How do you choose the best asset allocation for your family office? This question probably has as many answers as there are family offices. Each one will have a unique style dictated by the values, vision and purpose of the individual or individuals behind it. Yet while the focus of one family office may differ greatly from another, all tend to have a common mission: to preserve and grow the wealth of the founding family for the long term, preferably spanning generations. Thus, certain basic investment principles often apply, such as building a diversified portfolio and being focused on asset allocation. And when setting long term strategic asset allocation bands, an increasingly common question amongst family offices is whether cryptocurrency should be part of asset allocation.
According to research cited by Forbes, 1% of the average family office portfolio is invested in cryptocurrency, which equates to an average of approximately $11 million of crypto holdings for each office. For those family offices yet to commit to crypto as an asset class, we know that the subject comes up time and again in investment committee meetings.
Cryptocurrency for family offices
Industry commentators frequently refer to bitcoin as digital gold, and there are some parallels between the two when you look broadly at the history of money and the evolution of its functions. Many inanimate objects – seashells, metal ingots, beads – have served as currency throughout human history. Beginning in the 17th century, gold underpinned the development of today’s financial systems with the promise initially that central bank notes could be converted into agreed quantities of the rare metal.
In 1971, President Nixon ended the gold standard, meaning that foreign governments could no longer exchange their dollars for gold. This severed the link between government-backed currency and underlying assets and paved the way for alternative currencies. With its 5,000 year history, and having survived various currency regimes, gold has gone on to become a safe haven asset and an inflation hedge in periods of rising inflation. It is, however, difficult to move across space and is very much an analogue monetary technology in a digital world.
Enter bitcoin, a digitally-native currency for the digital age. Bitcoin has programmed scarcity in that there will only ever be 21 million coins minted. It is weightless and can be transferred almost instantly to anyone, anywhere around the world. Not only that, the underlying blockchain technology provides an immutable record of exchange and ownership.
The intrinsic benefits of bitcoin and other cryptocurrencies have led to a situation where, as of January this year, the total value of cryptocurrencies in circulation around the world was $ 2 trillion, more than the GDP of all but the world’s seven richest nations.
And the innovation of digitally-native currency is just beginning. Blockchain and crypto startups raised a record $33 billion in funding in 2021, an eightfold increase from the previous year.
Where should crypto go within a family office portfolio?
If figures like this make a persuasive case for incorporating some level of crypto exposure into portfolios, the next question then becomes where should we put them in the wider assets allocation matrix. A useful framework that often works well is adding crypto to the “alternatives” bucket.
Why do institutional investors use alternative assets in a portfolio, to begin with, moving away from the historical 60/40 stock/bond portfolio? Broadly, there are three primary reasons:
- Diversification and risk reduction
- Return enhancement
- Yield or income generation
Now let’s take that one step further and ask the question, does bitcoin belong in the alternatives bucket alongside hedge funds, venture capital and commodity allocations? Bitcoin has shown it has differing return and risk drivers through time with low but increasing correlations to traditional risk assets. Fluid investment narratives have seen bitcoin act as a “risk-on” asset at times as well as a “safe-haven” asset at other times. Other unique factors play a part as well such as its retail-first origin story and the 24/7 decentralised nature of bitcoin liquidity.
Amid the noise and froth of volatile markets, it’s easy to overlook the fact that cryptocurrencies have evolved and are becoming serious financial tools, as evidenced by El Salvador’s adoption of bitcoin as legal tender and the flurry of real-world use cases coming to market from stablecoins to decentralised finance (DeFi).
Alongside growing institutional adoption, there is the fact that cryptocurrencies offer excellent risk-adjusted returns when added to a portfolio. Despite notorious volatility, and using bitcoin as a proxy for the entire asset class, long-term performance on a risk-adjusted basis and over 5 year rolling periods is outstanding versus all other asset classes – as demonstrated here.
Bitcoin, for example, has risen around 3,700% over the last five years. Ethereum has gone up roughly 5,700%. This shows more promise than some high growth tech stocks, the historical go-to asset class for market-beating returns, with the S&P technology sector seeing around 220% growth over the last five years and market darlings Tesla and Amazon at around 1,800%, and 290%, respectively.
Family offices generally have long-term investment horizons and many are structured as permanent capital vehicles. Long-term thinking and investment horizons provide family offices with a structural advantage and thus allow for increased risk-taking as long as the returns compensate for the additional volatility.
That said, and despite the media clamour, the volatility of bitcoin is these days not significantly different from many mainstream equities. Given that bitcoin is a little over 13 years old, a tendency toward lower volatility makes sense for a new asset class that is maturing.
Crypto is no longer on the fringe
The relative youth of bitcoin reminds us that we are at a very early stage in the development and evolution of transformative technology. Cryptocurrencies are well on their way to becoming the fastest technology to ever reach mainstream usage, with the current rate of adoption outpacing the take-up of the internet. Data suggests that cryptocurrencies got to 100 million users faster than the World Wide Web. And whereas it took Microsoft 44 years to reach a $1 trillion market capitalisation, Amazon 24 years and Google 21 years, bitcoin reached this milestone in just 12 years. For family offices, with their long horizons and their tolerance for managed risk, cryptocurrencies hold huge amounts of potential.
Having covered diversification and return enhancement, the third reason for including alternative assets in portfolios was yield or income generation. And cryptocurrencies have a role to play there too. Emerging crypto lending markets offer fixed yields, like those available for cash but frequently with better rates of return.
In a world of low, and even negative, interest rates for cash holdings, and where good returns are hard to find on standard fixed-income investments, cryptocurrency banking services offer an attractive option. Crypto lending markets are based on serving the borrowing needs of cryptocurrency market participants that are willing to pay higher interest rates to borrow USD-linked stablecoins. Professional trading firms, for instance, need access to liquidity on existing positions for other trading opportunities. This allows crypto lending products, to offer returns of between 4% and 8% APY depending on market conditions. With current technology, cryptocurrency assets do not leave secure custody and are insured against cybercrime while they’re held there. Consequently, cryptocurrency yield services present an appealing alternative to low-risk, fixed-income assets as part of the portfolio mix. The above framework should help family office investment professionals think through how to allocate to crypto assets.