Last financial year, we began investing in crypto currencies, influenced by the work of Lyn Alden. and her analysis of Bitcoin, along with Real Vision's Crypto White Paper.
The reason why Bitcoin is attractive to us is as follows:
High returns. Bitcoin has outperformed very other asset class over the past 12 years.
Scarcity. There will only ever be 21 million bitcoins in existence. Scarce asset valuations perform very well in the current environment of expanding central bank balance sheets and low interest rates.
Security. Bitcoin secures payments and transactions through proof-of-work, and as the network of users, nodes, and miners grows, the network becomes more secure.
Network effect. Over the past 12 years, the number of Bitcoin users has grown to 135 million people. Currently, on chain data shows 1.2 million users are being added to the Bitcoin network per month (source: @woonomic).
Optionality. Layer 2 applications, such as the lightning Network, are broadening Bitcoin's use case beyond being a store of value. Currently, the Lightning Network capacity is growing at a rate of 20% per month.
Dominance. Bitcoin is the dominant network, with the most users.
Bitcoin's decentralised foundations, make it very difficult to change the protocol's core features, ensuring protocol stability.
Bitcoin's returns have a very low correlation to equities, with Bitcoin returns following the four year rhythm of the protocol's halving cycle. As can be seen in Figure 1 below, the SPX - Bitcoin correlation is extremely low, typically within the range 0f 0.2 to -0.2. Bitcoin's correlation to equities is very similar to that of gold.
Figure 1 - SPX - Bitcoin Correlation
Our Approach to Investing in Crypto Currencies
We have outlined above why we like Bitcoin and the crypto currency sector, however, the sector and opportunity comes with a number risks and downsides, that we outline below:
High volatility. Bitcoin volatility, as can be seen in Figure 2 below, shows Bitcoin's volatility since 2016 in comparison to the S & P 500, gold, and fixed income. A small allocation to Bitcoin will have an outsized impact on one's investment returns.
Figure 2 - Bitcoin Volatility Comparison
As the Bitcoin network grows, it will become an increasing threat to central banks and government, who compete for investment capital. There is a risk that central banks will attempt to ban the network if it gets to big, and draws away the interest of future bond holders. .
An entity attempts a 51% attack on the Bitcoin network. it would be an enormous undertaken, and is highly unlikely, but is theoretically possible.
Governments regulations fail to keep pace with innovation and change in the sector, resulting in adverse regulatory outcomes.
Bitcoin miners fail to establish ESG appropriate practices, deterring institutional adoption.
Given the volatility of Crypto assets, and some significant tail risks, we have limited the size of the Crypto Fund to 5% of total assets under management. The upside of the volatility in Crypto assets, is we need a smaller proportion of Crypto assets to hedge against the volatility in our other two funds, making the 'Gold Hedge' in Luke's Fund now unnecessarily large. This will be wound back over time to a 5-10% position in the portfolio.
Initially, the fund will only invest in Bitcoin, but we anticipate diversifying into other Crypto assets over time, once a protocol/ /token has demonstrated it has:
A strong, growing network effect.
A sustainable use case.
A clear competitive lead.
A large developer ecosystem.
Performance in FY 2020/21
Luke's Crypto Fund achieved a return of 56.4% for the financial year, and this is despite the majority of assets being deployed in the second half of the financial year.
The Breakdown in asset allocation between the three funds as at June 30, 2021 is as follows:
Figure 3 - Asset Allocation Pie Chart
As can be seen in Figure 3, we were close to our maximum allocation size as at June 30. Given we are possibly entering the final phase of the Quadrennial bull cycle, we intend to allow the Crypto Fund to expand up to a 15% allocation of assets for a maximum period of one month. Proceeds from the sale of crypto assets for re-balancing purposes will be transferred to Luke's Fund and Luke's Global Fund on a 50 / 50 % split. Should the Crypto Fund asset allocation fall below 4%, funds will be distributed from Luke's Fund and Luke's Global Fund on a 50 / 50 % split to restore the 5% allocation over time. However, we intend to allow the Crypto Fund to fall well below the 5% asset allocation for a duration of up to 12 months, given this reflects the typical Crypto bear market duration.
Future Reporting
Given the relatively small size of the Crypto Fund, we will provide updates quarterly, and we will include a review of our overall asset allocation between the three funds as part of the Crypto Fund reporting.
If you have any opinions on our asset allocation, crypto, or what like to know more, we would love to hear your feedback.
Regards,
Sean