The answer is less straightforward than it first appears.
Today’s headline poses what seems to be a rhetorical query. Should pension funds risk other people’s money by buying volatile, poorly regulated assets? Obviously not. We therefore know how this column will proceed. Having erected this straw man, the author will triumphantly torch it in a blaze of self-righteousness.
Such was my initial plan, after reading about pension funds with cryptocurrency-related losses. Houston Firefighters Relief and Retirement Fund invested $25 million in bitcoin and ethereum. The State of Wisconsin Investment Board placed about $20 million in cryptocurrency service providers. Worst of all, Quebec’s largest pension manager, CDPQ, wrote off almost its entire $150 million stake in a cryptocurrency lending firm Celsius Network, which went bankrupt.
But upon reflection, the topic deserves a fuller hearing. Through the decades, observers have chastised professional managers when they have invested outside the mainstream. They did when pension funds first bought leveraged-buyout funds, venture-capital funds, and small-company stocks. Each time, the critics were wrong, as those securities have since become core holdings for pension funds. Might opposing the expansion into cryptocurrencies be a similar mistake?
Pension funds are governed by the Employment Retirement Income Security Act. Under Erisa, such funds can be held liable if they invest incorrectly. Specifically, the statute requires that investment professionals
1) Exercise their duties solely on behalf of their participants and their beneficiaries.
2) Manage the portfolio with “the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise with a like character and with like aims.” (Only lawyers write that way.)
3) Diversify the portfolio, to minimize the risk of large losses.
4) Follow the rules laid out in the plan documents.
We can dispense with the first, third, and fourth items. Pension fund managers who invest in cryptocurrencies for any reason besides improving performance would violate Erisa, but the infraction would not be specific to cryptocurrencies. Nor would breaches of plan rules. As for improperly diversifying the portfolio, no pension fund currently faces that possibility, as even the enthusiasts have limited their cryptocurrency-related purchases to less than 1% of their portfolios’ assets.
Which leaves us with the second Erisa requirement: to act as would a prudent man (or, presumably, a prudent woman). Do investments in cryptocurrencies, or in businesses that profit from cryptocurrency trading, satisfy this standard?
To make a long story short, yes. At one time, this “prudent man rule” was applied to each portfolio position. Consequently, it prohibited various investments, including low-quality bonds and shares of companies that engaged in “new and untried enterprises.” If that interpretation of the prudent man rule still applied, it would ban cryptocurrency investments. In recent years, though, that original doctrine has been largely replaced by the ”prudent investor rule,” which permits individually hazardous securities as long as the overall portfolio is deemed prudent.
(Unfortunately, the same logic does not apply to the eye exams for an Illinois drivers license. Although my vision is 20/20 when using both eyes, I am required to wear glasses while driving, because my right eye fails the test. Harrumph.)
Nor can one condemn cryptocurrencies because they cannot generate cash. Stocks declare dividends and bonds provide interest. Cryptocurrencies do neither. Thus, they can profit only through the “greater fool theory”: the possibility that somebody, somewhere, will eventually pay a higher price. However, that same principle also applies to conventional currencies, gold bullion, and undeveloped land, which are all commonly accepted investments.
Also, the riskiest cryptocurrency investments are not the currencies themselves, but instead either cryptocurrency loans or shares in companies that service the industry. In theory, those holdings can in fact distribute cash, as the former pays a yield, while the latter carries the hope of future corporate profits. In practice, though, they are extremely dangerous. Theory therefore does not avail us.
It would suffice if cryptocurrency investing were openly unprofitable. Pension funds cannot prudently purchase lottery tickets that return 50 cents on the dollar, because the investment math cannot be denied. However, the expected performance of cryptocurrency is nowhere near so predictable. Anything is possible. And that anything is just what portfolio managers are paid to assess.
Although legal protections exist to prevent pension fund managers from acting irrationally, those regulations would not seem to forbid cryptocurrency-related purchases. (If you do not wish to accept my legal opinion—which I understand—then accept the implicit views of the lawyers and compliance offers who staff those pension funds. Those employees gave their permission, although they exist to say no.) Nor does history bar the way. Over the years, pension funds have dabbled in many murky waters. Those efforts have often been rewarded.
To return to the question posed by this column’s headline: I do not know whether pension funds should invest in cryptocurrencies. However, I do not believe that they should be barred from doing so. To be sure, they should not own enough cryptocurrency to sink their portfolios, as required by Erisa. But they should be able to own enough to help—or harm—their own careers.
Gresham’s law states that “bad money drives out good.” Literally, this means that a distrusted currency that is backed by a valuable commodity (such as gold) will eventually become the only money that circulates, because people keep the commodity for themselves while paying their bills with the disliked currency.
The same precept applies to social-media discussions: Bad comments drive out good. I thought about that habit this weekend, upon receiving an email that attacked my Friday column as “shilling” for active investment management. If you are familiar with my work, you know that allegation is akin to calling Bernie Sanders a tool of corporate America, or Donald Trump an apologist for Black Lives Matter protests. A friend of active fund managers I have not been.
No worries. I sent the writer some of my previous articles, he acknowledged that he had been overly hasty, and all was fine. But had those words appeared on a comment board, the subsequent discussion would likely have been derailed by attacks on sellout journalists and Wall Street scams, without resolution. People become easily angered on public comment boards. Not so much with the private exchanges of emails.
John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
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