Can Family Offices Protect Their Legacy Without Bitcoin?
It is now irresponsible for fund managers with medium to long term investment horizons to have no allocations in scarce and non-debaseable assets.
Initially published on the blog of Knox Custody.
The looming “Great Monetary Inflation” hints at no.
It is now irresponsible for fund managers with medium to long term investment horizons to have no allocations in scarce and non-debaseable assets. Over the last decade, bond yields have reached their lowest lows, real estate has recently hit all time highs, and an ounce of gold is now topping $2,000. Many asset classes are inflating in fiat terms. Most asset classes are accruing a monetary premium for their relative scarcity compared to central bank-issued fiat currencies, divorced from the intrinsic value of their underlying valuations or cash flow models. Such currency manipulation leads to market price distortions confusing participants in their allocations of capital—leading to wide-scale misallocations that build up over time.
Even risk-on assets such as stocks have been surging since the global monetary printing presses went full blast back in March 2020, with over $6 trillion of quantitative easing, all the while fundamentals such as corporate earnings have stayed flat if not worsened. Wealth inequality is further polarizing society as rich asset owners get richer, while poor workers keep spinning on the hamster wheel, living paycheck to paycheck. A phenomenon known as the Cantillon Effect is at play, where monetary inflation favors entities that are the closest to the source of money production, such as public companies. Political extremism and global social unrest are direct consequences of such economic distortions.
Global monetary printing presses are being legitimized by politicians, leveraging populist narratives of universal basic income and helicopter money to cool down social tensions. At the crossroad of monetary easing and fiscal austerity, politicians and governments will favor options that would most likely get them elected—a subtle fiat currency debasement. The money printing press is acutely politicized. Uncertainty in the markets materializes in price volatility, but it is artificially choked. In such an environment where market price signals are distorted by currency manipulation, how do individuals and families make sound investments to preserve wealth and capture value? What is a responsible capital allocation strategy for the next 20–30 years, let alone the next 50? How do politics play into the risk management strategies of these fund managers? Can family offices afford to not hold an apolitical and scarce asset such as Bitcoin?
Multi-generational wealth management is a complex risk equation best thought about with a multi-decade time horizon. Bitcoin appears as one of the most responsible instruments to hold to limit political, inflationary, fiscal and capital controls risk. In this brief essay, we will be evaluating how family offices and high net worth individuals need Bitcoin to preserve wealth.
Building a Legacy
The contemporary concept of family offices was established in the 19th century when the family of J.P. Morgan founded the House of Morgan in 1838. Half a century later, the American industrial and banking family, the Rockefellers, founded their family office, which prevailed until the modern day. With industrialization and the rupture of the Bretton Woods agreements in 1971, wealth concentration has skyrocketed in recent years, reaching levels not seen since the 1930s. Fewer individuals ended up amassing large amounts of capital, demanding services to manage this newly acquired wealth.
Multi-family offices act as private wealth management advisory firms to support ultra high net worth investors, with a full suite of financial services, including matters such as budget modeling, insurance, corporate management, wealth transfer, and fiscal optimizations. These private wealth managers are more nimble than their institutional counterparts with rigid investment mandates, including track record benchmarks required to be authorized in the deployment of investment strategies. Institutional investors such as pension funds, endowments, labor unions, banks, etc. are often held up in lengthy bureaucratic processes to validate an investment thesis. Due diligence requirements in family offices (whether single or multi-family) are generally less restricted by legacy standards in the allocation of their pool of capital, which makes them more likely to construct novel asset allocations to preserve their wealth.
Family offices often manage their own capital (80% of the total assets under management), and the multi-family offices who happen to manage funds on behalf of others have trusted relationships with principals. The private wealth management industry is worth around $206 trillion of asset value with family offices (both single and multi) representing $5.9 trillion across 7,300 offices, a rise of 38% in the number of distinct families. Most family wealth was acquired by “first and second generations” in the last few decades, and have a preference for investments in technology and finance, which is the crossroad for novel asset classes such as Bitcoin.
Traditional Assets Remain Uncertain
Prior to the market distress of March 2020, fixed income and equities represented the majority of portfolio allocation strategies for family offices. However, the bulk of family returns was seen in alternative assets such as private equity, real estate, hedge funds and allocations into emerging market debt instruments. In order to hedge volatility and liquidity risk, physical gold and cash holding positions have been increased recently due to market uncertainty.
"[Gold] is certainly above the 2% average holding some families have. It is probably a low double-digit holding.”
As macro investor Preston Pysh highlights in a thread on Twitter, equities markets are manipulated by currency devaluations, which erodes the value of cash over time. While US stock markets such as the DOW Jones Industrial Averages had its best week since 1938 with a 12.38% rise, US unemployment filings had reached all-time highs at 16 million people. Such bifurcations between market fundamentals and price action suggest that we may be experiencing the beginning of a currency failure in the US.
In times of uncertainty, it is expected that private wealth managers increase their cash holdings to maintain adequate liquidity to service unforeseen short term obligations in their portfolio. Corporate treasury management has also been facing drastic reductions in risk exposure, accumulating larger amounts of cash to weather a potential storm brewing with over $1 trillion of cash accumulated by NASDAQ 100 companies. This phenomenon has been highlighted by the velocity of M2 money, which is a measure of how quickly money changes hands in an economy. It is currently hitting all-time lows at 1.12, which is a ratio comparing nominal GDP growth with the average M2 money stock for the period. In times of high uncertainty, this metric turns lower as individuals and businesses either hold onto their cash holdings or nest the updated money stock (including recent flow) into inflated asset classes.
As consumer confidence remains low, the velocity of money may stay in the low ranges as well, but when market confidence is re-instilled, inflation may be perceived both in asset and consumer prices, highlighting the value erosion of cash due to the recent easing of monetary policies.
Cash is King, But for How Long?
As material amounts of cash holdings accumulate on corporate balance sheets, fund managers have also revised their overall portfolio risk exposure following the recent Covid panic, with cash seeing the largest positive rebalancing in portfolio allocations. A combination of near-zero interest rates deteriorating fixed income returns, along with central bank monetary expansion were the global response to the Covid outbreak. This has pushed business operators and fund managers to slow down investments, cut spending and raise excess cash reserves.
With aggressive quantitative easing programs, the new injections of liquidity could deteriorate the value of cash, which may not lead to inflation in the short term, but certainly will devalue cash over a longer time horizon. As global central banks pursue their mandate to maintain “price stability” with a target consumer price inflation rate, this trend is bound to continue, especially as the fear of short term deflation remains.
Where can real, inflation-adjusted yield be found in the long term for families who are looking to preserve wealth and protect their legacy for generations to come?
Monetizing a Neutral Store of Value
While gold has earned a good track record for holding value across time, it is known to have suffered from price suppression due to the artificial supply of “paper gold” that emerged in its financialization. There are many more claims and derivatives on gold than there is gold held in vaults, which increases the counterparty risk of having a position in this asset class. Added to these concerns, gold has political risk as it has been seized or censored by central banks many times in the past. During the Covid panic, swapping New York futures with London spot physical gold had a material surge in its cost, showing inefficiencies in logistics and distrust in the physical settlement of the commodity. Holding physical gold in self-controlled vaults is, however, a costly endeavour, which bears significant fees in storage and insurance coverage that do not scale very well as the asset price inflates.
Compared to gold’s 5,000 years of track record and roughly $9 trillion of market value, Bitcoin is only worth $200 billion after only 11 years of existence on the Internet. Lots of literature was published on Bitcoin, notably The Bullish Case for Bitcoin and The Bitcoin Standard as two seminal pieces, though many others were released, highlighting its nascency as the native Monetary Layer of the Internet. For reference, Satoshi Nakamoto announced Bitcoin as “Peer-to-Peer Electronic Cash System” in a whitepaper that he published on October 31st, 2008.
Since its inception, Bitcoin has been in a process of monetization, accruing a monetary premium for the properties of its protocol that makes it useful as money. It started as a scarce digital collectible that early adopters were curious about, often attracted by the technical achievement around the Byzantine Generals Problem or the anarcho-libertarian ethos of money divorcing from the State.
As Bitcoin grew, additional social circles came to appreciate the properties that made it a sound monetary good, such as its extreme scarcity with a cap of 21 million interchangeable units available (BTC) in its network. Additionally, Bitcoin is a bearer instrument, so holding BTC makes the holder the rightful owner of the asset. As Bitcoin is a digital good, it is hard to seize and its intangible nature makes it quite durable over time, which makes it a good store of value. There are many more properties that make Bitcoin a reliable monetary good, such as its divisibility, as 1 BTC equals 100,000,000 satoshis. It is also very portable as Bitcoin itself is a computer network that allows digital transfers on the Internet that are nearly impossible to censor. These properties combined together make it a useful tool to exchange value.
Akin to a digital estate, Bitcoin is a grid of 21 million units that can each be subdivided into 100,000,000 floors. Nothing more, nothing less.
Bitcoin is monetized energy that is traded 24/7 across the world against many other different goods. Many more people now come to trust it as a savings vehicle. Over the years, Bitcoin has slowly become a unit to measure the value of some goods and services, making it a unit of account for a very limited set of the population, as it is the case for alternative cryptocurrencies’ speculators. Even though Bitcoin is still volatile, Bitcoin’s fiat denominated price has been trending upwards over the last decade. Individual holders are incentivized to re-assess the opportunity cost of not holding it, as all other goods (both capital, consumer and monetary) deflate against Bitcoin’s long term market price appreciation.
It seems evident that Bitcoin is in its early stages of monetization, as it is moving on from its first phase as a speculative digital collectible to a phase of a more recognized store of value that is reliable for a growing segment of the population. When Bitcoin stabilizes as a store of value, while its Lightning payment infrastructure matures, the next step will be for it to become a globally recognized medium of exchange that natively runs on the Internet. These phases are natural occurrences in the emergence of a new monetary standard that is uncorrelated to other asset classes, which can increase portfolio diversification in the long term.
Hedging legacy risks with Bitcoin
With $49 billion of assets under management, investment firm VanEck has produced an investment case on Bitcoin, in which they compare and contrast the intrinsic and monetary value of assets, and how Bitcoin could be assimilated to digital gold, which is a reference to its functions as a long term storehold of wealth.
As specified in VanEck’s Bitcoin investment case, it appears that Bitcoin is not only uncorrelated to traditional asset classes such as equities and fixed income, but it also improves the risk profile of a diversified portfolio, lifting its long term upside potential, as well as reduces its downward volatility risk.
With the emergence of regulated futures markets, Bitcoin has seen new all-time highs on open interests for Q2 2020, allowing institutional exposure to Bitcoin’s price action with additional venues facilitating its price discovery while improving its liquidity. Prominent hedge funds manager Paul Tudor Jones has made public his long Bitcoin position in the publication of a concerned observation relating to the Great Monetary Inflation of 2020.
“Quite often, how the markets respond will be at odds with your priors. But remember,the P&L always wins in the long run. With that in mind, in a world that craves new safe assets, there may be a growing role for Bitcoin. [...] At the end of the day, the best profit-maximizing strategy is to own the fastest horse. Just own the best performer and not get wed to an intellectual side that might leave you weeping in the performance dust because you thought you were smarter than the market. If I am forced to forecast, my bet is it will be Bitcoin. ” — Paul Tudor Jones
Stars are Aligned
Bitcoin can be understood as an asymmetric bet for a small allocation in a diversified portfolio with a long time horizon. Over the course of its lifetime, the protocol has demonstrated a self-reinforcing network effect, powered by holders and substantial amounts of computational power providing security to its ledger that makes it more trusted to its investors. Lyn Alden, Founder of Lyn Alden Investment Strategy, has written a detailed article on the rationale behind allocating capital into Bitcoin in 2020, explaining why current macro events combined with Bitcoin’s established track record and timing in the protocol’s programmed monetary hardening are potentially creating quite a bullish scenario for the coming years.
“At the current time, I view Bitcoin as an asymmetric bet for a small part of a diversified portfolio, based on a) Bitcoin’s demonstrated network effect and security, b) where we are in Bitcoin’s programmed halving cycle, and c) the unusual macro backdrop that favors Bitcoin as a potential hedge.”
Fidelity Digital Assets, established in 2019 by its parent company, a global asset manager with trillions of dollars under management, has also published an investment thesis on Bitcoin during the summer of 2020. It highlights the sound properties of the protocol legitimizing it as a rising store of value for long term investors. Their audience of investors include fiduciaries, pension funds, endowments, and other institutional investment managers who are seeking alternative investment products to hedge against current market uncertainties. Fidelity has recently announced a Bitcoin fund, in SEC filings published earlier this year, demonstrating the legitimacy of Bitcoin as an investable asset.
Forward-thinking family offices such as Mimesis Capital, and their Founder & Chief Investment Officer Louis Liu, are leading the way, allocating a portion of their portfolio into Bitcoin, as its value appears to be well over its current market price. Since most family offices have a business operation, their funds act generally as a vehicle for asset allocation for the family businesses.
“Family offices may or may not be managed by the family members. If they do, from my experience, it will likely be made by the second generation of family members. Bitcoin is a generational wealth transfer event. As family offices, they have more incentive to act aggressively to use Bitcoin as a savings technology to preserve wealth for generations to come. I think Bitcoin is the perfect asset for wealth preservation based on its characteristics like censorship resistance, security, global liquidity, portability, un-seizablilty, and un-inflatability. At Mimesis Capital, we believe Bitcoin deserves to be part of everyone’s portfolio as a treasury reserve and an asymmetric hedge against Modern Monetary Policy.”
The Rebirth of Value Investing
Family offices have discretionary investment mandates that can be tailored to their own needs and preferences, which incentivizes them to stay nimble and seek good risk/reward combinations for their allocations of capital. Value investing is one methodology that can optimize capital utilization for this segment of asset managers. However, it is becoming evident that value investing can be difficult to execute in an environment where monetary easing distorts price signals.
The Covid panic of March 2020 led to immense money printing, expanding the Fed’s balance sheet by 72% in less than three months. Bitcoin and its built-in monetary hardening fixes this, by taking away the risk of currency debasement for portfolio managers holding cash reserves. Bitcoin is still fundamentally underpriced as an investable asset. It’s main valuation model relates to its stock-to-flow ratio, which is a measure of scarcity over time, and currently sits roughly at 56. There are indeed 18,483,996.08 BTC in circulation with a current yearly flow of 327,974.4 BTC per year.
The value of a monetary good is tied to its monetary premium exclusively, which is derived from its monetary properties, such as scarcity, durability, divisibility, portability, fungibility, censorability, and seizability. It is becoming evident that Bitcoin’s worth could be valued as the aggregate amount of monetary premiums accrued by other assets with such properties, including fiat currencies, bonds, stocks, gold, real estate, or art. This figure is north of $100 trillion. So far, with over 11 years of market data, it appears that Bitcoin’s stock-to-flow ratio is highly correlated with its spot price, with a coefficient of 99.5%. While the past is not an indicator of the future, this statistically significant metric provides a value model based on scarcity to assess whether or not Bitcoin is adequately priced by the market.
The Jevon’s Paradox tells us that as a technology makes a resource more efficient, its rate of utilization will tend to increase because people find it more useful. Money being the other side of all trades in the world, this effect may have a substantial impact on its value to the market, and influence the worth of Bitcoin as both a fast growing monetary network and reserve asset. Bitcoin is the only investable asset that is absolutely scarce and apolitical so it represents an opportunity for families looking to diversify their portfolio of equities, bonds and private investments that are exposed to other sets of risk to which Bitcoin is agnostic.
Predictability in an Uncertain Future
As Bitcoin’s ledger integrity and monetary policy credibility are both enforced by a code base that is auditable by millions of individuals and businesses, it offers a meaningful amount of reliability that is welcome in a tumultuous macro environment. These properties can be instrumental to family offices in the business of protecting, preserving and growing wealth to build lasting legacies that resist the test of time.
Capital erosion over economic cycles fuelled by easy money and debt expansion are unnatural and afflict great pain to the productive use of capital, which is complex to mitigate. Multiple trillions of dollars of capital held by family offices are seeking long term safety to protect lifetimes of hard work. Bitcoin can be the most reasonable addition to a diversified portfolio, acting as a put option or an insurance policy against the current Great Monetary Inflation that we are witnessing. Corporate CFOs have realized their cash holdings are at risk and have already shifted Bitcoin from a speculative asset to a responsible reserve asset, as NASDAQ-listed MicroStrategy recently bought $250 million of bitcoin, worth 50% of their cash reserves at the time of purchase in August 2020.
With a long time horizon for capital deployment and the agility of principal capital holders, it seems any family office not taking a hard look at Bitcoin as an investable asset is missing its core mandate—long term wealth preservation. Will family offices realize that their portfolios are at risk without Bitcoin as a hedge? Many risks remain to be understood by such managers when it comes to building a position over time. Best execution with low slippage, tight spreads, deep liquidity and efficient order routing on diverse venues are essential, including simple and secure custody with expansive insurance policies covering theft and loss of Bitcoin holdings. We are working on some of these institutional solutions at Knox Custody, a Bitcoin custodian with 1:1 dedicated insurance coverage for client assets. Ultimately, each family and ultra high net worth individuals have personal goals and risk profiles, but it appears that they all have something in common—they cannot afford to ignore Bitcoin anymore.
“It might make sense just to get some in case it catches on. If enough people think the same way, that becomes a self fulfilling prophecy.” — Satoshi Nakamoto
Thank you to Arthur C. Salzer, CIO of Northland Wealth Management, Elizabeth Prefontaine, Founder of Octonomics and Louis Liu, Founder & CIO of Mimesis Capital for reviewing this article.