Investing Used to be Simple — The Case for a Little Cryptocurrency

Depending on how old you are, investing was a matter of simply setting aside your 401(k) or trusting your stockbroker to do the rest, you only had to focus on your job and getting through the day. Otherwise, investing was a matter of dividing between bonds and equities and depending on your age and risk appetite, adjusting that ration accordingly.

 

Conventional wisdom would have us believe that an allocation of our savings into an index instrument such as the S&P500 would ensure a sizeable nest egg for our retirement, regardless if we knew what stocks made up the index or not, the confidence was that the American economy would always grow and over longer periods of time, the S&P500 would outperform, but therein lies the fallacy of that assumption — over much longer periods, the S&P500’s numbers are disappointing at best.

According to DataTrek’s Nicholas Colas, the average trailing 20-year compounded annual growth rate over the past century for the S&P500 was a paltry 11% and over the last 20 years? A pathetic 5.6% and the worst run since the late 1940s. When adjusted for inflation over a century, the gain is 7% a year, not bad, if you can live over a hundred years, but for those more interested in the more recent future, the S&P500 has only delivered a real annual return of 3.3%, barely in line with inflation and certainly insufficient for you to quit your day job or to take up that crafts project you’ve been putting off for some additional Etsy-fueled income. And therein lies the problem with investing in the modern age — we need to take more personal responsibility for our investments and a far more active role than perhaps our forebears were used to. The unprecedented economic run-ups have all but played out, proving once again that old German saying, “Trees do not grow to the sky.”

And if you’re wondering why despite these paltry results from the stock markets, the rich somehow seem to keep getting richer, that’s because of their access to highly paid investment professionals who have since 2009 (after the financial crisis) diversified their client’s portfolios into all manner of assets from private equity to venture capital, fixed income to alternative asset classes, which I will discuss shortly. But the regular Mom-and-Pop will almost never have access to these riskier but far more profitable opportunities because they are limited to accredited investors — investors with sufficient net worth to make them (somewhat) more immune to the inherent riskiness of investments into things like venture capital. But the result of regulation protecting the regular Joe has been an inability to save for a decent retirement or to get out of the middle-income trap or the debt trap or the poverty trap or whatever other trap economists care to label. 

And if you’re wondering where the “smart” money is going? It’s not stocks. Last week, one of the world’s largest asset managers, BlackRock, released a survey of 230 institutional clients with a combined US$7 trillion under management that showed over half of them planned to reduce their exposure to equities this year, with most of these clients based in the United States, the United Kingdom and Canada. The destination of choice for re-allocation? Alternative real assets such as infrastructure, farmland, paintings and other collectibles, as well as private equity. And while to a lesser extent, there has also been discussion among managers for a small allocation into alternative virtual assets — cryptocurrencies.

But before we dive deeper into cryptocurrencies, it’s helpful to understand why managers are now seeking alpha in other assets.

Infrastructure

While infrastructure may seem like the purview of governments as opposed to private investors, the fact that successive administrations have neglected the United States’ crumbling infrastructure has created a perhaps once in a lifetime opportunity for private investors to access and control to some of the key components of modern living. From airports to highways, rail to public transport, bridges to dams, American infrastructure, once the envy of the world is in a state of disrepair. 

According to the American Society of Civil Engineers’ (ACSE) 2017 Infrastructure Report Card 2017 Infrastructure Report Card, which is published every four years, American infrastructure got a D+ grade, the same grade it got in 2013.

And with the ACSE estimating that the U.S. will need to spend some US$4.5 trillion by 2025 to improve the state of the country’s roads, bridges, dams, airports, schools, and more, the scope, or need for private investment is more obvious than ever. With the Trump administration expecting local and state governments to foot the infrastructure bill (the federal budget is more likely to include funding for a border wall than for much needed infrastructure maintenance) and local and state governments either bankrupt or close to bankruptcy, private investors have cottoned on the opportunity to own key U.S. infrastructure for the first time ever.

According to Mark O’Connell, CEO of OCO Global,

“There’s no shortage of international appetite for investing in infrastructure in the states.”

Tom Osbourne, Executive Director for Infrastructure for IFM Investors was even more sanguine in his comments,

“The only viable path forward I see for closing the U.S. infrastructure investment gap is one that involves multiple funding sources including where appropriate the private sector.”

And while infrastructure projects generally can take decades to turn a profit, in the case of U.S. infrastructure, because the infrastructural investment is mainly for urgently needed repairs and upgrades, that profit horizon is much more condensed, meaning that investors can see a return on investment and control key American infrastructure in far shorter time frames than ever before.

Farmland

There are some analysts who take the view that the next wars will be waged over food and water and with global population growing at an unprecedented rate, as well as rising living standards across the developing world, there is more than just anecdotal evidence to suggest that food and water will become increasingly valuable commodities in the near term. Already, China’s burgeoning middle class with its penchant for meat consumption has put tremendous pressure on farmland. 

Livestock is the world’s largest user of land resources, with pasture and arable land dedicated to the production of feed representing almost 80% of the total agricultural land. One-third of global arable land is used to grow feed, while 26% of the Earth’s ice-free terrestrial surface is used for grazing. As populations grow and become increasingly urban, there will be competition and pressure for global arable land not just for other competing land uses, but also to produce more food per acre than before. Accredited investors and their managers are betting on this trend to continue well into the next century and are therefore betting big on farmland. Unless the world loses its taste for cheeseburgers overnight, there is more than sufficient cause to consider an investment into farmland.

Paintings & Other Collectibles

The rich have collected paintings as well as other collectibles for millennia. But paintings have always been on the list of items that well-heeled investors have coveted for several reasons. First, given that beauty tends to be in the eye of the beholder, inflated prices for art were often used as a way to mask less innocent transactions. And because auctioneers as well as valuers could only be expected to provide “indicative” values of works of art, their actual prices at the auction block could vary greatly. With the rise of the affluent Chinese, global demand for art and in particular paintings, have skyrocketed. Paintings are particularly favored (especially to facilitate capital flight) because of their ease of transport (a rolled up Renoir can be as little as a copy of the New York Times) and liquidity (there’s always a buyer at the right price). Small wonder then that the highly wanted Jho Low (of 1MDB fame) bought not one, but several paintings using allegedly ill-gotten gains from Malaysia’s sovereign wealth fund and stashed them away in Switzerland for quick disposal should he fall on hard times.

 

But it’s not just paintings that managers have increasingly allocated their clients’ money to — rare vintage and classic cars, whisky and wine have all entered the purview of the versatile asset manager. And while not all of these alternative assets will necessarily turn a profit, their exclusivity means that if they do, their investors will no doubt have sold off these assets to the same rarefied strata of society from whom they had acquired such assets to begin with.

Private Equity

There are many flavors for private equity, from distressed debt asset acquisition to takeovers and venture capital. Private equity allows the well-appointed investor access to some of the most exclusive deals and opportunities in the investing world. Whereas private equity used to be limited to investments in privately-held companies or restructuring distressed companies, it has since been expanded to also include the acquisition of increasingly exotic assets, including barges and even distressed debt. 

Traditionally, private equity is employed to help restructure ailing firms (like Sears) and bringing value back to the firm to then re-sell it later at a higher price. Private equity also forms the funding engine for venture capital into some of the hottest startups, with a view that these companies will later go public for investors to get a return on their investments.

Retail Investors Left Out in the Cold

For the independently wealthy, there is no shortage of investment options and opportunities, but for the retail investor, options are much more limited, with many retirement and college funds subject to the vagaries of the stock market. If one considers the lack of real wage growth this century, there is little wonder that the average investor is disenchanted with stocks over the last two decades. In contrast, for the two decades prior to 1999, the compounded nominal return of the S&P500 in real terms was 17.5% and 13.7% respectively — which explains why stocks were considered the best place to put your funds on the run-up to the dotcom bubble. 

But for retail investors setting financial goals from 2040 and beyond, stocks may no longer provide the returns that they once did. Already price-to-earnings (PE) ratios are at astronomical highs. And there are now countless stocks on the NASDAQ for which PE ratios are more aspirational than actual. It’s almost as if the market learned nothing from the dotcom bubble, once gain companies that have little more than a growing user base, a hot idea and a superstar founder can “moon” on IPO — four years of profit be damned. And tech firms are starting to realize that the market can only absorb so much aspiration — already tech firms are staying private for longer periods of time and being bought out by bigger players without ever hitting the market. Just recently, for US$8 billion, just days before it was due to IPO. And while it may be tempting to hope that a fresh crop of disruptive tech companies goes public in the next few years, to breathe vibrancy back into IPO markets, there’s no guarantee that that will likely happen. Managers are already observing that stocks have become overvalued and with clients pulling out of equities, there is a strong case to be made for firms to pursue acquisition as opposed to IPO, which would subject their investments to the vagaries of the stock market.

Last week, Japanese conglomerate Softbank, which also incubates tech firms, announced that it was scaling back its investment into shared office provider WeWork — a sign that the frothiness in the tech and startup sector may be starting to ebb.

The ICO Craze

For retail investors, the initial coin offering (ICO) craze of 2016 to mid-2018 was finally then, an opportunity to gain access to some of the more risky investments that had long been the purview of accredited investors. Suddenly and oftentimes overnight, fortunes were made in ICOs, regardless of their merit. And while just as many investors lost a lot of money in these ICOs, just as many also made life-changing fortunes as well. 

To be sure, the merit and value of ICOs were in most cases suspect at best — perhaps no more so than dotcom companies in the run-up to the dotcom bubble. The legal status, as well as benefit of holding digital tokens in a company as opposed to shares, was hardly certain. But perhaps the only saving grace (if there was any at all) of the entire ICO episode was the accessibility to an investment class that had hitherto been restricted to the very wealthy. Unlike pre-IPO shares, which are normally only accessible to the well-connected or wealthy few, almost anyone could partake of an ICO. And retail investors were confronted with the personal responsibility to do their own due diligence on ICO projects as well as the merit and value (or lack thereof) of the ICO’s tokens.

And while the media has been quick to highlight stories of retail investors who bet the farm on ICOs and lost the farm and then some, there are also countless stories of retail investors who changed the course of their financial lives by getting out early. Understandably, a story of financial ruin can help to move more papers than a rags-to-riches story off the back of cryptocurrencies and ICOs.

Cryptocurrency for the Masses

As investing becomes more challenging, both for the wealthy and the less well-off, both classes of investors will need to take on far more personal responsibility to generate alpha and in the case of retail investors — even more so. For the wealthy, family offices have already started to stockpile some of their allocations into cryptocurrencies, in particular Bitcoin and Ethereum and some of the more forward-looking managers, into privacy-focused cryptocurrencies such as Monero and ZCash. But the silver-lining of this trend is that it’s not just limited to high net worth clients. Unlike for the other alternative asset classes, many of which are accessible only to accredited investors, cryptocurrencies are accessible generally by all. 

The world as a whole is entering an uncharted phase of development. With interest rates at such low levels for so long, asset bubbles from stocks to property have now grown to levels likely disproportionate to their inherent value. It is hard to say what will happen when these bubbles inevitably burst and the available monetary policy tools available to governments to deal with them when they do happen. Low interest rates are likely to also have fueled the speculative bubble into both ICOs, cryptocurrencies and blockchain companies and now that those bubbles have burst, the long term aftermath remains to be seen. To understand the long term value proposition of both cryptocurrencies and blockchain, the intelligent investor will need to wash out the noise by looking at the last time a disruptive technology appeared on the scene that was little understood — the internet.

In the run-up to the dotcom bubble of the early 21st century, scores of companies did not understand how important a technology it was nor how to apply it to their businesses. Today, scores of companies that had started experimenting with blockchain technology are now reporting that they neither understand how to apply the technology nor to utilize it to improve their processes. Let’s not forget for one minute that this was the exact same reaction that companies had towards the internet. Whether or not one thinks this is likely to change will depend very much on whether one views blockchain technology as similarly disruptive as the internet was or whether one sees it merely as a solution looking for a problem. Strictly from a technical and social engineering standpoint, blockchain and Bitcoin have solved hitherto insurmountable problems — the double-spending problem, the Byzantine Generals’ problem and provided the economic incentives to sustain a decentralized value transfer system. There’s never been anything like it before. So it should come as no surprise then that managers are allocating at least a portion of their assets into cryptocurrencies or if not at least considering the move.