We recently covered some of the basics of Ethereum for curious investors in the cryptocurrency space. Now is the time to focus on Ether (the official name of the native currency of the Ethereum protocol) as an investment asset.
Ether is so volatile that you could argue (and crypto aficionados probably will) that it doesn’t really fit into a traditional portfolio analysis framework. It’s more of a speculative game about the long-term evolution to digital currency and an ongoing revolution in the fintech landscape. Even so, investors tempted to bet on Ether should proceed with caution and keep in mind that even small doses of Ether can dramatically change a portfolio’s risk profile.
Big risks, big rewards
From an investment perspective, the case for ether is decidedly mixed. Investors who entered early literally made millions, as shown in the chart below. But the ether showed even more volatile price movements than bitcoin, with accelerations as large as 9,900% in 2017 (no, that’s not a typo), followed by a loss of 82%. in 2018. Like other cryptocurrencies, the ether has also been subjected to extreme conditions. price fluctuations in recent months. In the third week of May, for example, the price of ether fell about 38%, although it has since recouped most of its losses.
This high level of price volatility makes ether more difficult to own than bitcoin. Over the past five years, in fact, the standard deviation of the ether (a means of measuring volatility) has been more than 9 times that of the Morningstar US Market Index, a broad benchmark of US stocks. , and almost double that of bitcoin.
To quantify the potential impact of ether as an addition to the portfolio, I looked at the impact of adding different percentages of ether (using the CMBI Ethereum index as a proxy for the ether) to a portfolio combining an 80% weighting in the Morningstar US Market Index and 20% in the Morningstar US Core Bond Index. In each case, I removed the cryptocurrency allocation from the portfolio’s equity weighting, keeping the bond weighting constant.
As the graphic below illustrates, a little Ether goes a long way. While the ether’s generally low correlation with stocks and bonds helps mitigate the impact of its stratospheric volatility when combined with traditional portfolios, it still doesn’t take much exposure to significantly change the profile. risk of a portfolio. In fact, even a paltry 2% stake in Ether more than doubled the standard deviation of the portfolio in the five years leading up to the end of June 2021.
Investors willing to take the extra risk would have reaped large rewards: a 2% stake in Ether would have more than doubled the portfolio’s annualized returns over the five-year period. On a risk-adjusted basis, however, a tiny shard of aether seemed best.
The role of ether in a diversified portfolio
Of course, the performance of Ether’s portfolio will likely be different over the next five years. On the one hand, volatility has eased somewhat as cryptocurrencies have moved more towards the mainstream. For the three-year period, the monthly standard deviation of ether averaged 107.5%, compared to 81.1% for bitcoin and 19.3% for the Morningstar US Market Index. That’s still high in absolute terms, but a drop enough to make Ether more attractive from a portfolio perspective in recent years (despite falling sharply in the past two months).
The role that ether can play in a diversified portfolio will also depend on the evolution of correlation trends. Over the past five years, Ether has had very low correlations with most of the major asset classes, as shown in the chart below. Its correlation to US stocks and bonds, for example, was only 0.12 (a correlation of 1.0 means two assets move in tandem). Like bitcoin, ether has also shown a negative correlation with the US dollar, making it a potentially valuable hedge against the greenback’s long-term weakness. Correlations have increased more recently but remain weak overall.
Despite its huge gains in the past, the extreme volatility of the ether will likely rule it out for many investors. As with bitcoin, it is also difficult to determine what its underlying value should be, as it does not generate cash flow. Its price is largely based on what investors are willing to pay, which can change dramatically from week to week or even day to day.
On the bright side, ether fulfills a unique role in the cryptocurrency space. While bitcoin primarily serves as a digital currency and store of value, Ether also functions as a utility. As I explained in my previous article, it is used to power computing power into the network, execute smart contracts, and pay miners who validate and verify transactions to be added to the blockchain. This utility function should support continued demand and provide a (theoretical) floor price.
Ethereum Improvement Protocol 1559, which is expected to be implemented in August, is also expected to make Ether more attractive. Among other things, EIP will “burn” a small amount of Ether each time someone trades, effectively reducing the supply of Ether and increasing its value over time.
For now, however, Ether remains a fairly speculative investment asset. For conventional investors, it’s probably best to use it in (very) small doses as a hedge against the weak dollar and major disruptions in the global financial system.