Of all the many smart things Mark Twain allegedly said, one of my favorites, especially nowadays, is "It's not what you don't know that gets you in trouble. It's what you know for sure just isn't like that. "
In the turbulence of 2020, many “truths” of the market have turned into myths. And many trustworthy investment claims no longer make sense.
One thing that keeps puzzling me is how many financial advisors still recommend the 60/40 portfolio balance between stocks and bonds. The theory goes that stocks will give you growth. And bonds bring you income and provide a buffer in times of stock decline. If you want to keep capital well into old age, this is the diversification strategy for you.
That no longer applies.
Diversification itself is not examined here. Whether you subscribe to chaos theory or just eat a balanced diet, diversification is a good rule of thumb when it comes to a healthy lifestyle (except maybe when it comes to marriage).
This is the reason for diversification when it comes to investments that we need to think about.
The idea is that diversification spreads the risk. What harms one asset may benefit another, or at least may not do so much harm. An asset can have unique value drivers that characterize its performance. A position in low risk, highly liquid products allows investors to cover contingent liabilities and take advantage of other investment opportunities as they arise.
All of this is still largely true. What needs to be questioned is the assumption that diversification should be split between stocks and bonds.
One of the main reasons for the stock / bond allocation split is the need for hedging. Stocks and bonds traditionally move in reverse. In an economic downturn, central banks would cut interest rates to revive the economy. This would drive bond prices higher, which would partially offset the collapse in stocks and provide performance that would be superior to an unbalanced fund.
Since the 2008 crisis, that relationship has collapsed. As the chart below shows, stocks (represented by the S&P 500) have outperformed balanced funds (represented by the Vanguard Balanced Index) in terms of rolling annual performance over the past 20 years.
Why? First, central banks no longer have interest rates in their toolbox for fighting the recession. While negative interest rates are possible, they are unlikely to revive the economy to reverse a stock market that is falling on expectations of recession.
And as we've seen this year, the stock market can continue to rise even in an economic slump. With lower interest rates and a flood of new money chasing assets, stock valuations moved away from expected gains some time ago.
So there is no reason to expect stocks to have a pronounced downward year, and there is no reason to expect bonds to rise if they do so as long as central banks stick to their current policies. And it's hard to see how they can end their current strategies without causing significant damage to borrowers (including governments). Then where is the hedge?
Another reason to keep some of the bonds in portfolios is for guaranteed income. This was taken off the table by record low interest rates. As for the “safe” aspect of government bond holdings, the sovereign debt / GDP ratio is at an all-time high. Nobody expects the US government to default – but that's more a question of trust than a financial principle. Continuity of trust is perhaps another assumption that needs to be examined.
You may have heard this before: government bonds that were used to pay risk-free interest. Now they offer an interest-free risk.
Why are financial advisers still recommending a balance between bonds and stocks?
Another possible reason is hedging against volatility. In theory, stocks are more volatile than bonds because their valuation depends on a greater number of variables. In practice, however, bonds are often more volatile than stocks, as this graph of the 30-day volatilities of the TLT index for long-term bonds and the S&P 500 shows:
The justification of the 60/40 share / bond split therefore no longer has a meaningful argument, neither as an income generator nor as a safeguard. The point is already missing when setting the ratio. The underlying vulnerabilities for stocks and bonds now overlap.
Furthermore, there is no reason to believe that things will return to the way they were. Even without a divided government in the US, it will be difficult to carry out sufficient budget expansion to sustainably keep the economy alive. It is more likely that expansionary monetary policy will become the new normal. This will keep bond yields low, stock prices stable or rising, and deficits rising.
This begs the question: what should a portfolio hedge for?
The traditional mix hedged against the business cycle: in years of economic growth, stocks did well, and in years of decline, bonds came in. Only the business cycle no longer exists. The signals that were being used to send interest rates have been overridden by central banks, which means investment managers who still believe in business cycles are flying blindly.
What is the greatest investment risk for today's savers?
It's a currency devaluation. The expansionary monetary policy in the past relied on the resulting economic growth to absorb the new money supply. The numerator (GDP) and the denominator (circulation of money) grow together, so that each currency unit at least retains its value. Now new money is flooding the economy just to keep it afloat. The numerator stays flat (or even decreases) as the denominator shoots up. The value of each currency unit falls.
A falling base currency hits the values of stocks and bonds in long-term portfolios. Savers are less rich in terms of purchasing power than they used to be. The 60/40 split didn't help them.
In an environment where currency devaluation seems increasingly secure, a new type of portfolio hedging is required.
In this situation, assets that are immune to monetary policy and economic fluctuations are the ideal hedging instruments: assets whose valuation does not depend on the outcome and whose supply cannot be manipulated.
Gold is one such asset. Bitcoin is a different one, with an even more inelastic supply.
This has been boldly explained by the likes of Paul Tudor Jones, Michael Saylor (CEO of MicroStrategy), Jack Dorsey (CEO of Square), and others who have included Bitcoin in their portfolios and treasuries and are betting on its future value as a depreciation hedge. The idea is not new.
What is confusing, however, is that most professional managers and consultants still recommend splitting bonds / stocks when it no longer makes sense. Fundamentals have moved, but most portfolios are still sticking to an outdated formula.
Now, I don't recommend investing in Bitcoin per se. (Nothing in this newsletter is ever investment advice). The point I want to make is that investors and advisors have to challenge old assumptions in the face of a new reality. You need to rethink what coverage means and what risks your customers are really exposed to over the long term. Not doing is financially irresponsible.
It is understandable that in times of uncertainty we stick to old rules. With so much change, we instinctively reach for the comfort of the familiar. But it is precisely when things no longer make sense that assumptions must be questioned. Seldom has there been so much uncertainty about so many fundamental pillars of progress as there is now. In these times, the roles of professional investors and financial advisers are more important than ever as savers urgently need not only guidance but also protection.
It is therefore becoming increasingly important to rethink portfolio management strategies for conservative profiles as well. There is more than returns at risk if we don't.
Genesis (owned by DCG, also the parent company of CoinDesk) has released its digital asset market report for the third quarter, which shows strong growth in credit and trade volume and highlights an interesting industry shift.
Lending added $ 5.2 billion in new loans, more than double the amount in the second quarter ($ 2.2 billion). The growth resulted mainly from loans in ETH, cash and altcoins – BTC as a percentage of loans outstanding decreased from 51% to 41%. The number of individual institutional lenders increased 47% in the third quarter from the second quarter.
Spot trading volume increased by approximately 14% compared to the second quarter, with a clear upward trend in electronic execution. The volume of bilateral derivatives in the first full quarter of the derivatives desk was over $ 1 billion.
These numbers show two trends:
1) Growing institutional interest in crypto assets other than Bitcoin, largely due to the returns from the DeFi protocols. These are generally still too illiquid to hold significant institutional interest, but experimentation, both on-site and by investors, suggests that eventually innovative services and strategies will emerge that can handle larger volumes with controlled risk.
2) The advancement of increasingly sophisticated crypto trading and investment strategies by institutional investors. This underscores that the market for crypto assets is growing, which will bring in more institutional money, which in turn will provide incentives for further product and service development by Genesis and others. This positive cycle is driving the market where it should be: a liquid and sophisticated alternative asset market that affects how professional investors approach asset allocation more broadly.
The report also revealed that Genesis is working on a range of products and services designed to encourage the flow of institutional funds in and around the crypto market: a credit API that deposit aggregators can use to achieve yield, capital injection and fund management, and agencies trading. Together with the introduction of custody services in the third quarter, this will further consolidate the growing network of market investors and infrastructure participants.
This could indicate increasing consolidation in the crypto markets: the emergence of one-stop shops designed to support customers with all aspects of crypto asset management. A common obstacle to crypto investing is the fragmentation in the industry and the relative complications of positioning in crypto assets. Removing these barriers will make it easier for professional investors to take preliminary steps in the space, and access to liquidity could encourage some to make big statements.
Genesis will not be alone in this endeavor, and we could see a race by other well-known names to expand their inventory of institutionally-directed services. This could lead to a flurry of M&A activity as well as more strategic adjustments in traditional markets. In any case, the industry benefits from the additional experience and a mature market infrastructure.
Does anyone know what's still going on?
This week will undoubtedly go down in history as one of the most surreal when it comes to events that drive the markets.
First, Tuesday was the longest day I can remember. At the time of writing, Tuesday doesn't seem to be over yet.
Second, stocks seem to love uncertainty. Who knew.
Third, at a particularly confusing time, bitcoin price defies gravity, adding election results and political uncertainty to the potential narratives the market likes to understand.
Bitcoin's performance this week has cemented its position in the pantheon of outstanding outperformers of the year. The S&P 500 is putting on a good show, however – note that its November boost makes up most of its positive performance so far this year.
Veteran investor Bill Miller, Miller Value Partners' chief investment officer announced in an interview on CNBC this week that its MVP1 hedge fund has made half of its investments in Bitcoin. BRING AWAY: Another respected name cites inflation concerns as one of the reasons professional investors should consider Bitcoin. Another factor can be seen in Miller's statement that the risk of Bitcoin going to zero is "lower than ever". He speaks of asymmetric risk: the probability that Bitcoin will rise to USD 0 (a loss of 100%) is much less than the probability that a return of 200% or more will be achieved.
As if needing evidence that this Bitcoin rally is very different from the last one in 2017, the last time BTC was priced above $ 15,000. Google search for "Bitcoin" were also soaring. BRING AWAY: This implies that the hype is rather subdued this time around (despite the hubris on Crypto Twitter). This also suggests that fewer "newbies" are entering the market – buyers who are driving the price of Bitcoin up don't have to google it, which means they aren't just drawn to performance.
square According to an investor letter published this week, the Bitcoin service Cash app reported sales of $ 1.63 billion and gross profit of $ 32 million in the third quarter of 2020. This is a growth of around 1,000% or 1,400% compared to the previous year. BRING AWAY: Selling Bitcoin on the Cash app brings Square a little less than 2% profit. This is a very small margin compared to Square's overall business, which is running at much higher margins. However, the strong growth suggests a significant surge in retail demand for Bitcoin, which could partly explain the growth in BTC addresses and, of course, price dynamics.
Fidelity digital assets (FDA) hires over 20 engineers. In a post, the company said it was working to improve existing Bitcoin custody and execution services and develop new products. BRING AWAY: That stance hints at expansion plans for their digital asset services, which, given the reach of the FDA platform, could expand the boom for institutional investors.
We have published a special series of articles and publications on our topic Bitcoin for advisors Event from November 9th to 10th, all of which are worth reading:
This newsletter doesn't have much in focus ether (ETH), the native token of the Ethereum blockchain, as it lags behind Bitcoin in terms of market capitalization, liquidity, derivatives and the number of ramps. However, the infrastructure is maturing and there are significant technological changes that will affect the value proposition. In addition, it could serve as a good diversifier for a crypto asset allocation in portfolios. So far this year it has clearly outperformed Bitcoin (220% vs 117%).
When you're wondering where to go Ethereum 2.0 Our detailed explanatory report is about what effects this could have on the price and liquidity of ETH.
Ethereum 2.0 deposit contract is now live, marking a "point of no return" for the network to migrate to a proof-of-stake blockchain that aims to improve scalability and reduce costs. The Genesis time for Eth 2.0 is now set to December 1st, when 16,384 Validators have deposited funds of 524,288 Ether into the contract by then. BRING AWAY: The deposit agreement provides for 32 ETHs to participate in the new chain, which offers an annual return of up to 20% and acts as a one-way street between the current and the new chain. Ethereum's creator Vitalik Buterin has already sent 3,200 for 100 deposit contracts.
Crypto asset platform FTX announced that they will launch a staked ETH based derivative (called "Beacon Chain Ether" or BETH) that could act as a claim on the Beacon ETH when withdrawals are activated next year. BRING AWAY: This is just a hint of the innovation that will come as new products and use cases emerge. It could also increase interest in a staked ETH as it theoretically provides liquidity to participants and removes the illiquidity barrier for some investors.
Miners' income from processing transactions on the Ethereum blockchain more than halved in October as the madness for decentralized finance cooled and Transaction fees fell by over 60%. BRING AWAY: This drop in fees might not be so good news for the miners, but it's good for the Ethereum network as it indicates that congestion is going down. We covered this and other overload indicators in our monthly report from October 2020, which you can download here for free.