3 Top Advisor Questions on Digital Currency, Answered

Despite a steady buzz around Bitcoin and other digital currencies, financial advisors have been reluctant to add them to client portfolios. In fact, a survey conducted by the Financial Planning Association in 2018 found that only 1% of advisors were currently using or recommending digital currencies to their clients and only 2% planned to increase their usage or recommendation of digital currencies over the next 12 months.

However, more than half of the advisors surveyed in the same FPA research indicated that their clients had inquired about cryptocurrencies within the last six months. So, why aren't more advisors taking a closer look?

As digital currencies become more mainstream and more clients express an interest in allocating to this growing asset class, advisors should take the opportunity to better understand it for their clients.

For those skeptical about digital currencies, below are answers to three common questions about its suitability for client portfolios:

1. Are digital currencies a legitimate asset class?

Digital currencies like Bitcoin are often characterized as the emerging "Wild West" of investments. Certainly, Bitcoin's decade-long tenure doesn't compare to many traditional assets' histories; however, there are some key validators that lend to its legitimacy and potential staying power.

Digital currencies are now recognized by regulators and agencies all around the world, as well as by some of the biggest names in finance including Fidelity, NYSE and CME Group, who are all active participants in the space. Facebook's recent foray into digital currency is yet another example of mainstream interest in the sector. Growing institutional recognition of and commitment to digital currencies will bring further understanding and adoption of this technology on a global level.

Additionally, liquidity in digital currencies like Bitcoin continues to deepen, an important factor for many investors as they evaluate potential investments. At the time of this writing, the top five digital currencies have a combined market capitalization of more than $230 billion — we would expect that to grow along with greater awareness and investment into infrastructure for the asset class. As noted by pensions and endowments consultant firm Cambridge Associates to Bloomberg, "it is worthwhile for investors to begin exploring this area today with an eye toward the long term."

Dollars continue to flow into this asset class. At Grayscale Investments, we saw more than $30 million of inflows in Q4 2018, bringing total inflows for 2018 to nearly $360 million. This trend continued into 2019, with flows increasing quarter-over-quarter in 2019. And recent research from Fidelity found that 4 in 10 institutional investor respondents say they were open to future investments in digital currencies over the next five years.

2. Aren't digital currencies too volatile to recommend to my clients?

It's important to understand that digital currencies are a prime example of uncorrelated assets, moving independently of major global indexes and benchmarks. Therefore, volatility in digital currencies can actually benefit an investor's portfolio if allocated appropriately. In fact, investors increasingly see Bitcoin as a hedge when markets tumble or experience volatility.

Advisors and investors alike understand that diversification is vital to effective portfolio management. Prudent advisors work with their clients to build portfolios with higher risk-adjusted returns by allocating toward uncorrelated return streams. Introducing an uncorrelated asset like Bitcoin into client portfolios may add a layer of diversification that cannot easily be achieved by other investments.

Through that lens, allocating even a small percentage of client assets to digital currencies could help foster a more diverse portfolio and mitigate losses amid general market volatility and uncertainty.

Based on research and portfolio simulations, there is now a live debate around replacing a portfolio's allocation to gold — a traditional hedge against market uncertainty — with Bitcoin, or "digital gold," to improve performance and enhance diversification. Moreover, many digital assets are imperfectly correlated to one another, which indicates there may be further diversification benefits within the digital currency asset class itself.

3. When is a good time to explore opportunities for investing in digital currencies?

These are still early days, but it's undeniable that digital currencies are seeing growing momentum. Investors are beginning to note their potential to increase portfolio diversification and use them as a hedge against market dislocations. As institutional investors are seriously exploring the asset class, the global transaction network for Bitcoin continues to grow and strengthen. Additional signs of positive momentum are also demonstrated by growth in metrics like the number of wallets and transactions.

It is crucial for advisors to also consider that younger investors (i.e., millennials) are more likely to buy, hold and use Bitcoin than earlier generations. This is particularly important as an estimated $68 trillion in generational wealth is set to change hands in the U.S. over the next 25 years. Given the different investing behavior of millennials, we may see more investment dollars make their way into uncorrelated assets like digital currencies.

We are encouraged by regulatory bodies such as the Securities and Exchange Commission and the Financial Industry Regulatory Authority who continue to issue guidance and establish regulations as the digital currency asset class evolves. Concurrently, as client interest grows, it is important that advisors and investors remain alert to the risks associated with investing in the space without feeling discouraged from better understanding and exploring digital currency opportunities. With that in mind, we encourage advisors and investors to seek compliant and secure third parties as they explore this asset class.

As investors become increasingly aware of the potential benefits of digital currency investing, advisors should expect more inquiries from their clients. The time to better understand digital currencies is now.

Michael Sonnenshein is managing director of Grayscale Investments, a digital currency asset manager.