Should pension funds invest in cryptocurrencies?

Published on: 29 June 2022

Trading in cryptos remains popular among retail investors, and more and more institutional investors are getting in on the action too. Can pension funds afford to neglect this new asset class? We asked Thijs Knaap, APG's Chief Economist, and senior strategist Charles Kalshoven to lay out their case. "The people who got rich in the Gold Rush were not the ones that did the actual digging."


In the Netherlands more than a million people already invest in crypto, claims a radio commercial for a crypto trading platform. The main draw - together with the fact that everyone else seems to be investing in cryptos too - is the opportunity to get rich quickly. Because despite the recent heavy losses crypto investors have suffered and the crash of a stablecoin whose primary claim was that it could never crash, the returns are still impressive. Take bitcoin for example, the oldest of around 18,000 cryptocurrencies that exist today. Trading at a little over €2,000 five years ago, today a bitcoin is worth around €20,000 (down from a high of almost €60,000 at the end of 2021). Among those million-plus crypto investors, there are undoubtedly some whose pension is being managed by APG. And if they are willing to invest their own money, shouldn’t their pension fund jump in too?


In July 2021, Germany's financial regulator BaFin allowed just that when it enacted new regulations that say institutional investors can allocate up to 20 percent of their assets to cryptocurrencies. As the FT wrote at the time, this was an attempt by BaFin 'to balance its concerns about what is has described as the 'highly risky and speculative' nature of cryptocurrencies with its desire to encourage the development of new technologies that could have a significant effect on financial services.'


More recently, BlackRock, the world's biggest asset manager, launched its iShares Blockchain and Tech ETF that 'seeks to track the investment results of an index composed of U.S. and non-U.S. companies that are involved in the development, innovation, and utilization of blockchain and crypto technologies.' In an accompanying report, BlackRock is bullish: 'While most of the market attention has focused on the price and volatility of cryptocurrencies themselves, we believe the broader opportunity – leveraging blockchain technology for payments, contracts and consumption broadly – has not yet been priced in.'


With retail and institutional investors alike flocking to cryptocurrencies, and regulators holding open the doors, should APG not follow suit? "That's a legitimate question", says Thijs Knaap, APG's Chief Economist. "We're regularly being asked why we're not investing in cryptos, by media and by people on Twitter who point out that our coverage ratio would look a lot better if only we had been smart enough to invest in cryptos early. I haven't heard from those people lately, but we should look past the recent losses and crashes. Surely cryptos will increase in value again some day and new and improved currencies will be launched."


So when will APG begin to invest in cryptos?

Thijs: "Not anytime soon. Pension funds, even more so than other long-term investors, need to invest in assets that generate cash flows: stocks that pay dividends, bonds that pay interest, real estate for which rent payments are received. The basic idea is that every month about as much cash needs to flow in as APG pays out to pensioners. A fundamental objection against pension funds investing in cryptocurrencies is that they do not generate any cash. The only way to make a return on cryptos is to sell them to the next investor who is willing to pay more than you did. In the meantime nothing happens, to us that makes investing in cryptos unattractive as well as unpractical."


But pension funds invest in other assets without cash flows, like commodities and gold.

Thijs: "True, but apart from their inherent value these assets have other appealing characteristics. We know, based on data that sometimes goes back hundreds of years, how they correlate with other asset classes or economic parameters. Gold for example moves along with the general price level and thus provides a good hedge against inflation. Bitcoin doesn't have a 200-year history, and neither does it have a strong correlation with other assets. Well, lately maybe with stocks, but that provides no diversification to our portfolio and no hedge against anything. So in short: crypto currencies provide no cash flows and no hedges. From a technical investment perspective we therefore don't see a reason to invest in them."

Charles: "Let me add an argument from portfolio theory. You can take a well-diversified portfolio with a certain risk and return ratio and study what happens when you add bitcoins to such a portfolio. In my calculations I necessarily had to make some assumptions about correlations and volatility, but in any case the outcome was very clear: only with an expected return of 25 percent per year would it be worthwhile to add bitcoins to the portfolio. With a horizon of 15 years, you have to ask if there is anything that justifies a growth of 25 percent year on year for such a period. The answer is no, there is simply no way I can justify that. So along that line of thought you come to the same conclusion: the investment case for cryptocurrencies just isn't there."


Do pension fund participants, the ones who may now be investing their own money in cryptos, have a say in all this?

Charles: "Only in very indirect ways they have. They are being sampled about their investments preferences and risk appetites, and union members among them could petition their representatives in the pension fund board. But it will be up to that board to decide if they want to invest in crypto. Then APG would be asked to develop a formal investment case, for which we would have to extensively document aspects such as expected returns, risk, liquidity, correlations and so on. We would also have to take into account ESG criteria. The bona fides of counterparties would be concern, as well as the fact that the mining of cryptocurrencies requires an inordinate amount of energy. A pension fund that has banned investments in fossil energy would have a hard time letting that pass. Then there are regulators that don't have a favorable view of cryptocurrencies, and finally it would operationally be very challenging for us and different from how we manage our other assets. So apart from the lack of an investment rationale, there is also a host of practical reasons why APG won't be investing directly in cryptocurrencies in the foreseeable future."


In the early days of the internet, there probably wasn't an investment case to be made for search engines. But if you had been one of the first investors in Google, you would have done pretty well.

Charles: "That's a nice analogy, but the essential difference between Google and bitcoins is that for search engines you could, even early on, imagine a viable business model that monetized advertising and all kinds of services. For bitcoins really the only thing that allows you to make money is the greater fool approach to investing: find someone who is willing to pay more for them than you did. There's just nothing else that would make them worth more."


In the aforementioned report BlackRock addresses this criticism as well. It points out how three features of blockchains, the technology that underpins cryptocurrencies, can fundamentally alter the digital market place: peer-to-peer transactions, digital scarcity and immutable records. As BlackRock writes: 'These features have wide-ranging implications for the protection, monetization, and verification of anything digital - which is incalculably valuable to the two billion people worldwide who are expected to buy goods and services online.' In other words, since the potential demand for cryptocurrencies is enormous and will keep growing, and given that the supply of cryptocurrencies is by design limited, the value of cryptocurrencies over time can only go one way: up.


So there is something underneath cryptocurrencies that will continue to make them worth more.

Thijs: "It's a valid point that even if we don't see the investment case for cryptos now, we still have to look very carefully if there are no reasons that will drive their future value up. The basic story in this regard is that cryptos cut you loose from the traditional financial sector that is slow, expensive and over-regulated. That is what makes them attractive. Cryptocurrencies enable you to make transactions completely autonomously and with anyone anywhere, as long as they have a computer or a smart phone."

Charles: "Among the first to appreciate that were drug dealers and arms traders. The main application for bitcoin so far seems to be the payment of ransom money to some Russian who has encrypted your hard disc."

Thijs: "That shows you the basic idea works fine. You don't have to bother with Know Your Customer or money laundering controls. Pension funds however simply can't be buying bitcoins from someone who may have earned them in some illegal manner, so they bring their whole regulatory apparatus with them. That will cause a strange dynamic to come into play once cryptos become so big and successful that traditional financial institutions have no choice but to get involved. When that happens, it will be the kiss of death. Cryptos will become wrapped in the traditional world of finance, which means the very aspect that made them attractive will disappear. It's like this night club that's so great because only cool people go there. The moment we enter that club is the moment it stops being great and cool. So there is trade-off: cryptos can either remain entirely separate from traditional finance and find little adoption, or they can embrace elements of traditional finance and lose some of their appeal."


Are you not afraid this will cast you as a pair of conservative men who just don't get The Next Big Thing and who are not open to anything new?

Thijs: "That is a concern indeed, we certainly wouldn't want that. But we look at cryptos first as pension fund investors: are they an attractive investment for our purposes? Obviously we think they are not. That doesn't mean we don't welcome innovations and that we don't recognize the potential of cryptos and blockchain technology to improve financial services."

Charles: "But there is a difference between direct investments in cryptos and investing in businesses that offer products and services based crypto assets or blockchains. But we haven't seen the new Google yet, to come back to the analogy about the early internet. Brokers and platforms that facilitate trading in cryptos could very well be a good investment. In fact, some are listed on the Nasdaq and therefore APG already has a little exposure to them. But it's always good to remember that the people who got rich in the California Gold Rush of the nineteenth century were not the ones who did the actual digging, but those that sold them shovels, pickaxes and pairs of jeans."