Will wealth managers learn to love bitcoin and its ilk, or will the associated volatility risks and lack of regulation remain a strong deterrent for most in the sector?
The surging popularity of cryptocurrencies and digital assets in general has caused consternation as well as excitement. In June, the Financial Conduct Authority (FCA) revealed that 2.3 million adults in the UK were holding crypto assets, up from 1.9 million 12 months previously. This prompted the regulator to warn investors that they should “be prepared to lose all their money”.
The suitability of these assets for ordinary retail investors has been fiercely debated, but what of the super-rich, the ultra-high-net-worth (UHNW) people who possess enough capital to safely accommodate high-risk investments?
The UK wealth management industry has yet to fully engage with cryptocurrencies. Many of the nation’s most established players have refrained from investing in them so far.
Charles Stanley Direct is one of them. The firm’s chief analyst, Rob Morgan, says: “We don’t consider crypto assets investable at present.”
But he adds that the buzz being generated by crypto investments means that the subject is coming up more in discussions with clients. “We can’t ignore the subject. It receives a huge amount of attention from the public and the media, so we have to hold open and honest conversations about what it is and the risks it poses.”
Tilney Smith & Williamson is another big wealth manager that has yet to take the plunge. The firm’s MD of corporate affairs, Jason Hollands, says that crypto investments are hard to discuss because the asset class is still at a “nascent” stage.
“When constructing portfolios for their clients, most wealth managers are highly focused on the risk/reward balance,” he says. “This can be especially true in the case of UHNW clients, whose objectives often include preserving the capital that they’ve built up over time. They can actually be less inclined than most to take unnecessary risks.”
Other wealth managers are unwilling to discuss the subject with clients. One of these is Rick Eling, investment director at Quilter Financial Planning, who describes crypto as “fool’s gold”.
He believes that such investments “should be considered more akin to gambling. Their volatile nature means that you should be prepared to lose everything. Cryptocurrencies are simply not a legitimate alternative to real investments.”
Traditional investment decisions use evidence-based assessments of a given asset’s value-creating potential. For instance, a wealth manager may choose to buy shares in a company because it is consistently making big profits. Hollands says the highly speculative nature of digital assets makes this a very different scenario for portfolio management.
“They generate no yield and it is questionable whether they have any intrinsic value,” he says. “Cynics might say that crypto investment is a classic example of ‘greater fool theory’. That is, to know whether the price of an asset is low, fair or expensive in the absence of fundamental valuation measures, you simply invest in the hope that the next buyer is willing to pay more than you have.”
Despite such criticism, more financial institutions are exploring how they might capitalise on the attention that cryptocurrencies are attracting. One such firm is WisdomTree, which is offering a number of crypto-based exchange-traded funds and products.
The firm’s director of digital assets, Benjamin Dean, accepts why wealth managers would want to steer clear of cryptocurrencies. But he argues that, with the right mix of assets, an appropriately sized crypto allocation can increase a portfolio’s Sharpe ratio – an indication of how well an asset’s returns compensate for the level of risk they oblige the investor to take on.
“Our analysis has indicated that making a 2% allocation to bitcoin in a sample global 60:40 equity/bond portfolio would have resulted in a 0.5 percentage-point increase in portfolio volatility, from 9.0% to 9.5%, and delivered a return of 9.4% compared with 7.1% for a 60:40 portfolio not featuring bitcoin,” Dean says. “In effect, adding bitcoin improved the portfolio’s Sharpe ratio from 0.71 to 0.94. To give some perspective to that figure, the MSCI All-Country World Index returned 10.1% with 13.7% volatility – equating to a Sharpe ratio of 0.68 – during our period of study.”
But it’s the lack of regulation that remains the main reason why many wealth managers feel that they can’t seriously consider crypto investments, despite the huge reserves and appetite for risk that some of their UHNW clients will undoubtedly possess.
“Insurers that provide professional indemnity cover are wary when it comes to cryptocurrencies. Very few are willing to underwrite crypto risks, which presents a challenge for wealth managers seeking cover,” says John Greene, divisional director at Howden Insurance Brokers. “The professional indemnity market is already challenged, with businesses facing higher rates and coverage restrictions, so they are probably choosing to avoid introducing extra non-essential risks such as crypto.”
The legal minefield surrounding crypto cannot be ignored, warns Kate Troup, a partner and specialist in financial services regulation at law firm Fladgate.
“It’s important for wealth managers to know that the FCA doesn’t want investors to be confused about whether or not a service offered by a regulated firm is covered by regulatory protections,” she says. “If managers do want to provide advice or management services for crypto assets, this must be managed carefully from a compliance perspective. To protect their reputations, they will need to consider whether they have the appropriate in-house expertise to ensure that they can offer a similar level of service to that which they provide for traditional investments.”
For these reasons, many wealth managers are choosing to steer clear of cryptocurrencies, notes Eling, who argues that there is no point in allocating such assets for his clients until better safeguards are available.
“We are likely to see a devastating collapse in the crypto market one day,” he predicts. “And I would not wish for our clients to be among the casualties.”