The crypto movement has grown from an obscure hobby project in 2009 to a multi-billion-dollar asset class over the past decade. According to CoinMarketCap, there are nearly 6,000 cryptocurrencies with an aggregate market capitalization of about $325 billion. The launch of crypto funds and other financial products has also brought the asset to mainstream investors.
Many investors have started to build crypto assets into their portfolios, but professional money managers have been somewhat slow to adopt them. While they may meet the definition of an asset class, they lack the size and scale that many portfolio managers require. Others maintain that there’s too much risk and volatility associated with most crypto assets.
Let’s take at whether cryptocurrencies are an asset class and, if so, what the designation means for investors interested in crypto assets.
What is an Asset Class?
Asset classes are groups of investments that have similar characteristics and are subject to the same laws and regulations. For example, equities (stocks) are considered an asset class since every stock represents a fractional share of a company and must abide by the same regulations, while every bond is a debt instrument that follows their own regulations.
The most popular asset classes are:
- Fixed Income
- Cash Equivalents
- Real Estate
The concept of an asset class is primarily used in the context of diversifying a portfolio. A diverse mix of asset classes helps smooth out volatility and thereby reduce risk. For example, a drop in the stock market isn’t as impactful if a portfolio consists of 40% bonds. Diversification helps improve risk-adjusted returns by minimizing the risk part of the equation.
Sample Asset Allocations - Source: Fidelity
Vanguard found that 88% of volatility and returns can be traced back to asset allocation. In other words, your experience will be very consistent with any other diversified investor with the same asset allocation, regardless of the specific investments that they choose. Asset allocations are therefore one of the most important considerations when building a portfolio.
Crypto as an Asset Class
Crypto assets meet the definition of an asset class since they are a group of investments that have similar characteristics and are subject to the same laws and regulations—although these laws and regulations are just starting to take shape. In fact, crypto assets may span multiple asset classes given the differences between them.
There are two primary types of crypto assets:
- Hard Currency
- Cash Equivalents
While Bitcoin is a hard currency with a purpose similar to gold in a portfolio, Tether is a cash equivalent that’s tied to the value of the U.S. dollar. The differing characteristics of these two crypto assets could make them two separate asset classes—one as a capital asset that diversifies a portfolio and the other as a liquid asset similar to a money market fund.
Many professional money managers have yet to add crypto assets to their portfolios despite their growing popularity. Some believe that they haven’t reached a critical mass in terms of market capitalization and liquidity to be widely adopted, while others point to the tremendous amount of volatility that leads to excessive risk in many crypto assets.
Merits as an Asset Class
The primary purpose of an asset class is to diversify a portfolio and increase risk-adjusted returns. For example, many investors hold a portion of their portfolios in bonds since they are inversely correlated with equities, which evens out volatility and reduces risk. There’s little point in holding novel asset classes unless they provide some kind of benefit.
Goldman Sachs famously gave five reasons that it doesn’t consider Bitcoin an asset class:
- It does not generate cash flow like a bond.
- It does not generate earnings through exposure to global economic growth.
- It does not provide consistent diversification.
- It does not dampen volatility.
- It does not show evidence of hedging against inflation.
Cryptocurrencies have a mixed track record when it comes to diversification. While some studies have shown insignificant correlation with economic factors, the market downturn following the COVID-19 pandemic demonstrated a strong correlation with equities. Their correlation with conventional assets appears to depend on the investment climate.
S&P 500 Index vs. Bitcoin Futures Correlation - Source: TradingView
For example, the S&P 500 index versus Bitcoin futures chart above shows that both equities and Bitcoin fell sharply between February and March when the COVID-19 pandemic hit the United States. These dynamics hurt Bitcoin’s reputation as an alternative asset that could help diversify against sudden economic shocks.
Many cryptocurrencies also have high levels of volatility on an individual basis compared to equities or fixed income investments. While these levels of volatility introduce greater risk to portfolios, they can be mitigated to some extent by holding a diverse portfolio of crypto assets, just like holding many equities rather than a single equity.
A diversified portfolio that contains 5% or 10% crypto assets will likely not be severely impacted by the volatility of any single crypto asset—just like it’s not impacted by the volatility of any individual stock. The key is maintaining a diversified portfolio of asset classes that aren’t all correlated and moving in the same direction all the time.
Blockchain as a Medium
It’s important to differentiate crypto assets from blockchain technology. For example, some cryptocurrencies are actually just a digital representation of a physical asset. Rather than representing a new asset class, they simply improve the way existing assets trade and offer investors an alternative way to own something.
A few cryptocurrencies fall under these definitions:
- Asset-based Coins
- Transactional Tokens
For example, Basic Attention Token (BAT) is a cryptocurrency that seeks to improve the efficiency of digital advertising by creating a new token that can be exchanged between publishers, advertisers and users on the Ethereum blockchain. Ethereum itself is another example of a crypto asset that’s designed to be a technology platform.
These cryptocurrencies are created to facilitate transactions rather than form a new asset class, which means they may not fall under the conventional asset class definition. Crypto investors should keep these important differences in mind.
The Bottom Line
Crypto assets have grown to more than $300 billion over the past decade, which has drawn the attention of both traders and investors. While they meet the definition of an asset class, most professional money managers are waiting for the market to mature before committing capital.
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