- Institutional investors, including pension funds, show increased interest in cryptocurrencies.
- Cryptocurrencies could play a role as a diversifier of the pension fund portfolio.
- However, there are some obstacles to overcome such as regulatory uncertainties and the high energy use of crypto mining.
On first glance, cryptocurrencies are not something you would expect in the portfolio of a pension fund. The crypto market, often labeled as a ‘Wild West market’, is known for its high volatility, high regulatory risk and sometimes even as a mean for money laundering. Pension fund on the other hand, tend to act conservative and are reluctant to non-quantifiable risks. Furthermore, the investment decisions of pension funds are often based on various ESG requirements which does not fit well with the high energy use of crypto mining. Nonetheless, we see an increased interest of institutional investors, including pension funds, in the rapidly growing crypto market. But how would cryptocurrencies fit in the portfolio of a pension funds?
According to a recent study of Fidelity Digital Assets, it does not stop with interest of institutional investors. Their survey states that 56% of European institutional investors is actually already invested in cryptocurrencies. Pension funds are a bit more cautious with including cryptocurrencies in their portfolio, there are however a few exceptions. Thus far, some smaller funds in the US have included cryptocurrencies in their portfolio. Furthermore, one of Australia’s largest pension funds QIC mentioned considering investing a small part of their portfolio into cryptocurrencies. Another interesting example is CDPQ, the second largest fund of Canada. They made a significant investment in Celsius Network, a crypto lending platform, because they believe in the future of blockchain technology. However, they also mention that a direct investment in for example Bitcoin is a bridge too far.
The specific case of CDPQ is an example of how pension funds are interested in blockchain technology but are reluctant to directly invest in the crypto market. An important reason for this is the immaturity of the operational framework for institutional investing in the crypto market. When the industry matures and regulatory requirements become more clear, it becomes more likely that pension funds will follow other institutional investors and allocate some of their wealth into cryptocurrencies. For the time being, ETPs (Exchange trade products) appear to be viable option for institutional investors interested in investing in cryptocurrencies. ETPs are securities that track underlying securities, which also could be cryptocurrencies. In this way, pension funds can invest in cryptocurrencies without interaction with unregulated entities and operational setup costs associated with entering a new kind of market. A potential drawback of these ETPs is that the investors are limited to the cryptocurrencies offered by the issuer, which are often only the most liquid ones. However, for a multi-asset portfolio of a pension fund this likely is sufficient. Moreover, investing in altcoins (all cryptocurrencies other than Bitcoin) requires more research on the use case of the token and is even more speculative and uncertain than Bitcoin. It is therefore likely that most pension funds would start with Bitcoin, which already is a very speculative investment from the conservative perspective of pension funds.
Individual investors often try to earn high returns in a short time period on the crypto market. For pension funds however, the reason to invest in Bitcoin would be more from a diversification standpoint. In this way, the high volatility of Bitcoin is not a large problem, of importance is the volatility of the entire portfolio. This volatility is greatly influenced by the correlation of the assets within the portfolio. The portfolio of pension funds typically consists of asset which often have a low correlation among each other such as stocks, bonds, commodities and real estate. The advantage of Bitcoin is that it has a low correlation of around 0.2-0.3 with stocks, bonds and real estate. Bitcoin has therefore great potential as a diversifier. This means it might be optimal for a pension fund to invest a small percentage of their portfolio into Bitcoin.
However, the optimal asset choice depends on more than the risk-return tradeoff. Many pension funds would be afraid of their reputation and are therefore reluctant to invest in cryptocurrencies. The main reason is the mismatch regarding sustainability between cryptocurrencies and pension funds. A lot of cryptocurrencies, including Bitcoin, are based on blockchain technology which involves crypto mining according to the ‘proof of work’ method. This method requires a lot of computing power which leads to extremely high energy use and a high carbon footprint. However, there are also cryptocurrencies that use the ‘proof of stake method’, where block transactions can be mined or validated based on the holdings a party has in that coin, which does not require high energy use. With this method some cryptocurrencies are even able to have a carbon negative network like for example Algorand. The chance that Bitcoin changes to this method is quite low because of the large technical challenges involved in this transition. It is however, not impossible to change from one method to another. Ethereum, the second largest cryptocurrency based on market capitalization, is currently in the process of switching to a proof of stake system. Transitions like this, can make cryptocurrencies more attractive for pension funds since it makes them more sustainable. Important to consider is that this means that pension funds should be comfortable with investing in tokens other than Bitcoin.
For now, it seems that cryptocurrencies do have some potential to have a place in the portfolio of pension funds, mainly for diversification purposes. There are however, some issues which probably only can be overcome as the crypto market matures, which may take some more time or may not even happen at all. Particularly interesting would be to follow if cryptocurrencies with sustainable blockchains can obtain a similair status as Bitcoin has now.