Cryptocurrency Investments Not As Contrarian As Conceived

When an idea is universally held in finance, it often pays to be cautious, which is why your portfolio may benefit from a dose of contrarianism when it comes to cryptocurrencies.

When Ted Chang arrived in Taipei on business for the first time in the early 1990s, he noticed everyone seemed to be drinking boba (bubble) tea. A pleasantly sweet mixture of tea with milk and tapioca pearls that look more like chewable marbles — Chang was instantly hooked on the beverage the first time he tried it.

Chang, who was in Taipei to speak with semiconductor suppliers, was surprised that boba tea was unavailable in his home Singapore. So convinced was Chang that the drink would be a sure hit in the sweltering heat of the island state, he quit his job, got in touch with franchise partners in Taipei and brought the first boba tea shop to Singapore.

And because Chang was the first boba tea shop in the country, he could charge a princely sum for the refreshing beverage — US$5 a cup, for ingredients that probably cost no more than 50 cents.

Boba tea was an instant hit in Singapore. Overnight, lines snaked around the block as customers couldn’t get enough of the drink.

In those early days, the conventional wisdom was that boba tea, a simple business to set up, would make owners of these shops overnight millionaires given customer’s insatiable appetite for boba tea.

And since the resources needed to set up a boba tea shop were relatively low, scores flocked to either invest in boba tea businesses, or set up their own competitors to Chang’s original boba tea place.

Before long, there was a boba tea shop at every street corner, which quickly led to diminishing returns.

So widely available was boba tea that prices started to drop. From US$5 a cup, prices soon plummeted to as low as US$1.50.

Over time, boba tea drinkers experienced “boba tea fatigue” as there was just simply too much of the stuff and boba tea places started to close down as quickly as they had started up, before disappearing almost entirely from Singapore in the mid-2000s.

While boba tea may have since made a comeback, the craze, as well as the craze to invest in the business offers a lesson on “conventional wisdom” — which is often neither “conventional” nor “wise.”

Lemmings Tend To Follow Each Other Off Cliffs

Instinctively, we all know that contrarianism is what produces outstanding results — the courage and perhaps the foresight, to go against the grain of conventional thinking, to perceive what others may have missed out — are the narrative of the fearless entrepreneur, who paves the trail so that others may follow.

Yet over the past decade, there has been a dramatic shift by investors towards “passive” funds — walking the trail that has been well trodden.

These passive funds track highly liquid, publicly listed stocks or bonds and the most popular of these funds are massive (in the trillions of dollars), run by computers, widely held and with minimal fees.

The conventional wisdom suggests that as stocks (over the very long run) should always appreciate, instead of trying to discern which stocks will do best, buying an index will provide long term gains at the lowest cost.

This investment philosophy was first made popular by John “Jack” Bogle, founder of the Vanguard Group, which is credited with creating the world’s first index fund.

An avid investor and money manager himself, Bogle’s first index fund came out in 1975, mimicking the performance of the index over the long run and which delivered higher returns with lower costs.

Over the last decade, Bogle’s idea really took off, as average investors shunned stock pickers and other human-managed funds with their high fees to pour into billion-dollar index products.

Yet as global growth has slowed and as a prolonged period of low or near-zero interest rates has persisted against a backdrop of low inflation, many long term assumptions over the direction of stocks and bonds over the last decade have been called into question, leading to the return of interest in private capital.

The Phoenix Rises For Private Capital

The boom in passive investing has not only made investments more accessible to average investors, it has also spawned its antithesis — niche funds run by humans which are secretive, thinly traded and high fee — and targeted at richest people and institutional investors.

Because institutional investors and high net worth individuals know that conventional investing approaches can only yield conventional returns, many are rushing headlong into such actively managed funds, including pricate equity, venture capital, private debt and cryptocurrencies.

Globally, pools of private capital, including investments in private equity, private debt, unlisted real estate and hedge funds, including cryptocurrency hedge funds have grown by over 44% in the last five years alone, according to data from JPMorgan Chase.

The flood of capital into these private market instruments ultimately reflects a growing belief that these will outperform public market instruments and there is evidence for this.

Even after substantial fees, the best run private capital managers have beaten the returns from public markets and there are grounds to believe that this was no statistical fluke.

Private capital, whether it’s in cryptocurrency hedge funds or private debt, reduces “agency costs.”

Agency costs arise whenever one party, usually the principal, delegates a task to another party, typically the agent, and their interests conflict.

To understand why agency costs arise, consider that in the public markets, no one has a big enough stake to make it worthwhile to monitor the firms that constitute the index.

As a result, the firms constituting this index either get complacent, or indulge in short-term earnings management to the detriment of long term investment in capital or capability.

Ivy League Crypto

But it’s not just the well-heeled who are turning to private capital, the well-read are as well.

In recent years, there’s been an intellectual revolution among investors, led by the endowments of some of the largest American colleges.

Almost two years ago, it was reported that the endowments of Harvard University, Stanford University, Dartmouth College, Massachusetts Institute of Technology and the University of North Carolina all invested into at least one cryptocurrency hedge fund — this at a time when Bitcoin’s price was tanking.

But the foray of such funds into cryptocurrency waters is understandable.

Because university endowments, similar to life-insurance funds and sovereign wealth funds, have obligations far into the future, they can take a long term investment horizon.

Which means that if these investors sense value in the cryptocurrency space, they’re willing to go long and bet big.

Such longer time horizon investors are able to sacrifice the liquidity of public markets for the far better returns of private market instruments, including cryptocurrency hedge funds — where data is scarce, assets are complex and value is tricky to appraise — but more importantly, where finding the right opportunities takes patience.

Turbo Charging

And while few investors will admit to it, part of the allure of private investment instruments is their ability to pile on leverage — especially in the unregulated cryptocurrency space.

While most cryptocurrency hedge funds manage leverage within reason, the opportunity to leverage from a a few hundred times to a few thousand times of the amount staked, means that the potential to dramatically amp up returns in relatively shorter periods of time (compared to an index fund) is a clear and present attraction.

Whereas public shares mean that some pension funds are forced to sell their holdings at the worst possible time, for instance when markets tank, either to comply with solvency rules or because trustees panic — the same considerations don’t necessarily apply to private market instruments such as cryptocurrency derivatives held by cryptocurrency hedge funds.

And with the substantial returns of some cryptocurrency hedge funds far outstripping the returns of the S&P500, even after fees, the risk-reward ratio becomes highly skewed towards rolling the dice with a cryptocurrency hedge fund, than passing on the opportunity.

But as with all things in life, to the victor go the spoils — investors in the top quartile of funds enjoyed returns substantially higher than public shares, whereas investors in the bottom quartile of funds fared comparatively worse.

Despite the high-stakes of private investment, the boom shows little sign of stopping for now.

Low interest rates mean that a global hunt is on for higher returns and the coronavirus crisis will mean that central banks are likely to ease rates further, in an unending race to the bottom.

Because many pension funds were built around conventional wisdom (at the time) that a U.S. Treasury Bill would pay out 8% (a rate that hasn’t been paid out in almost two decades), their managers are now scrambling to allocate greater amounts to private investment instruments, in an attempt to try and plug the yawning funding deficit.

But when it comes down to private capital and cryptocurrency hedge funds, it’s not a cakewalk.

Fees are high and given the opacity of much in the cryptocurrency space, managers of cryptocurrency hedge funds enjoy a greater deal of discretion than their counterparts in private markets, especially when it comes to valuing their assets and the timing of buying and selling cryptocurrencies and their derivatives.

Just as there are costs of monitoring the performance of publicly listed firms, there are also costs involved with monitoring your private capital manager and nowhere is this more apparent than with cryptocurrency hedge funds.

According to one pension fund manager based in Maryland,

“You’re dealing with an asset class that up to a few years ago and probably even now, isn’t strictly speaking considered an asset class.”

“Many of the tools used by fund administrators, auditors and accountants to value (cryptocurrencies) were developed in the past two years alone. There is much more ground to cover.”

But for those who can hack the opacity and struggle of dealing with private market instruments, a decade or two will prove whether their bets ultimately pay off.

“Given their valuation now and the amounts we’ve allocated, it’s not going to move the needle on our overall portfolio.”

“Can we afford to be wrong when it comes to cryptocurrencies? Absolutely.

“At present levels, we can afford to be wrong and lose our stakes in those (cryptocurrency) investments.”

“What I don’t see us being able to afford is being wrong about cryptocurrencies as an investment class.”

“If cryptocurrencies turn out to be a runaway success, we can’t afford not to have been the ones to not have taken a swing.”

For now at least, sluggish growth and near-zero interest rates will no doubt have contributed to the growth of alternative asset investment classes, for which cryptocurrencies are simply one of many.

What is less clear is how these private market instruments will fare against a backdrop of rising interest rates and faster growth — or even a recession for that matter.

Considering Bitcoin was born out of a financial crisis, it has yet to weather one — only time will tell whether or not Bitcoin ages well in a recession, or whether it starts to grow long in the tooth.

For now at least, an examination of such factors seems remote — and given the increasing amounts pouring into private market instruments, investors are banking on that.