Use of digital assets within an SMSF
Diversification is the gift of good portfolio construction: you can keep expected returns high, but you can significantly reduce risk. Unfortunately, in an environment of central bank financial repression, where defensive asset classes offer negative real returns, good portfolio construction is more difficult to achieve. Digital assets, with their hedged volatility, represent a big opportunity.
In Australia, established SMSFs have had the opportunity to invest in property at reasonable prices, which has proven to be an excellent investment offering growth and rental income. Similarly, other SMSFs have built reasonably priced equity portfolios that offer both growth and dividend income. Focusing on either asset class is a valid, albeit high conviction, investment strategy.
Going forward, however, SMSFs face a different investment environment.
First, interest rates will eventually rise, probably sooner rather than later. The value of any financial asset is the present value of its future cash generation and higher interest rates decrease the value of those future cash flows. Simply put, higher interest rates are generally not good for stocks and real estate. Add to that very high equity and real estate valuations and logic dictates that now may not be the ideal time to allocate more to these asset classes.
It would also make sense to introduce some diversification to complement the excellent existing exposures already held. There is a science to diversification – essentially good diversification reduces risk without reducing return. In practice, this means that you need two elements of due diligence: first, the potential investments could match the return generation of your stocks and/or real estate, and second, the potential investments would behave differently than your stocks. and/or real estate.
THE RIDDLE OF CORRELATION
Let’s dig a little deeper into the second point about behavior. A good portfolio is like a marriage, when one partner is going through a rough patch, the other partner can somewhat balance that negative. The most common metric used to calculate the ability to “balance” a particular asset is correlation – if an asset is highly correlated with the rest of your portfolio, it’s like a husband and wife being stressed at the same time. What we really want are uncorrelated assets that offer strong diversification benefits.
Calculating the correlation manually means dividing the covariance by the product of the standard deviations. Financial software easily provides this information, or like everyone else in finance, you can use the “Correl” command in Excel. The final result will be between -1 (perfectly correlated negatively) and +1 (perfectly correlated positively).
As the table below shows, many of the investment options that one would expect to have strong diversification characteristics do not. For example, over the five years, real estate in the eight major Australian capitals has had an almost perfectly positive correlation with Ether, the cryptocurrency used in the Ethereum blockchain.
Even gold, which is a commodity and generally considered a good tool for portfolio diversification, had a positive correlation of 0.44 with Australian equities and a very strongly positive correlation of 0.74 with global equities on the period.
Correlations of 0.4 and 0.5 are not what we want. What we really want is no correlation or, even better, negative correlations. Historically, we have used bonds for this purpose, but with inflation rising and expected to rise further, and central banks continuing their financial repression, negative expected real returns are a heavy price to pay for your diversification.
SMSF INVESTMENT STRATEGY
Portfolio construction challenges like those discussed above are addressed in an investment strategy, a document as important as a trust deed and over which you will have much more control. The first point to note is that SMSFs must have a documented investment strategy. This should not be viewed as a burden, but rather as a way to use these structured governance responsibilities as opportunities and embed good portfolio construction practices into your own financial well-being – after all, an SMSF is a matter of choice and control. Each institutional investor will have a documented investment strategy incorporating in-depth stakeholder analysis and discussions.
Some of the points to address in your investment strategy:
Risk Appetite – Institutional money managers start here, for example, what is the maximum amount I would be willing to lose in a “worst case” stress test scenario? This is key information because a portfolio can then be constructed to maximize the expected return without violating the worst case scenario. A simple approach to quantifying risk is standard deviation, while a more detailed approach would be to model certain scenarios using historical data to inform of an expected shortfall.
Return Objectives – The returns generated over time will have a huge impact on the purchasing power of a portfolio in the future. Investors demand more return for more risk, so for higher returns you will generally need to subject the portfolio to volatility and even the risk of permanent capital loss. A simple approach to expected returns is the average of past returns, a more detailed approach involves one or more valuations.
Tax efficiency – Superannuation is an ideal environment to invest due to tax efficiency. The realization of volatility-inducing capital gains and losses is generally less welcomed than income.
One approach Balmoral Digital has pioneered for Australian SMSFs is to harness the notorious volatility of digital assets and turn that volatility into a revenue stream.
The first step is to do due diligence on the digital exchanges and digital protocols you are willing to invest in. The protocols selected must have sufficient liquidity in the corresponding derivatives to be able to cover the risks. Earlier in the article we mentioned looking for low levels of correlation to improve diversification, Balmoral’s portfolio is full of stocks that are perfectly negatively correlated to the stocks we hold, making our portfolio effectively delta neutral. Recall that investors require compensation for additional market risks, by hedging its market risks Balmoral removes the volatility of the underlying assets and currency risk and thus changes the risk profile of our portfolio into a very stable investment.
Looking at the derivatives we use, many of them will pay us to take this position. For example, if we own bitcoin, we can hedge it with a short bitcoin futures contract. If we take the short side of a bitcoin futures contract that allows another investor to take a long position in a bitcoin futures contract, which is a leveraged play on
Bitcoin. If investors expect Bitcoin to rise, it makes sense that they would pay their counterparty (Balmoral) to take the short side of their trade. This way, we eliminate our market risk and in doing so turn that volatility into revenue generation.
Finally, we have a proprietary database tracking the historical rates that counterparties have been willing to pay, across all exchanges, for the various digital assets and their derivatives.
When one of our investment positions is no longer generating returns, we seek to consider the expected return, the stability of historical returns and the liquidity available in alternative positions. This database ensures that we consider the most profitable opportunities for our investors first, as we eliminate those where there is insufficient stability or liquidity for our lower risk profile investment strategy.
There are several advantages to this approach:
Because digital assets are so volatile, the return potential of our delta neutral approach is very strong. The strategy can generate double-digit returns and thus contribute strongly to the investment objectives;
By hedging all directional risk, the fund eliminates market risk. This means that the investor is not shaken by the rising and falling prices of digital assets, the extreme volatility for which they are so famous. This characteristic, combined with strong returns, means that the fund offers very strong risk-adjusted returns, or Sharpe ratio, a measure sought by most institutional investors;
Since market risks are hedged, the fund is uncorrelated to existing SMSF investments, such as real estate and equities. This means that the Digital Asset Fund offers strong diversification characteristics, which will be the logical cornerstone of most SMSF investment strategies;
By exchanging capital gains for income, the investment is better suited to SMSF’s tax-efficient environment, whether in funding, transitioning to retirement or in the drawdown phase. Instead of dealing with realized capital gains and losses, income received receives more favorable tax treatment under the super environment; and
The fund offers SMSF investors a lower-risk way to invest in the extraordinary growth opportunities available in digital assets.
Investors will benefit from the innate technological sophistication of the asset class. For example, Balmoral investors will have a mobile app showing the value of their investment in real time and offering a direct connection to their investment manager.
Angus Crennan is co-founder and portfolio manager at Balmoral Digital.