Pendal: Getting defensive with crypto

By Elizabeth Fry

Cryptocurrencies should be added to new alternative defensive portfolios as government bonds have lost their value as a hedge against risk says Pendal Group's head of alternative duration strategies, Vimal Gor.

Gor says as bond yields head to near zero and stay there, they are less likely to protect a portfolio from equity market weakness

"The main reason to hold bonds is to hedge against equities in times of stress, so when bond yields fall to zero and do not move, they cannot provide that defensive pay-off," he adds.

"The markets are completely different now, so why do we stick to the old ways of thinking about defensive portfolios."

He thinks it's dangerous for institutional investors to rely on government bonds and credit securities when building a defensive asset portfolio, given the dramatic changes in financial markets since the pandemic.

"Why don't we approach new asset classes and new ways of combining assets rather than running asset allocation processes that are 30 years old and now completely irrelevant."

The bond specialist is not arguing that cryptocurrencies can replace bonds. But while they are not a substitute, they do belong in a portfolio along with other assets with strong defensive characteristics.

He says cryptocurrencies offer a useful hedge because of the uncorrelated nature of their returns when compared to traditional asset classes.

Crucially, these markets sit outside of the price-setting mechanism that central banks control.

Rewriting the rules 

Gor is leading a new team at Pendal tasked with designing a new approach to asset allocation. He started a project three years called alternative duration which looks at getting defensive characteristics in a portfolio when government bonds no longer perform.

Gor's approach is to abandon the traditional portfolio optimisation model that has funds optimising asset allocation using forecasts of risk and return.

Essentially, he says, here the outcome is driven by the assets owned which is too simplistic.

In essence, Gor has turned that model on its head by defining the required outcomes or characteristics before determining the right asset mix to achieve that outcome.

Put simply, he has moved from a concentrated bond heavy defensive portfolio to a more diverse allocation by adding numerous asset classes and consequently, many more returns streams.

"The more returns streams you can add in the better and if you can add in a return stream from an asset like crypto that will make the portfolio more efficient," he explains.

Remarkably, given the positive attributes of cryptocurrencies, institutional investors are reluctant to invest in them.

Gor concedes there are reasons for this. Governments globally have been slow to respond with regulation for the cryptocurrency markets and the safe custody of assets was in doubt until recently.

However, that is all about to change. The roadblocks have been removed which Gor expects will trigger massive institutional demand in the next few months.

The bond specialist urges institutions to embrace the creation of new assets like cryptocurrencies.

"Investing in digital assets doesn't mean you're always going to hold them, but in some parts of the cycle, they work very well," he argues.

"Neither does it mean that you are holding crypto because you believe the fiat currency system will collapse, You should look at the asset purely as another return stream.

"Just because you don't like an asset, it doesn't mean you can't make money out of it."

In contrast to many of his peers, Gor did not wait for these safeguards to be put in place.

He thinks that crypto exposure acts and feels like an option so there is inherent protection already built-in.

"The chances that crypto will go to zero are low as the use cases are well defined, so you have limited downside and a massive upside. It looks like an option premium, and I would buy options all day long at these prices."

"You can put a little bit of capital down and see a big payoff."

How millennials invest remains a wild card for global investors when it comes to the adoption of crypto.

Gor says crypto will become the new gold and will play a greater role in the financial system He notes that there is US$15 trillion of gold in the world yet the market cap of the entire crypto market is just $US2 billion.

He notes that if everyone who buys gold as a portfolio asset switch to cryptocurrencies then the market will skyrocket.

"You don't find millennials holding gold," he explains.

´╗┐Blame the central banks

Gor blames quantitative easing policies for distorting the markets so badly that price discovery is now nearly impossible.  It has kept bond yields down and that has impacted every other asset.

As he sees it, central banks have become default political machines.

"After 30 years of trying to be independent, they have proven to be just a government arm whose sole job is to finance the government whenever they want to do fiscal easing," he said.

"Monetary policy soaks up the bonds. So what use are government bonds in your portfolio if they are largely manufactured in a manipulated market run by central banks?"

With yields at near zero, he goes on to say, global government bond markets go from being the biggest asset class in the world to being largely irrelevant.