The role of crypto in a portfolio

19 October 2021

The saying used to be that if you can’t beat the crypto crowd, it might be time to join them. But we seem to be quite past those days, and it is a fact that crypto has found a place in most investors’ portfolios (out of “FOMO”, faith, greed or thorough analysis).

But what role do cryptocurrencies actually play in an allocation?

Asset allocation a.k.a. risk management

Choosing which assets to include in a portfolio is a search for the “right” diversification, the appropriate combination of  investments with different risk profiles and low levels of correlation to protect against excessive volatility. Diversifying across asset classes that are not correlated reduces – or so the theory goes – the overall portfolio risk, regardless of the portfolio-specific risk-return profile. 

A good place to start a discussion on the role of crypto in investors’ portfolios then seems to be an assessment of the current level of correlation between asset classes.

Correlation

In case correlation is a scary word for you, it is quite simply explained. Two asset classes are negatively correlated when, if one goes up in value the other goes down – the first one then offering a hedge against the decline of the other. 

While for decades a classic asset allocation would balance “high risk” stocks with negatively correlated “low risk” bonds, we are currently living in strange and unchartered times. Negative interest rates, unprecedented pandemic-triggered levels of government support and monetary easing, have caused traditional asset classes (equities, bonds, real estate) to be extraordinarily expensive all at the same time, i.e. to be very much correlated.
Could an investment in crypto go beyond pure speculation and, within a multi-asset portfolio, offer diversification through little to no correlation with traditional asset classes? 

That is a question with no obvious answer. And while the title refers to crypto, in this post we use Bitcoin as a proxy for the overall world of cryptocurrencies, given Bitcoin’s relative weight and legitimacy. Bitcoin is also the oldest crypto asset but it has not been around for a long time: the validity of any historical analysis is therefore limited by the lack of a very large (or large enough?) data set of reference. 

The jury is out

One correlation study proclaims high correlation, showing how the longer the observation period becomes, the more correlated with equities Bitcoin appears to be (as high as 75% over a 3-year period, i.e. 75% of times equities and Bitcoin moved in the same direction).
Another paper from the National Bureau of Economic Research establishes that “the  risk-return  tradeoff  of  cryptocurrencies is distinct from those of stocks, currencies, and precious metals” and that “cryptocurrencies have no exposure to  most common  stock  market  and  macroeconomic  factors”. Yet, amid the current unprecedented amount of new money printed (and the consequent depreciating effect on regular currencies)  Bitcoin, much like gold, is advocated by some as the ideal instrument to protect against inflation, given its finite supply.

Portfolio performance

If not diversification, does an allocation to cryptocurrencies improve portfolio performance? It probably does, but this is likely to be due more to the increase in returns than in the reduction of volatility. It comes down to the individual investors’ view on how much Bitcoin will outperform other assets, and therefore the risk he or she would be willing to take (or able to stomach) to reflect their convictions in their portfolios. The same study cited above concludes that investors should hold between 1% and 6.1% of their portfolios in Bitcoin, depending on how much they believe in the future outperformance of Bitcoin (from 30% per year to 200% per year).

One thing is certain. The more you believe in crypto, the bumpier your road to double (or triple) digit returns will be.

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