By Dan Hallett on December 5, 2019
I have often criticized the investment industry for pumping out products designed to sell, rather than build, wealth for investors, and have worked to raise investor awareness of how gimmicky products destroy wealth. The battle against such products took a step backward recently with an Ontario Securities Commission (OSC) panel’s decision to allow a Bitcoin investment fund’s launch.
The OSC was initially opposed to the fund, citing several concerns pertaining to public interests. The panel’s decision document clearly lays out the OSC’s legal limits when it comes to approving products that are considered risky and speculative. Ultimately, the panel concluded that the fund will be able to reliably value the fund’s assets, secure the holdings (from hacks/theft), and complete a full financial audit.
Look Elsewhere for Wise Diversification
Many look to Bitcoin – and other assets like gold and other commodities – to provide diversification from traditional financial assets. An investment must meet two basic conditions for it to effectively diversify a portfolio:
- It must be poorly correlated with other investments
- It must produce a positive return
Bitcoin passes the first test with flying colours. But the second – providing a positive return – is quite a leap of faith, and violates the warning attached to virtually all investment products.
Regulators have long required every investment fund prospectus to be stamped with a statement reminding investors that past performance is no indication of the future. And yet, it seems that any assumption that bitcoin offers portfolio diversification is implicitly based on bitcoin’s performance during its one-decade in existence. This is a drop in the bucket with regards to financial market history. But there are two problems with this assumption.
First, we have no idea – even using history – how Bitcoin will behave in a recession, financial crisis, or bear market. History can be useful to gauge behavioural patterns and worst-case scenarios. But Bitcoin hasn’t existed through any such environment.
Second, by claiming that Bitcoin can diversify portfolios, I wonder what basis is used for assuming positive future returns. As I stated in a Globe and Mail article on the panel’s decision:
“We design client portfolios to achieve a specific goal – a specific long-term return target. I can take each component of the portfolio and give you a very good ballpark estimate of how each piece will contribute to achieving that long-term goal. I have no idea how anyone can do this with bitcoin or any cryptocurrency. It can’t be done.”
Rely on Facts and Sensible Models
We have designed an algorithm to forecast long-term asset class returns. The method is summarized in this 2012 blog post and has proven pretty accurate. But Bitcoin doesn’t fit into this and any other sensible model that facilitates a confident return forecast. I’m certainly not comfortable blindly relying on ten years of data to form any type of future return expectation, particularly since that decade overlapped a very long economic recovery and bull market.
Bitcoin and other crypto or digital currencies are likely to have a future. And blockchain technology seems destined to change some industries – e.g., the way we handle legal documents. But investment assets require fundamental characteristics upon which to base some value assessment and, in turn, return expectations. In the absence of such characteristics, buying Bitcoin and other cryptocurrencies either for attractive returns or portfolio diversification is speculating – not investing.
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