLT and Cryptoasset Funds, CryptoCompare Notes: Data as of: 30th September 2021. Net Returns, calculated in USD

There are over 400 crypto hedge funds, over 400 blockchain venture capital and private equity funds, several hundred Exchange Traded Products (ETP), including crypto ETPs and Exchange Traded Notes, some structured products such as Actively Managed Certificates and an increasing number of equity funds such as blockchain ETFs and investment trusts. The DLT and crypto asset management industry is now estimated to have over $100 billion in Assets under Management. 

We split the strategy landscape into three buckets. 

  • Non-Directional strategies focus on capturing the short-term inefficiencies in cryptoassets through arbitrage or opportunistic approaches. 
  • Trading funds focus on timing the market, taking on beta to get higher returns, whilst managing some of the short-term volatility. 
  • Long Term strategies often invest well beyond the top 100 cryptoassets, and look at public equities, as well as early-stage unlisted tokens and private equity.

Individually, these macro buckets offer exposure to various subsets of the market, but in combination they form a more balanced approach this growth story. One can enhance the key performance metrics by rotating between the different strategies, depending on the market outlook. In a bull market, more Long Term and High Beta Trading exposure will enhance returns, whilst in bear markets, Non-Directional and Low Beta Trading will protect the portfolio. This is what we do at Aaro with our own portfolio.

Footnotes

1  Source: Aaro Capital Research  

Disclaimer

Aaro Capital is the trading name of Aaro Capital Limited (“Aaro”), a private limited company, registered in England and Wales with number 11419585, whose registered office is at 5th Floor 14-16 Dowgate Hill, London, United Kingdom, EC4R 2SU. Aaro is not authorised or regulated by the Malta Financial Services Authority ("MFSA") or any other financial regulator.

The material provided in this article is being provided for general informational purposes. Aaro does not provide, and does not hold itself out as providing, investment advice and the information provided in this article should not be relied upon or form the basis of any investment decision nor for the potential suitability of any particular investment. The figures shown in this article refer to the past or are provided as examples only. Past performance is not reliable indicator of future results.

This article may contain information about cryptoassets. Cryptoassets are at a developmental stage and anyone thinking about investing into these types of assets should be cautious and take appropriate advice in relation to the risks associated with these assets including (without limitation) volatility, total capital loss, and lack of regulation over certain market participants. While the directors of Aaro have used their reasonable endeavours to ensure the accuracy of the information contained in this article, neither Aaro Capital Limited nor its directors give any warranty or guarantee as to the accuracy and completeness of such information.

Please be sure to consult your own appropriately qualified financial advisor when making decisions regarding your own investments.

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