Gold/Cryptos differences

Differences between Gold and Cryptos within a portfolio:

The fast rise of cryptocurrencies in the last few years has been notable for investors and many times, investment in cryptos is compared to investment in gold. There are some similarities but gold stands apart from cryptocurrencies, fundamentally and practically.

- Sources of gold demand are more diverse
- Supply and ownership of cryptocurrency is more concentrated
- Cryptos have contributed to portfolio performance mainly through returns by adding great risk
- Gold is a high-quality liquid asset and portfolios with cryptos may benefit from higher allocations to gold
- Evolving regulatory frameworks may change the value proposition of cryptocurrencies

Gold and cryptos are fundamentally different. The recent developments in blockchain and crypto don’t mean that cryptos are a substitute for gold and the argument that the two of them are similar appears from their limited supply and their role as alternatives to fiat currencies. This comparison is simplistic and overlooks fundamental differences, not only in terms of market dynamics but also in terms of their performance and the role they play in portfolios.

Gold has a dual nature. For more than 2000 years, gold has served as means of exchange and has been used as store of value, owned by institutional and individual investors and central banks.

Gold is a consumer good. Gold’s demand is linked to investment and consumption. Jewellery is an integral part of gold market. A large portion of gold demand is connected to cultural and religious beliefs, it’s widely used in high-end electronics. Therefore, it sets it apart from many assets and gives it a unique dual nature that performs well in times of economic stress and benefiting from long term economic expansion which underpins gold’s strategic role in portfolios as a source of returns as well as an effective diversifier.
In contrast cryptocurrencies are digital (non-tangible) assets and their source of demand is for investment.

Gold is a unique and scarce natural element. One of the most referenced similarities between gold and crypto is scarcity. Gold’s above-ground stocks grew at a rate of 1.7% through mine production in 2020 and has not changed much over the past 20 years. The stock of Bitcoin is currently increasing at an annual rate close to 3% and is engineered to slowly decline to 0 growth around the year 2140. While both gold and Bitcoin are finite, Bitcoin’s predetermined number of units in existence may seemingly create an advantage. However, gold’s relevance has been cemented by a combination of elemental physical and chemical properties, as well as a good balance between availability and scarcity. Thus, while there exist other metals and precious metals, gold was the preferred asset used in currency standards and has remained a key component in foreign reserves even after the end of the Bretton-Woods system.

The crypto space has exploded in recent years, and it’s estimated that there are more than 10000 cryptocurrencies available through various online platforms. Bitcoin is more volatile and has lost 2.5% or more once in 4 weeks on average compared to once in 12 weeks on average for S&P 500 or NASDAQ, or once in 13 weeks on average for gold. Bitcoin’s Value-at-Risk is five times higher than that for gold. Investors choose to embrace high-reward tactical assets such as Bitcoin, but they still need the right tools to manage the additional risk. A higher exposure to cryptocurrencies warrants a higher allocation to gold.

Diversification is not just about low correlation which is between gold and Bitcoin low, ranging from -0.5 to 0.5 most of the time which was positive on average during 2020, but is still not consistent in one direction which indicates that gold and Bitcoin are not behaving as substitutes.
If Bitcoin were a replacement for gold, it would behave similarly to gold in terms of its reaction to performance of other assets, in particular, equities. And while both have generally had relatively low correlation to equity, it is the correlation when equities fall that matters most to investors as this is usually when diversifiers are most useful.
Presently, Bitcoin has benefited from its name recognition and large network effect but the space is highly competitive and its still too early to know how this issue may play out.

Gold production and ownership is diverse. Gold mining is well distributed around the world with the top 5 gold producing countries, China, Russia, Australia, US and Canada. Average annual production is evenly distributed with Europe the only continent accounting for less than 10% and no continent accounting for more than 25%. The US Treasury is the largest known single holder of gold but only owns 4% of all above/ground stocks. 50% almost exists in form of jewellery, while 21% is owned by large number of individual and institutional investors, in form of bars, coins and gold ETFs.

Concentration risk has been flagged as key issue for cryptocurrencies. The number of Bitcoin miners has been whittled down from thousands to a handful of key participants, 5 mining entities, all of the based in China, control 49.9% of all computing power on the network, the highest concentration of mining power ever, a new analysis from Token Analyst found, which, if increased, could pose severe risks to network. Furthermore, while number of Bitcoin holders has risen over the past year, ownership is very concentrated, only 2% of Bitcoin holders own 95% of all available Bitcoins. Sharp increases in Bitcoin ownership have coincided with significant selloffs in recent years.

Gold and Crypto prices behave differently. High potential reward brings added risk. Bitcoin has been 5 times more volatile than gold. Gold prices tend to increase when tech stocks fall but the same has not been true so far for Bitcoin.
Bitcoin has yet to prove itself as a save haven. It trades like a high-octane tactical asset with no consistency in moving in a similar way to some traditional hedges such as gold.

Some studies have suggested that adding Bitcoin to a hypothetical portfolio would have increased risk-adjusted returns. Over the past 5 years, a 1% to 5% allocation to Bitcoin would have increased the risk-adjusted return of a well-diversified hypothetical portfolio. However, the improvement would have come from Bitcoin’s rapid price appreciation and not from a reduction of portfolio volatility, as one would expect from a diversifier or safe-haven asset. In contrast, gold’s portfolio impact over the same period would have come from both a contribution to portfolio returns as well as reduction in volatility. This highlights gold’s relevance as a strategic risk-management tool in asset allocation.

Gold’s liquidity helps investors manage risk. Gold trades in a well-established and liquid market. Gold volume trading exceeded in 2020 USD180bn a day on average between over-the-counter transactions, futures and gold ETFs. This helped keep bid-ask spread of most gold-traded instruments quite right, usually less than a couple of basis points, thus giving investors the ability to easily enter or exit their gold positions.

In contract, Bitcoin spot trading volumes, which can vary widely from source to source and are not always easy to verify, were estimated to be less than USD2bn on average in 2020 with a range up to USD4bn. And while volumes seem to have increased substantially so far in 2021 reaching levels close to USD10bn, reporting in online platforms is not regulated and may not be homogenous. Additionally, the number of Bitcoin transactions as a function of its market cap has decreased to almost 0. This could indicate insufficient liquidity in the market if many investors, or even on e large on, were to attempt to exit the market and anecdotal evidence suggests that bid-ask spreads not only remain wide but vary substantially.
Bitcoin transaction velocity has waned, raising potential liquidity concerns.

An evolving regulatory environment. Some crypto enthusiast argued that Bitcoin could replace traditional currencies in transactions. While some vendors do accept Bitcoin, on average only about 340000 Bitcoin out of approximately 18 million in existence are used for daily transactions which is less than 2%. In comparison, the USD transacted nearly USD6trn per day on average in 2019., 40% of the total M2. Bitcoin lacks of course the regulatory framework to function as a means of exchange and limitations of the network itself could prevent widespread adoption.

In recent years, partly because of concerns surrounding stable coins such as Diem, governments have looked more closely at digital assets, especially development of digital versions of national currencies which may catalyse changes to the regulatory environment of cryptocurrencies.

Gold is proven and established. Gold stands apart from cryptocurrencies and Bitcoin in general, It’s an effective, tried and tested investment tool in portfolios with having been a source of returns rivalling that of the stock market over various time horizons and performed well during period of inflation, it’s highly liquid, acted as an important portfolio diversifier exemplifying negative correlation to the market during downturns.
The recent performance of cryptocurrencies has been noteworthy, but their purpose of investment seems quite different to that of gold. The crypto market is still in development and liquidity is scarce. The price behaviours is still attractive to many investors and seems to be driven in large part by high return expectations, fuelled by momentum and aided by low interest rates.

Gold too is likely to perform well in low-rate environment but its behaviour responds to 4 key drivers that underpin the relevance of gold as a strategic asset.
Gold is uncorrelated to all assets held in typical investor portfolio and cryptocurrencies fundamentally do not replace gold’s role in a portfolio. Gold and bitcoin can play different roles in a portfolio, bitcoin is more speculative and gold protects wealth. Therefore, the two have different value propositions.

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