This article originally appeared in Institutional Investor on January 5, 2018.
Hedge funds grew from a boutique investment area serving wealthy individuals and families to a full-blown institutional phenomenon after Yale and CalPERS gave credence to the category. Cryptocurrencies are on the same path, awaiting that institutional first-mover.
The revolutionary potential of the blockchain and investment opportunities in Bitcoin, cryptocurrencies, and initial coin offerings is today’s topic du jour.
Yet for all the talk, direct institutional investment in the space is essentially nonexistent.
So when will Yale — or another thought leader — dive in?
Capital allocators spend the preponderance of their time surveying the world in search of incremental opportunities to improve their portfolios. They look top down for dislocations and asymmetry, and bottom up for high-quality managers. New investments typically fit into an existing framework, as investment teams and governance boards function most effectively when adhering to an agreed-upon policy statement and investment strategy.
Investing for the long term and sticking to the plan get challenged when a new idea like the blockchain arises that might warrant investment outside of the existing framework.
Diverting a board’s attention can derail the consistent application of a sound process and can take scarce time away from the important decisions that drive returns.
On the other hand, successful investing requires evolutionary thinking — and occasionally a new idea can have a positive impact on a portfolio.
For example, investing in China and India over the last two decades, or recognizing the risk of leverage in the financial system leading into the global financial crisis, would have substantially moved the needle if incorporated at the time.
Most boards default to following inertia — and are wise to do so. Governance bodies work hard to execute on a defined process in normal times; adding a layer of complexity by defining a process for change is even harder. Adopting a new investment area is the very “uninstitutional behavior demanded of institutions” that Yale endowment legend David Swensen wrote about years ago.
Yet new ideas inevitably enter the mainstream. Diversification into global equities, absolute-return strategies, and private equity were all once off limits to institutions, only to become common practice.
The mechanism for their adoption follows a recurring pattern. Early adopters tend to be high-net-worth family offices and individuals who can take risk on their capital without risking their careers. When the investments prove fruitful, those individuals encourage the boards on which they serve to investigate the areas. Early institutional movers with credibility and support from their boards then dip their toes in the water. If those early allocations are successful, word eventually gets out broadly, offering support for those with more rigid requirements to put big dollars to work.
The rise of hedge funds as an asset class exemplifies this process.
After generating high returns for a small group of investors in the 1980s and ’90s, Yale and the California pension giant CalPERS publicly gave credence to the category. Shortly thereafter, hedge funds experienced a wildly successful period of relative performance, and board discussions flipped from “Why would you consider such a risky, opaque investment?” to “Why aren’t we investing in this important diversifying return stream?” Over time, hedge funds grew from a boutique investment area serving wealthy individuals and families to a full-blown phenomenon.
Investment in Bitcoin and crypto assets is starting with individuals, family offices, and venture capitalists. Should these investments prove successful — and the perception of risk-reward shift from volatile and binary to exciting with definable risk — we may see a move up the food chain.
For that to happen, someone must move first.
Ari Paul left his seat at the University of Chicago endowment two years ago to create BlockTower Capital, a leading crypto hedge fund. Asked when the University of Chicago endowment would invest in Bitcoin, he proclaims, “Six months after Yale does.”
Crypto assets are a long way from constituting a new asset class. Stewards of capital researching crypto investments find sufficient concerns about security, volatility, and intrinsic value to risk a substantial position. Instead they are getting limited indirect exposure from their venture capital and hedge fund manager allocations.
If you listen to experts like Paul describe what will happen over the next decade or two, it’s hard to ignore the possibility that we are on the cusp of another technological innovation as important as the internet.
If that proves to be the case, the early movers to make significant direct allocations will reap the greatest rewards.
The next big investment opportunity could be staring us in the face. Who will be first to make the leap?