Cryptocurrencies as a long-term investment

The results to date of investment in bitcoin have been spectacular. But what about the long-term? For equities, Benjamin Graham famously thought that undervaluation and low risk together would generate superior returns. Undervaluation is a highly difficult term to pin down, but some combination of (a) the discounted value of cash flows exceeds market price, (b) low price by comparison to net current asset values should suffice. If he were universally correct, gold would be worthless, along with any asset generating zero yields. But fortunately for investors, they are not. As CCR Wealth Management rightly said, ultimately, Bitcoin’s value will be determined by demand and supply – just like gold, US$ and – speak it softly – everything else too.

It is a challenge, however, to predict what that value will be. When what UBS in October 2017 called the speculative bubble abates, as is highly likely, valuation methods for cryptocurrencies are more likely eventually to revolve around the theory of Purchasing Power Parity (PPP), which assumes that ceteris paribus, identical goods in different countries should be identically priced when converted to a common currency, say bitcoin. PPP though is designed to function through real economies, with models such as those used by Morgan Stanley focusing on the long-term statistical relationships of key fundamentals e.g. terms of trade, productivity or net foreign assets.

For cryptocurrencies, the parallel relationships will have to be sought in commodity or industry-specific data that can act as leading indicators of rising interest and transactional volatility in specific cryptocurrencies. Other strategies derived from emerging market foreign currency investment might apply. One strategy borrowed from foreign currency markets that might work is rolling investment: jumping from one cryptocurrency to another in order to benefit from successive ICO bounces and individual demand patterns, to avoid the curse of mean-reversion, zero net return investment that theory (and a lot of practice) declares will be the consequence of any long-term currency investment strategy. This will require considerable insight so it is not likely to be of much use to retail investors, but hedge funds are already using the strategy.

There are risks, too, which have led wealth advisers like Richardson GMP to suggest staying clear – for now. Tax is clearly one. Governments are setting out regulatory frameworks that will include the inclusion of cryptocurrencies in domestic capital gains tax regimes, with the Achilles’ heel for any avoidance strategy being the existence of exchange rates between domestic and cryptocurrencies, and between cryptocurrencies and real assets. Owners of bitcoins may be gratified that companies such as Microsoft, Virgin Galactic, Expedia, Dish Network, and Overstock.com now accept them: but so are the tax authorities. Self-regulation is a second: bitcoin value is dependent on investors’ belief in the algorithm limiting circulation to hold, and whilst this might be fair for Bitcoin, forks notwithstanding, as well as for Ripple and Ethereum, there is less certainty with others – and the less risky the cryptocurrency, the more difficult it is for investors to access it.  Security is a third: security – hacking has resulted in huge losses already. Volatility is clearly another, although we can expect this to reduce over time simply because of a downturn in speculative interest, notwithstanding UBS’ theoretical argument that Bitcoin’s value gyrates wildly because its supply cannot be readily changed. For now, investors must contend with incompatible wallet technologies and diversity of tokens, as well as insider knowledge, all spread across more than a thousand altcoins. Subscriber services like Follow Coin are a help even now, but these problems can reasonably be expected to ease, as they did for the successful tech companies of a previous generation, first and foremost Amazon. Liquidity is a fourth. Transactions in bitcoin are still taking hours. In that time, the value could collapse.

The cryptocurrency derivatives currently in the train (e.g. by the CME and CBOE launching in December) should alleviate that issue. But clearly, if transactions are going to take this long to execute, covering hedges are essential.  Nor do we yet know with what assets cryptocurrencies will be correlated. As yet the sustained rally of bitcoin, in particular, has exceeded any other asset, but longer term, correlations will be detected (e.g. with domestic inflation rates) and arbitrage strategies developed, both between cryptocurrencies and between them and other assets, like real estate denominated in US$. If cryptocurrencies really are to develop into a separate asset class, long-term investment strategies will also probably involve index funds, some of which are already in the market, such as Cryptomover, professionally assembled and released in a fashion analogous to the MSCI indices. None of the risks is impossible to overcome.

And it seems clear, there is no going back now. Government monopoly on money is over, blockchain uses for cryptocurrencies are slowly rising. The only issue is how and when cryptocurrencies should feature in an investment strategy. RBC Global Asset Management says, keep an open mind but recognize the risks. That makes sense for long-term investors.

Author Julian Roach of Redcliffe Training

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