Doc's Daily Commentary
Mind Of Mav
Why Bitcoin Is The Best Investment In 2021
As we talked about yesterday in our exploration of, ‘What are alternative investments?’, alternatives assets generate returns that do not mirror the returns of traditional assets and provide unusual risk exposures.
So, that brings us to a very important question: Is Bitcoin the best alternative asset for investment?
To explore this, let’s talk about the difference between return and risk.
Bitcoin’s Return Vs. Risk
A Yale study conducted by economists Aleh Tsyvinski and Yukun Liu examined whether the returns of digital assets (specifically Bitcoin, ether, and ripple) behave like the returns of other asset classes (stocks, traditional currencies, and precious metal commodities).
Based on their analysis, the return behavior of all digital assets, including Bitcoin, could not be explained by the risk factors that account for the returns in stocks, currencies, or precious metal commodities or by macroeconomic factors such as non-durable consumption growth, durable consumption growth, industrial production growth, and personal income growth.
Rather, the economists found that Bitcoin’s performance is driven by “cryptocurrency-specific factors,” such as the momentum effect and proxies for average and negative investor attention. The momentum effect refers to the trend that an asset is likely to continue increasing in value if it has just increased in value. This is in line with the idea that Bitcoin is reflexive in that price and sentiment experience a self-reinforcing effect. The second factor that influences Bitcoin price is investor attention as measured by Twitter post counts for “Bitcoin” and Google search data series (e.g., if Bitcoin mentions are abnormally high, the value of the asset will increase).
The Bitcoin Narrative
Something to really consider about Bitcoin, and digital assets as a whole, is that what drives their price — their narrative — changes and potentially matures over time.
For example, performance has not been historically connected to the change in Bitcoin’s fundamental metrics. If you’ve followed crypto for any length of time, you know that the performance of digital assets hasn’t always been driven by “fundamentals,” due to higher levels of speculative and sentiment driven trading activity.
Over time, as the investors and market participants analyzing and participating in Bitcoin markets evolve, its performance may be tied to a greater extent to fundamental adoption variables and to a lesser extent to reflexivity and sentiment.
Global investor sentiment certainly has an impact on Bitcoin’s price, but Bitcoin has distinct underlying fundamentals that are not affected by the health and economic situation created by COVID-19 (e.g., Bitcoin does not have any cash flows or production to cut).
Demand shocks (the decline in consumer demand for goods and services due to lockdowns and unemployment), supply shocks (production limitations or supply chain shutdowns), and the ensuing policy response by governments and central banks (quantitative easing and record low interest rates) have a direct and fundamentally negative impact on equities and fixed income, commodities, and fiat currencies.
On the other hand, Bitcoin’s fundamentals and utility are not directly affected by a decline in profitability or production or an increase in the money supply. Rather, these headwinds may increase the attractiveness of an investment in Bitcoin, and investors are taking note.
Another angle on Bitcoin’s lack of movement with traditional assets is the absence of an agreed-upon narrative.
At any given time, the narratives have ranged from Bitcoin as a means of payment, a reserve currency for digital assets, a store of value asset, or a portfolio optimization tool, among others.
This lack of consensus could be an important reason why Bitcoin has not traded in line with other assets to date. If the lack of consensus on Bitcoin’s narrative persists, it may continue to be uncorrelated with all other assets. On the other hand, if Bitcoin’s narrative converges on a single thesis, its correlations to other assets with similar investment cases could converge as well.
A salient narrative this year has been that Bitcoin is an emerging store of value asset. Most recently, Bitcoin’s behavior has been inconsistent, with prices moving in step with a different asset class week to week.
However, more market participants are allocating to Bitcoin for its long-term potential. Interestingly, Bitcoin’s 60-day correlation to gold reached record highs in early September, potentially driven by concerns about real interest rates and inflation.
While this is a notable development, it is to be determined whether Bitcoin/gold correlations will hold in the long run. In the past, Bitcoin has experienced brief periods of elevated correlations with particular assets, including gold and equities, but the relationships break down over longer time horizons.
Greater Overlap Between Market Participants
In the early days of Bitcoin’s existence, events and sentiment affecting traditional markets had little to no impact on Bitcoin markets. Bitcoin’s trading infrastructure was completely independent of traditional market infrastructure and Bitcoin’s ability to react to current events affecting traditional markets in real time was limited because Bitcoin trading was not integrated into traditional market infrastructure.
As the infrastructure has matured, participants in Bitcoin markets and traditional markets have started to overlap. Institutional investors can trade Bitcoin futures and options on the same platform they use to trade derivatives of other assets (e.g., CME, Bakkt). Retail investors can buy and sell Bitcoin on certain platforms that allow them to trade stocks (e.g., Robinhood, Square Cash).
As Bitcoin matures and the profile of market participants in Bitcoin expands to include more participants from traditional markets, Bitcoin could become more correlated (positively or negatively) with other assets.
Retail Driven Phenomenon
As more institutions allocate to Bitcoin, this investor segment will certainly have a greater impact on Bitcoin markets. However, there is reason to believe retail investor influence will persist. Bitcoin started as a retail asset and continues to have the attention of many retail investors. One potential proxy to gauge retail interest is the number of addresses holding less than 10 Bitcoins (though there is no way to say definitively that it is all retail). As displayed in the charts below, the number of addresses with less than 10 Bitcoins has been steadily increasing.
In fact, in plotting the month-over-month change, we can see that there have been only seven separate occasions since January 2012, where the change in the end-of- month count of addresses with a balance of less than 10 Bitcoins has been negative.
The behavior of retail investors and institutional investors can be different, which could be another factor contributing to Bitcoin’s lack of correlation to other assets that are mostly dominated by institutional sentiment.
We saw evidence of the contrasting behavior of retail and institutional investors during the March 2020 sell-off. Retail-focused companies like Coinbase, River Financial, and Simplex reported record levels of retail investors buying the dip as traders and institutional investors sold their positions.
Coinbase shared that its retail trading arm experienced a substantial increase in cash and crypto deposits, new user sign-ups, and total traded volume in the 48 hours following the sell-off versus the last 12-month average. Coinbase also highlighted that the majority of retail users active during this time were buyers.
We are also starting to witness an era of retail resurgence in traditional markets with the rise of zero fee trading by major brokerages and easy-to-use platforms for trading.
The channels that retail investors rely on for financial information and advice are also shifting to platforms such as Twitter, Reddit, Telegram, YouTube, and Tik Tok, where information dissemination is much more viral and rapid than it is in traditional closed channels. The adoption of Bitcoin has been and continues to be driven by conversations taking place on these platforms, explaining the connection between Bitcoin performance and social media mentions discussed above.
As this new wave of retail investors familiarize themselves with these channels, some of their attention will undoubtedly flow to Bitcoin and other digital assets.
Tying It Together
Bitcoin does not just belong to retail investors.
The involvement of traditional institutions in Bitcoin is at the highest level it has been. As Bitcoin becomes more intertwined with traditional markets, external events could have an increasing impact on Bitcoin, especially if Bitcoin’s narrative converges on a single use case.
In other words, if Bitcoin becomes more correlated with certain assets in light of this potential trend, its portfolio diversification benefits relative to certain assets could decline.
However, Bitcoin is fundamentally less exposed to the prolonged economic headwinds that other assets will likely face in the next months and years. Combined with its multifaceted narratives and an interesting effect of persisting retail and growing institutional sentiment, it could be a potentially useful and uncorrelated addition to any portfolio.
If investors view Bitcoin as a component of their alternatives bucket, it could be beneficial given the growing interest in alternatives amidst overvalued public equities and low yields and the potential for funds to flow out of fixed income into other asset buckets.
Bitcoin’s lack of correlation in the early days may be partially explained by the retail-driven market, Bitcoin’s separation from traditional markets, and the lack of overlap between institutional participants in traditional and Bitcoin markets. Bitcoin’s growing institutional investor base could lead to its growing correlation with other assets, depending on their narrative for Bitcoin.
However, there are reasons why Bitcoin could continue to serve as a portfolio diversifier and return enhancement tool. Notably, the factors that explain returns in Bitcoin are distinct from those that explain returns in other asset classes. Bitcoin’s fundamentals are relatively shielded from the economic impact of the COVID-19 pandemic as its functionality is not predicated on profitability or production and Bitcoin is natively digital.
Bitcoin is also unique in that it continues to be influenced by retail investor sentiment and can capitalize on the shift in the way retail investors interact with traditional markets and consume financial information as well as the transfer of wealth to the millennial generation over the next 10 years. Our report explores the analytical reasons why investors believe Bitcoin can serve a similar role as other alternative investments in a portfolio.
A more uncomplicated explanation is that Bitcoin simply does not fit into defined asset categories. It also has dynamic narratives, which make it difficult to define (and easy to call an “alternative”).
Today, Bitcoin is very small in terms of market size and trading volume to be considered an independent asset class with a strategic allocation in portfolios. However, being classified as an alternative investment for now, as Bitcoin grows and matures and as investors study its characteristics, does not preclude Bitcoin from maturing into an independent asset class.
Independent and alternative are not necessarily mutually exclusive—many independent asset classes (e.g., commodities, real estate, infrastructure) may simultaneously be classified as alternative investments.
That, I think, is the most important narrative surrounding Bitcoin in 2021: Bitcoin is not just an alternative asset or investment anymore. It is not part of a larger alternative asset class — it is an alternative asset class that stands alone and above other alternative asset classes.
Bitcoin is a unique investable asset with compelling differences relative to traditional asset classes as well as conventional alternative investments that could make it a beneficial addition to a portfolio.
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