We receive inquiries regularly regarding our thoughts on whether to include cryptocurrencies in portfolios, especially in moments like recent months when the price of Bitcoin has been testing new highs. Our answer to this question is “No, at least not yet,” and we’d like to explain our thinking in some depth.
While we value innovation and find the rise of cryptocurrencies to be fascinating, we continue to advise caution on including it in portfolios. At Mercer Advisors, we are fiduciaries and trusted stewards of our clients’ hard-earned wealth, and it is through this lens that we should consider the basic question of whether to invest in crypto.
There are many assets an investor could buy, but not all of them qualify as “investable assets.” We define an investable asset as something that satisfactorily passes three basic, yet critical, tests:
- The asset should reasonably be expected to generate future cash flows.
- Investors’ ownership rights of the asset should be well-defined and enforceable in U.S. courts of law.
- You should be able to invest in the asset through a regulated market (whether public or private) where buyers and sellers can freely and securely transact.
In serving our clients, we believe it’s critical to build portfolios that consist exclusively of high quality, investable assets. At the time of this writing, cryptocurrencies, including Bitcoin, do not satisfactorily meet our definition of what it means to be an investable asset. We will continue to follow developments in this space, but for now, here is how we evaluate Bitcoin against our three tests.
Test #1: An investable asset should be reasonably expected to generate future cash flows in the form of profits, dividends, interest, rental income, etc.
When we think about most investment assets, they generate some type of cash flow. Free cash flows are dollars generated by assets for the sole legal benefit of investors. Investors in investable assets can be either owners or lenders. Investable assets are businesses that earn profits and potentially pay dividends. They could be bonds that pay interest to lenders. Or real estate that produces rental income. One purchases these such assets to have a legal claim on those future cash flows. Bitcoin, obviously, generates no such cash flow.
The problem of valuation
Without current or future expected cash flows, it’s arguably impossible to put a price on an investable asset. Consider Bitcoin’s current price of approximately $92,000. If one believes $92,000 is a “good price” at which to buy, at which price would one sell? And why? Why is $92,000 a “good price”? Should one buy Bitcoin at any price?
With stocks, bonds, real estate, private equity, or private credit, investors can relate the valuation of the asset to the profits or interest income the asset is expected to generate. This is not just useful for analysis of the asset, it’s the fundamental reason you buy the asset in the first place – for that future cash flow.
Betting on appreciation alone
Bitcoin has certainly enjoyed considerable appreciation. But betting on appreciation alone, sans cash flows, is a textbook example of the “Greater Fool” theory. It’s true that if you can find someone to pay even more money for your asset then you can profit, but who will this person sell the asset to? Finally, market participants are generally highly sophisticated; said differently, there are few fools in financial markets (at least at scale) that affect prices at the margins.
What about commodities? Commodities generate cash flow at the point of sale, and their cash flow is a function of their utility in producing industrial goods, cars, mining equipment, or jewelry. Their cash flows are a direct derivative of the end-state products they’re used to manufacture.
Bitcoin lacks such use cases. To some extent, Bitcoin resembles a form of “digital gold” (although gold does have some industrial and commercial use). Though its current valuation cannot be denied, its lack of cash flows or demand – and its reliance on betting on appreciation – could be a key driver of Bitcoin’s dramatic boom and bust cycles.
Test #2: We must be able to enforce our claims of ownership in a US court of law
A central challenge with cryptocurrency and bitcoin, specifically, is you don’t really own anything. There’s no deed, or title, beyond the blockchain itself. Some may see this as a benefit, but if you needed the courts to enforce a claim of ownership there may be nothing they can do, as only the person who knows the keys to the cryptocurrency can transfer it.
In the absence of a system of deeds or titles, nothing exists to establish rightful ownership. This is a potentially serious complication in many legal situations: bankruptcy proceedings, splitting assets in a divorce, settling an estate. Many of these scenarios are when clients turn to us for the help of a unified in-house team.
Consider the headaches created when FTX failed in November 2022, holding funds for over 1 million customers. The firm’s chief executive, Sam Bankman-Fried, went to jail and the bankruptcy courts have only recently approved plans to begin making payouts to creditors of the exchange. Crucially, customers won’t receive their Bitcoin back; they’ll instead receive a payout based on the value of Bitcoin at the time of the collapse.
Given the lack of public record via a system of deeds and titles, it is unusually easy to lose crypto assets. This has led to a remarkable situation where an unknown number of Bitcoins – estimated as high as nearly 4 million out of only 21 million that can be produced – are likely forever lost because keys were forgotten or lost on old hard drives, or the person who knows how to access the coins dies. Perhaps the hardware on which keys were stored crashes or is lost. (Famously, a man in Wales inadvertently threw away a computer containing the keys to Bitcoin now worth $800 million. He has sought to excavate the landfill to retrieve it.)
One can’t accidentally throw away the computer holding an $800 million stock portfolio and have no recourse.
Test #3: A regulated market where buyers and sellers can freely transact in a regulated, transparent, and secure manner
Whether bitcoin and crypto fit that bill remains to be seen. There are many companies working on developing this sort of regime, but for now this represents a real risk to investors.
There is huge value to investors in being able to transact in a regulated, transparent, and secure marketplace. Securities exchanges, state laws protecting buyers and sellers, U.S. GAAP, anti-money laundering laws, the Public Company Accounting Oversight Board (PCAOB) – these are all arguably really, really good things for investors. They boost investor confidence in markets and facilitate capital formation.
It was a lack of regulation that contributed to the fraud committed by FTX and its subsequent collapse. No regulatory oversight existed to detect that the company was comingling customer funds with its in-house hedge fund. John J. Ray, the executive brought into wind down FTX during the bankruptcy proceedings remarked “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” We should note that John J. Ray was also the same person brought into wind down Enron.
Many people expect the incoming Trump administration to create a more favorable regime for cryptocurrencies. President-elect Trump has said he intends to be a “crypto president.” That could mean that some of the regulatory ambiguities facing crypto may be resolved, but it remains to be seen exactly how this will be implemented.
Takeaways
Despite the current high price of Bitcoin, it’s our view, as fiduciaries, that it still doesn’t meet the most basic requirements to be considered an investable asset. That said, humility in all things, especially markets, is important; this space is still rapidly evolving. The answer to any of our three tests may change with time and, consequently, so might our decision to consider it worthy of investment. For now, we’ve chosen to pass.
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