Two reasons for a pension fund to consider an investment in bitcoin
Updated: Jul 9, 2019
In this article I share my view on why I think every pension fund should consider an investment in bitcoin. I see three different reasons why the giants of the financial markets should consider an investment. With the current developments in the area of institutional grade custody and Cambridge Associates advocating for crypto assets as an asset class to consider, I expect to see more funds tipping their toes in the years to come. Aside from it being no longer technically impossible, investments in emerging asset classes should be following from a fundamental conviction. The fact that investments are technically possible, should not be a reason to invest, but it should lead to a house view which results from proper research on the matter. Having that said, I see three different reasons for a pension fund to consider an investment in this new asset class. In short;
- bitcoin as uncorrelated asset with asymmetric risk return profile
- bitcoin as strategic hedge against systemic risk and monetary inflation
A little history on asset management at (Dutch) pension funds
Before we consider bitcoin as an investment, let's start with a little history on how pension funds manage their assets. Pension funds are always looking to optimise portfolios over risk and return. In the early days they were allowed to use an actuarial rate of 4% flat to discount future liabilities. As a consequence there was no sensitivity to actual market interest rates. Asset allocation was a matter of solving for the optimal portfolio that maximised expected returns while minimising risk; better known as mean-variance optimisation which was introduced by Markowitz in 1952.
The actuarial discount rate of 4% was considered a conservative discount rate for a long time, until actual market rates started to come down. With long term interest rates trading below 4%, the discounted value of future liabilities was higher against market rates. While lots of (especially smaller) pension funds thought their assets were covering their liabilities, they were running short or close to running short in case of valuation based on actual market interest rates. In order to be able to pay out all future liabilities, this is of major concern for any pension fund. So, regulators stepped in and introduced a new framework which prescribed pension funds to value liabilities against market interest rates. As of that moment, all pension funds suddenly were sensitive to interest rate risk on their liabilities, while they were historically only exposed to this risk on the asset side of their balance. With terms like cashflow matching, overlay strategies and liability driven investing, pension funds started to use part of their assets to mitigate the interest rate risk present in their liabilities, which by the way is the largest type of risk any pension fund is facing. These days most funds have split their assets into two sections; a matching section in which interest rate risk is hedged and a return section in which the objective is to optimise return over risk. And for sake of completeness it's worth mentioning that the methodology to value future liabilities has changed a couple of times over the past years, but the relation to actual market rates remained. Bitcoin could be considered in the return section of the portfolio in case the investment is driven by the asymmetric risk return profile, or in the overlay portfolio in case it is considered either a hedge against inflation or systemic risk.
Bitcoin as diversifying asset with attractive risk return profile
Before I discuss how bitcoin could fit in on a pension fund balance sheet, I will first introduce you to bitcoin demand and supply. Due to the scarce nature of bitcoin, market forces pushed price higher as adoption increased. As there's a limited supply, increase in demand is reflected in higher prices. At inception the first bitcoin blocks were mined with a mining reward of 50 bitcoins per block; every 10 minutes a miner received a reward of 10 bitcoins for adding another block of transactions to the existing bitcoin blockchain. With every created block another 50 bitcoins came into existence. The bitcoin supply increased with 50 bitcoins every 10 minutes as of January 3rd 2009. The 50 bitcoin reward isn't there forever; after every 210.000 blocks the mining reward reduces by 50%. 210.000 blocks roughly equals a period of four years, so every four year the number of newly created bitcoins declines by 50%. This is important for two reasons:
1) Natural sellers (the miners) have less bitcoins to sell if their rewards are reduced.
2) The total number of bitcoins that ever get into existence converges to 21 million.
If you realise that the number of bitcoin wallets and transactions has only been increasing over time (which indicates an increase in adoption), and you understand that the number of newly minted bitcoins decreases over time, price theoretically has to move up. That's exactly what happened over the past 10 years. It never was a straight line upwards. Like with every nascent technology you'll see multiple waves of adoption. What once started as an experiment by some cypherpunks and resonated with some early adopters who thought magical internet money would be nice, the first digital scarce asset is now in a phase where institutions worldwide are investigating how to get involved. Aside from the multiple waves of adoption that drive price action, there's also the effect of the mining reward halvings. Looking back at the past halving events, I noticed how speculators start to drive up prices roughly a year before the next halving. Once the halving kicks in, you'll see price rallying for another year before the retrace kicks in and price moves from overshoot territory to undershoot territory. Is this just a coincidence or is there a certain relation between price and scarcity? A very interesting article on bitcoin valuation based on its supply and miner rewards can be found here.
For a pension fund it is very interesting to add high return assets in case they have no or small correlation to other assets on the balance sheet. Adding assets with a higher expected return and low correlations enable pension funds to decrease risk on a portfolio level while increasing expected return, even though bitcoin is a very volatile asset. In the correlation matrix below, the correlations between bitcoin and other assets is shown. (Source: www.theblockcrypto.com)
Aside from bitcoin being uncorrelated, in an investment universe where positive yield is diminishing, a new investment instrument with an average return exceeding its volatility (which is very uncommon with other asset classes), should be welcomed with open arms.
Bitcoin as strategic hedge against systemic risk and monetary inflation
While Trump shows no sign of calming down on the trade war with China, the risk of collateral damage intensifies. Imposed higher tariffs are answered with higher tariffs and lead to both increased political and economic tension eventually followed by instability. Aside from the current trade war, there's also still QE. While the intention was to consider quantitative easing an emergency tool, these days it seems more like it is a drug that we can't get rid of. While the end of QE was announced in December 2018 by Draghi, he recently surprised many by stating that a fresh round of monetary stimulus and possibly a reactivation of the bond-buying programme could be expected in case inflation outlooks for the EU don't improve. Short term government bonds like treasuries were always considered safe investments. Every institutional investor should wonder wether these type of investments are still as safe as they once were. The reason that institutional investors are accepting negative rates on their government bond investments lies in the idea that they rather trust governments than banks when it comes to storing value. Throughout history there are plenty of examples of governments that failed to control their spending and with it the stability of their currency though. So, if you know upfront you are guaranteed to lose part of your investment in order to preserve capital, and you know these governments might fail eventually as well, it might be time to consider a plan B.
Holding enormous amounts of fiat currency isn't a good plan either. When monetary stimuli are used, you are better off by storing value in assets (which are preferably scarce), as those stimuli are nothing less than currency debasement. A practice that originates from ancient times where governments would debase their currency by adding a lower value metal to the gold or silver content of the coins. By mixing the precious metals with a lower quality metal, they were able to create additional coins of the same denomination, essentially expanding the money supply in order to finance their increased spendings (most often in times of war). The major difference is that in those times the currency was actually backed by precious metals, while these days it's all based on hope and promises. Fiat currency is not called fiat currency without a reason. When the system starts to slide and people lose faith, fiat currency loses its value at the same speed as people lose faith.
Precious metals have been a safe haven for centuries and it shouldn't come as a surprise that amidst the current economic climate, central banks worldwide are running a gold hoarding competition. So buying physical gold or other precious metals and keeping it safe would not be a bad idea. While cash and government bonds are all part of the same financial system built on hope and promises, precious metals are on their own. If you own any today, you can be certain that you will own value in a century from now as well. Value of these precious metals is dependent of industry usage for a small part, but mostly depends on their scarcity. A great way to measure scarcity is by the ratio of existing stock over yearly newly mined. With a stock-to-flow of 67 for gold and a stock-to-flow of 13 for silver, bitcoin fits in between with a current stock-to-flow of roughly 27 (by approximation). The interesting part is that bitcoins stock-to-flow improves significantly every 4 years as miner rewards halves. As of May 2020 bitcoins stock to flow will jump to 57 as a result and in 2024 it will surpass the stock-to-flow of gold. (See chart below for evolution of stock-to-flow over time.) In terms of scarcity bitcoin will be superior to gold as of 2024 but also comes with other benefits. It's better divisible, better portable and easier to transfer.
While central banks are currently still accumulating gold, I wouldn't be surprised to see the same happening for bitcoin once its scarcity surpasses that of gold. With the introduction of physically settled bitcoin futures this year by BAKKT among others, and the institutional grade custody solutions popping up this year, it will be easier for institutions to start accumulating bitcoin soon.