For a long time, many people have asked when and if the managers of the main institutional funds will begin to invest their powerful resources cryptocurrencies.
The correct question should be: why should institutional investors consider such an investment? It is no secret that cryptographic investments are among the most volatile and risky available at the moment. When, therefore, a pension fund, for example, whose fundamental principle is to protect its capital and minimize risk, be dragged into something unpredictable and immature like cryptocurrencies?
There has been a flood of community articles suggesting that many institutional investors (also called Smart Money) are ready to invest trillions of dollars in the cryptocurrency market as soon as the regulatory conditions are presented.
Big names like Rockefeller, Rothschild or George Soros investing in cryptography has stimulated the imagination of individual investors, raising the hopes for a return to rapid growth and the exorbitant returns on investments seen at the end of December 2017 and January 2018.
These articles they say that the main reason these institutions will end up investing in this market is "the enormous potential for development fueled by further development and by the real adaptation of blockchain technology in the economy".
While this thesis sounds more or less logical and is difficult to challenge, in my opinion, this is not exactly the case when it comes to institutional funds themselves.
The main difference between an individual investor and an institutional investor is that an individual investor looks to the investment through the prism of the growth potential, while an institutional investor does so through the risk prism.
As I have already said, cryptocurrencies appear to be "uninteresting" resources for institutions such as pension funds in this regard. C & # 39; is it something that could eventually convince them to invest in this market?
The correlation coefficient is called
The correlation coefficient is a fairly simple indicator that shows if 2 investment assets are moving in the same direction. The coefficient has a value between 1 and -1, where 1 is a completely positive correlation. That is, activities A and B are moving in the same direction with exactly the same performance, while the coefficient of -1 indicates a completely negative correlation – that is, 2 assets are behaving exactly inversely with opposite dynamics. The coefficient around 0 indicates no correlation.
A good example of a strong positive correlation is, for example, the price of crude oil and the price of mining companies' shares.
Ok, but why is it so important?
When building an investment portfolio, it is extremely important to select investment activities in such a way as to minimize the risk of loss. But what does this mean in practice?
Suppose our portfolio consists of shares in mining companies, oil futures, Norwegian krone (Norway is famous for its oil exports).
At first glance, we have highly diversified assets (stocks, commodities, forex); we feel safe. The wallet is going very well; The increase in oil prices is pushing our mining companies towards the top, while the Norwegian krone is also strengthening against other currencies. Our portfolio is much more advanced than the market benchmarks; we are investment geniuses!
After a few days, however, the oil market plummets, prices hit a dozen percentage points, the market is in complete panic. It turns out that we are not only suffering losses on oil contracts, but also our actions and the Norwegian crown are in freefall. We have lost all our profits in the blink of an eye, and our portfolio is losing very well despite the speed, although we wanted to limit the risk of such losses through diversification.
Where did we go wrong?
The fundamental problem of our portfolio consisted of poorly selected investment assets, which contributed to the tumultuous fluctuations in the value of our portfolio. The activities were strongly correlated; therefore, a standard reduction in the price of oil contracts of 3% meant that the value of the entire portfolio fell even further than this value. the form of diversification of the portfolio has failed to fulfill its alleged function.
So, how can we control the risk?
A key indicator used by investment portfolios is the so-called Sharpe Ratio.
This indicates the relationship between the potential risk, measured by the price volatility of a given asset and the expected return on investment. In short, the Sharpe Ratio helps investors determine whether the fund manager is taking the appropriate risk in relation to the expected return on investment.
The greater the value of Sharpe, the better, because it suggests a presumed higher return in relation to a certain level of risk.
Now for the most interesting part: we can improve our relationship by adding resources not related to our portfolio, even if they are at high risk.
Let's go back to our sample portfolio, which was basically based entirely on assets strongly linked to crude oil. If unrelated resources were added to our portfolio, for example, the shares of transport companies (which could even rise from lower oil prices), our portfolio would be more diversified and would probably lose less value.
So, where do cryptocurrencies come from?
We all know that cryptocurrencies are an extremely risky investment, but the most interesting feature of this market is the correlation coefficient with the traditional financial market.
As we can see, all the cryptocurrencies listed in the table above are closely related (with a factor greater than 0.5). After all, we see the "traditional" financial instruments that serve as a point of reference for the entire capital market.
To clarify, SPX means index S & P 500, VIX is the volatility index of the market (colloquially called "index of fear"), GLD generally represents the gold market and TNX indicates the yield of bonds US at 10 years.
In all 4 cases, we see that the correlation with the cryptocurrency market in the last year fluctuates around zero or even is negative!
This is the key mathematical proof of the lack of a correlation between the financial market and the cryptographic market!
What does this mean for Crypto?
The efforts of investment fund managers to increase their Sharpe Ratio will lead them to add cryptocurrencies to their investment portfolios, although they may not fully understand the technology itself or its potential in the future. For them, only historical statistics related to the correlation of this market with traditional investment instruments are important.
As I have already said, their investment decisions are made on the basis of statistical formulas and models and not on intuitions or a desire for rapid profits.
In my opinion, this is the biggest factor that will attract large institutional funds for the cryptocurrency market, which, due to the deflationary nature of cryptocurrencies and the hyperinflated nature of 99% legal currencies, must ultimately lead to higher prices.
Therefore, it is about "when" rather than "if".
So if you believe in the development of this technology and you've kept your faith up to now, and if you're a real investor, I have only one message for you … HODL!
Contribution by Piotr Wojdat
Piotr Wojdat is the manager of Due Diligence and Analytics at Memorandum.Capital, an international investment company focused on blockchain-based activities. Their experience in Venture Capital, Private Equity and Investment Banking allows them to provide exemplary services to their clients and great opportunities for attracting investments.