APR 2020 - NEWSLETTER
The Case of Investing in Bitcoin
By Kas Vardhanabhuti
April 1, 2020
Based on my experience of working at global hedge funds like Soros Fund Management and Davidson Kempner, these are the times to make big macro bets. After a big crash, the world tends to change, providing select opportunities in new areas of the markets. One of the biggest opportunities that I see currently is in the digital asset space. I believe that the risk-reward of investing in Bitcoin right now is extremely skewed to the upside. I believe every portfolio (including institutional investors and family offices portfolios) needs to have a digital asset strategy.
With your investments in our fund, you have asymmetric exposure to one of the biggest macro opportunities in our lifetimes. Our fund is well-positioned to take advantage of both upside and downside directional movements in cryptocurrencies. We employ machine learning-based investment strategies that is fully automated 24/7, 365 days a year. Our algorithms find low-risk opportunities to enter / exit long and short positions. Although I expect Bitcoin and crypto as an asset class to rise significantly, there will be periods of large drawdowns if one invests in a long only / buy and hold strategy. Our fund avoids large drawdowns and allows greater compounding of investment returns by using artificial intelligence to trade the markets at high speed. Our algorithms process vast amounts of data and take directional exposure but only for short periods of times. This is one of the key innovations that our fund brings to the financial markets.
On the topic of crypto / Bitcoin, I have a bullish view on Bitcoin. Several fundamental valuation models suggest that Bitcoin price could rise to $100,000 range in the next 12-18 months from c.$7,000 today. While it is not our base case that Bitcoin will rise 14x, I do think there is significant upside potential underpinned by the following drivers:
Increase in money supply / helicopter money. The Fed’s balance sheet jumped by more than $1.1 trillion in the two weeks ending March 31, 2020 to $5.6 trillion. A figure that equates to more than $1 million in growth per second. Major US banks further forecast that the Fed’s balance sheet will reach $9 trillion end June 2020. As a result, I believe assets that are not quantitatively-easable (i.e. assets with a fixed supply) will outperform. Said another way, I believe the BTC/USDT cross-rate will rise significantly in the next 12-18 months given how much liquidity central banks are pumping into the markets. Bitcoin was invented in 2009 exactly because of this uncontrolled money printing.
Digital scarcity and the “halving” event in May 2020. In mid-May 2020, the amount of Bitcoin awarded per 10-minute block will be reduced by 50%. This means that Bitcoin will become a scarcer asset. Assets that are scarce tend to have higher valuation. This “halving” event could drive Bitcoin’s value. A fundamental framework to think about is the stock-to-flow model (SF). A high SF ratio equates to a high amount of existing stockpiles relative to its annual production. Gold has a high SF at around 60 (i.e. it takes about 60 years of production to recreate the current stockpile of gold). This is one of the reasons that gold is seen as a store of value. Bitcoin’s current SF is around 25 and will increase to 50 by the “halving” event in May 2020. It is difficult to know whether this is already discounted in the price but this “halving” is a catalyst that could drive a Bitcoin price rally.
Institutional participation in Bitcoin. Bitcoin is still under-owned as an asset class. Its market cap is around $130bn vs. gold at $9 trn (gold’s market cap is 70x Bitcoin’s market cap). Bitcoin is shunned by many investors across the world, being perceived as risky, volatile, difficult to securely store and hence not suitable for an institutional portfolio. Many companies (such as Bakkt, Coinbase, BitGo, and Gemini) are already offering institutional solutions for trading and storing cryptocurrencies. I believe that as the value of Bitcoin rises, more investors will need to own Bitcoin (whether to help with returns or as a hedge against inflation). In addition, one has to question what happens to bondholders when they receive negative real and nominal interest rates? Where will pension funds invest if they’re receiving negative bond returns but must fund future pension obligations?
Investment Risks. An investment discussion is not complete without highlighting the risks. There are of course multiple levels of risks that one needs to consider. Bitcoin fell around 50% in March 2020 peak-to-trough. A 50% drawdown is tough for anyone to stomach. There were three reasons for this large sell-off:
Events prior to and on March 12th, 2020 (COVID-19, oil dispute between Russia and OPEC, risk-parity bubble) led to a liquidation event / margin calls across all asset classes. As traditional markets sold off, market participants needed to raise cash. They sold off gold, US Treasuries and cryptocurrencies. In a liquidation event, correlations across different asset classes increase to 1.0. Everyone needs to raise cash from everywhere possible.
The moves in crypto were particularly large because many market participants were highly levered through futures trading (sometimes at 100x leverage). So as the market starts to sell-off, many crypto investors received margin calls, which precipitated a downward spiral as stop losses were taken out across the lower price continuum.
To further exacerbate the problems, the Bitcoin blockchain and one large exchange’s servers became congested, causing significant delays in processing. The normal arbitrage players across exchanges were unable to function properly to keep prices in-line across the exchanges.
These large and sudden sell-off events are main reasons why investors do not like investing in cryptocurrencies. From our perspective, we can mitigate most of these risks by leveraging our machine-learning strategies. I believe we will be faster, more nimble to reposition our portfolio in anticipation of these large market moves. Although we hadn’t started trading for the fund, all our algorithms were short ahead of the March 12th moves. We strongly believe our AI approach to investing in cryptocurrencies will find rich opportunities and we can generate high risk-adjusted returns for our investors in the coming years.