Using digital assets within an SMSF

Diversification is the gift of good portfolio construction: you get to keep high expected returns but can heavily reduce risk. Unfortunately, in an environment of central bank financial repression, where defensive asset classes are offering negative real returns, good portfolio construction is harder to achieve. Digital assets, with their volatility hedged out, represent a great opportunity.

THE CHALLENGES FACED BY SMSFs

In Australia, established SMSFs have had the opportunity to invest in real estate at reasonable prices, which has proven to be an excellent investment offering growth and rental income. Equally, other SMSFs have built share portfolios at reasonable prices which offer both growth and dividend incomes. Concentrating in either asset class is a valid, if high conviction, investment strategy. 

Looking forward, however, SMSFs face a different investing environment.

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Firstly, interest rates will eventually go up, likely sooner 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 cashflows. In layman’s terms, higher interest rates are generally not good for shares and real estate. Add to that headwind very high valuations across shares and real estate and logic dictates it might not be an ideal time to allocate more to those asset classes. 

What would also make sense would be to introduce some diversification to complement the existing excellent exposures already owned. There is a science in diversification – essentially good diversification reduces risk without reducing return. What this means in practice is you need two pieces of diligence: firstly, potential investments could match your shares and/or real estate return generation, and secondly that potential investments would behave differently to your shares and/or real estate.

THE CORRELATION CONUNDRUM

Let’s drill down a little further on the second point about behaviour. A good portfolio is like a marriage, when one partner is having a hard time then the other partner can balance that negative somewhat. The most commonly-used metric for calculating 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 who both get stressed at the same time. What we really want is uncorrelated assets which offer strong diversification benefits.

Calculating correlation manually means dividing covariance by the product of the standard deviations. Financial software provides this information readily, or like everyone else in finance, you can use the ‘Correl’ command in Excel. The end result is going to range between -1 (perfectly negatively correlated) and +1 (perfectly positively correlated). 

As the table below demonstrates, many of the investment options we would expect to have solid diversification characteristics in fact do not do so. For example, over the five years, real estate in the eight major Australian capital cities have had a near-perfectly positive correlation with Ether, the cryptocurrency used in the Ethereum blockchain.

Even gold, which is a commodity and generally regarded as a good portfolio diversifier, had a positive 0.44 correlation with Australian shares and very strongly positive correlation of 0.74 with global shares over the period.

Correlations of 0.4 and 0.5 are not what we want. What we really want is no correlation or, better still, negative correlations. Historically, we have utilised bonds for this purpose, however with inflation rising and expected to increase further, and central banks maintaining their financial repression, negative expected real returns is a heavy price to pay for your diversification.

SMSF'S INVESTMENT STRATEGY

Portfolio construction challenges like those discussed above are addressed in an investment strategy, a document as important as a trust deed and one you will have a lot more control over. The first point to note is that SMSFs are required to have a documented investment strategy. This shouldn’t be viewed as a burden but rather as a way to utilise these structured governance responsibilities as opportunities and build good portfolio construction practices into your own financial wellbeing – after all an SMSF is all about choice and control. Every institutional investor will have a documented investment strategy incorporating considerable analysis and discussion with stakeholders.
Some of the points to address in your investment strategy:

Risk appetite – Institutional portfolio managers begin 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 built to maximise expected return without breaching that worst-case outcome. A simple approach to quantifying risk is standard deviation whereas a more detailed approach would be to model some scenarios using historic data to inform an expected shortfall.
Return objectives – The returns generated over time will have an enormous impact on the purchasing power of a portfolio in the future. Investors demand more return for more risk, so for higher returns you will usually 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 have investments in because of tax efficiencies. Volatility-inducing capital gains and losses realisation is generally less welcome than income.

DIGITAL ASSETS

One approach which Balmoral Digital has pioneered for Australian SMSFs is to harness the famous volatility of digital assets and turn that volatility into an income stream. 

The first step is to complete due diligence on the digital exchanges and the digital protocols you are willing to invest in. The protocols selected need to have sufficient liquidity in matching derivatives to be able to hedge the risks. Earlier in the article, we mentioned seeking low levels of correlation to improve diversification, Balmoral’s portfolio is full of securities which are perfectly negatively correlated to the securities we own which makes our portfolio effectively delta neutral. Recall that investors demand compensation for additional market risks, by hedging out its market risks Balmoral removes the volatility of the underlying assets and the currency risk and thereby changing the risk profile of our portfolio into a very stable investment vehicle.

Looking at the derivatives we utilise, many of those will pay us to take that position. For example, if we own Bitcoin then we can hedge that with a short Bitcoin futures contract. If we are taking the short side of a Bitcoin futures contract that allows another investor the chance to go long a Bitcoin futures contract, which is a leveraged play on

Bitcoin. If investors are expecting Bitcoin to go up then it’s logical they will pay their counterparty (Balmoral) to take the short side of their trade. In this way, we remove our market risk and, in the process, turn that volatility into income generation.

Finally, we have a proprietary database tracking historic rates counterparties have been willing to pay, across exchanges, for the various digital assets and their derivatives.

When one of our investment positions is no longer generating the returns, we are seeking we can consider the expected return, the stability in historic returns and the liquidity available in alternate positions. This database ensures we look at the highest-returning opportunities for our investors first as we weed out those where there is insufficient stability or liquidity for our lower risk profile investing strategy.

There are a number of advantages under this approach:

Because digital assets are so volatile the return potential of our delta neutral approach is very strong. The strategy can deliver double digit returns and thus strongly contribute to investment objectives;

By hedging out all directional risks the fund removes market risks. This means the investor is not buffeted by digital asset prices going up and down, the extreme volatility they are so famous for. This characteristic combined with strong returns means the fund delivers very strong risk-adjusted returns, or Sharpe Ratio, a metric most institutional investors seek;

Because market risks are hedged the fund is uncorrelated with existing SMSF investments, such as real estate and equities. This means the Digital Asset Fund offers strong diversification characteristics, which will be a logical cornerstone of most SMSF investment strategies;

By exchanging the capital gains for income, the investment is better suited to the tax-favourable SMSF environment, whether that is in accumulation, transition to retirement or in drawdown phase. Instead of dealing with realised capital gains and losses, income received enjoys more favourable taxation treatment within the super environment; and

The fund offers SMSF investors a lower risk way of investing 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 phone app showing the value of their investment in real time and offering direct connection to their investment manager.  

Angus Crennan is co-founder and portfolio manager at Balmoral Digital.