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Magazine Issues » October 2020

Digital gold: The untapped potential of cryptocurrency ETFs

Glass_ballLargely led by fund manager VanEck, the development of ETFs exposed to bitcoin and similar cryptos is hindered by regulatory challenges. This has created a realm of untapped potential. Alex Rolandi reports.

For many asset managers, investing in cryptoassets such as bitcoin or ethereum through exchange-traded funds (ETFs) or similar vehicles is unknown territory in more than one sense.

Crypto markets remain fragile, and blockchain-based digital currencies present a whole new regulatory landscape to navigate for ETF strategists. Volatility – which can often be extreme – is another factor to contend with. 

Investors who bought into bitcoin at its inception and held on to it would have seen their investment surge, but with a number of drawdowns along the way. This includes a drop of more than 90% in 2011 – the worst decline recorded, apparently – according to researchers at crypto financial services firm Galaxy Digital. 

Data from Morningstar shows the number of global ETF products has more than doubled in ten years, exceeding 7,400 at the end of August, but there are still very few cryptoasset ETFs or similar vehicles. In the US, none have been approved by regulators, while in Europe, none are eligible for Ucits funds either. 

New York-headquartered VanEck has been trying to get a cryptocurrency ETF-like proposal off the ground for some time now in the States. From the offset, regulation has stood in the way. 

In September last year, the firm pulled the plug on a bitcoin offering it planned to launch in conjunction with the software development and financial services company SolidX. The fund manager’s chief executive, Jan van Eck, has since said that a bitcoin ETF in the United States is a long way from becoming available.

Embracing volatility
For Dominik Poiger, a Frankfurt-based ETF project manager at VanEck, the fact that regulators are scrutinising the asset class, and asking questions such as how companies can guarantee protection for their clients’ assets, is only natural. 

“Cryptocurrencies trade 24/7 and aren’t regulated. It’s a completely new asset class and difficult to understand,” he tells Funds Europe. “You have to be really careful.”

At the same time, the ETF trader believes that holding on to bitcoin long-term is enough to watch the initial investment grow, highlighting how it has outperformed many other asset classes. He questions what value active management can add. “There are multiple studies asking if active really is outperforming, and it’s not. I would presume that this tendency also applies to cryptoassets or bitcoin in general – hold on to it and wait,” he says.

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This view is backed up by the data. According to ETF specialist WisdomTree’s head of capital markets for Europe, Jason Guthrie, allocating to the cryptocurrency through a passive and systematic approach should ultimately lead to returns.

“For example, a 1% target weight, rebalanced at regular intervals, would have historically managed to harness bitcoin’s unique return profile, benefiting from sharp and sudden price appreciations in the asset, with a limited increase in volatility,” he says. This results in a material improvement of the portfolio’s Sharpe ratio, he adds.

From an investment point of view, VanEck’s Poiger argues, the key is to embrace cryptocurrencies’ volatility. “We see bitcoin as a form of digital gold,” he says. 

Looking at the bigger picture – and how bitcoin has performed against traditional asset classes since its creation, and has served as a diversifying asset – its volatility becomes irrelevant, he says. 

One commentator – financial services firm deVere’s chief executive Nigel Green –recently argued that within a generation, bitcoin will overtake gold as the go-to safe-haven asset in times of uncertainty. Millennial and Generation Z investors, Green said in a statement, “can be expected to go for bitcoin and other digital currencies instead”. 

Mining alternatives
The largely untapped potential of cryptoassets could be a digital goldmine for fund managers seeking further diversification in this ongoing environment of sky-high stock valuations and low, or even negative, bond yields.

“Money is being printed like never before, but bitcoin’s monetary policy cannot be manipulated,” says Poiger. 

According to WisdomTree’s Guthrie, who believes there is space for both active and passive management in the crypto area, even a small allocation to bitcoin can help improve a risk-adjusted portfolio.

“Despite showing a propensity to fall alongside other assets in times of intense market stress like we experienced back in March, bitcoin’s correlation remains low with traditional asset classes and alternative strategies over longer time frames,” he says.

WisdomTree launched its own physically backed passive bitcoin exchange-traded product (ETP) last year, listed on the Swiss stock exchange SIX. At launch, the firm’s head of Europe, Alexis Marinof, said that there was enough evidence to conclude that digital assets like bitcoin are “not a passing trend” and can play a role in portfolios. This is especially important given current investment circumstances. 

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In Switzerland, Dr Mattia Rattaggi, board chairman of boutique crypto specialist Ficas, believes traditional asset classes are saturated. “There’s a sense that we’ve reached the peak in these areas,” he says. “This is the proposition for diversifying: because other asset classes are exhausted.”

In July, Ficas unveiled what it claims is the first actively managed cryptocurrency ETP. Also listed on SIX, the product operates in a regulated environment, but is not actually regulated or supervised by the country’s financial authority. “Otherwise it wouldn’t be an ETP,” notes Rattaggi. 

Mitigating risk
Using a discretionary approach, he explains that the strategy trades bitcoin against other top-15 coins and moves to fiat currencies when this is deemed the best option, depending on movement in the markets. It means that investors in the ETP, available only through banks and brokers, are not overly exposed to the risk associated with cryptocurrencies, he says. 

The portfolio’s management relies on fundamental analysis to try and avoid the infamous dips seen in cryptocurrencies. Working with the right custodians also plays a key part in guaranteeing a level of security for investors. 

The launch came about against a backdrop of increased demand for diversification and alternative assets. The cryptocurrency strategy’s assets under management have since grown by around 50% to over three million Swiss francs (€2.8 million), according to the firm. 

“Setting it up was a challenge as we were venturing into unchartered waters, but this was part of the endeavour,” says Rattaggi. 

The fact that Switzerland is already a “crypto nation” facilitated the process, he adds. “There has to be an element of open-mindedness to innovation.” 

For VanEck in the US, it would be a different story. But VanEck’s Poiger says there is no way around the fact that bitcoin and other cryptoassets are becoming increasingly relevant.

Investing in cryptocurrencies through ETFs and similar products can act as a non-correlated diversification tool for both institutions and retail investors. Having the right expertise is paramount, however.

“The uncorrelated asset and diversification effect has become clearer to more and more investors – they just need to have patience,” says Poiger.

Unlike Poiger, Ficas’s Rattaggi believes active management is a “very appropriate way forward” for cryptoasset ETFs in order for them to function well. While passive investing may be the best approach for traditional asset classes, because markets are already efficient and well-structured, this is not the case for crypto markets, he says.

Entering the cryptocurrency space through a passive vehicle, or without the necessary knowledge base, leaves investors at the mercy of the market, Rattaggi argues. It could blow up in their face and they could lose everything – meaning deep knowledge or a strong algorithm is crucial.

Given how uncharted this territory is, there are likely to be many ‘firsts’ in the cryptoasset ETF space over the coming years as technology improves and regulation evolves. 

Established fund manager Fidelity Investments rolled out its cryptocurrency business in Europe last year to help European institutions invest in digital assets. Called Fidelity Digital Assets, the business is intended to offer clients access to custody and trade execution services for digital assets and an institutional-grade solution for bitcoin access, including vaulted cold storage.

More developments like this will surely follow that could, eventually, provide the right basis for cryptocurrency ETFs.

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