It is highly likely that financial advisers have been inundated with questions from clients regarding cryptocurrencies, and rightly so, as digital currencies have taken the investment world by storm in recent years. Whether you are a longtime skeptic like me, or a true believer in Bitcoin, you can no longer ask the question.
But answering the crypto questions that come your way is not easy, as you not only need to know the potential risk and reward of investing in Bitcoin or other crypto coins, but also have a working knowledge of blockchain and how cryptocurrencies work.
This article is not an introduction to Crypto 101 nor my thoughts on Bitcoin’s resistance and the chance of overthrowing the US dollar as a global reserve currency. Rather, it is intended to help you understand the risks and rewards of implementing digital currencies in your client portfolios, as well as the potential portfolio strategies that can be implemented.
Full Disclosure: I am skeptical and neither I nor my immediate family members own any cryptocurrencies. However, the following analysis opened my eyes to the benefits of including crypto / bitcoin in investment portfolios.
Not only is investing in cryptocurrencies immensely popular among retailers, institutions have jumped into the digital world as well. Companies like MassMutual have bought large amounts, you can transact using Bitcoin on PayPal and apps like Square and Robinhood, while brokerage firms like Morgan Stanley say investors should incorporate Bitcoin into their wallets.
And while investing in cryptocurrencies may not be as easy as buying a stock or a mutual fund, that hurdle is diminishing. Fidelity has added Bitcoin trading to its platforms while other brokerage houses like Morgan Stanley and JPMorgan are following suit. Exposure to cryptocurrencies can be obtained through separately managed accounts or publicly traded trusts like Grayscale Bitcoin Trust. For those looking for a more traditional vehicle, a number of asset managers, including Fidelity, have asked the Securities and Exchange Commission to offer a Bitcoin ETF.
As for the analysis of Bitcoin as an investment, we turn to quantitative analysis (Figure 1). It’s no secret that Bitcoin is a risky asset, no matter what measure of risk you choose. It’s in a class of its own. What is more surprising is the attractive risk-adjusted performance. âTo the moonâ returns help offset the huge risk, resulting in strong risk-adjusted performance no matter which metric you use.
It should be mentioned that the period used in this analysis begins in June 2011, when the return flow for Bitcoin begins. If I shorten the timeframe to say five or three years, the risk-adjusted scores for Bitcoin only get better and are the highest among other asset classes listed. As you will soon see, the strong Sharpe ratio makes it a very attractive option in portfolios created by taking advantage of efficient frontier and modern portfolio theories.
The next step is to see how Bitcoin affects investment wallets. One of the three building blocks of building an investment portfolio is incorporating assets that behave differently, which benefits Bitcoin, due to its low correlations with other major asset classes (Figure 2).
The strong diversification and risk-adjusted metrics make it an attractive addition to investment portfolios, which we see when building an effective frontier. There are three things that jumped out at me when I compared an efficient border with Bitcoin and one without when all other inputs and assets are equal. First, there are minimal differences between the effective frontier that includes Bitcoin and the one that does not. In fact, they almost overlap.
Second, almost all of the wallets along the efficient frontier include an allocation to Bitcoin; even a conservative 20/80 portfolio calls for an allocation of 0.20%. Finally, the most efficient / optimal (highest Sharpe ratio) portfolio along the efficient frontier includes an allocation of 1.26% to Bitcoin. If you shorten the timeframe to five years from the common start date (June 2011) used in the optimization, the Bitcoin allocation in the most optimal portfolio increases to 6.75% and the Sharpe ratio of the portfolio increases. increases to 0.55.
It should be noted that the effective frontier is skewed towards the upper right corner due to the high yield and risk levels of Bitcoin. Due to this asymmetry, many 40% standard deviation wallets have a huge allocation to Bitcoin, which are not conservative wallets for most of your clients.
In Figure 3, you can see the portfolio allocations with the corresponding returns, standard deviations and Sharpe ratios for the portfolios. Again, note the allocation to Bitcoin across all wallets, albeit low in the 20/80 wallet.
Finally, when backtesting these portfolios from the common date (June 2011-March 2021), you can see that all the portfolios performed well (Figure 4). Interestingly, all five portfolios had better Sharpe ratios than the blended benchmark of 60% MSCI ACWI / 40% Barclays Global Aggregate.
The more conservative portfolios showed the best risk-adjusted returns, while the 80/20 portfolio with a 1.37% allocation to Bitcoin had the best absolute return numbers – in fact, it was very comparable on an adjusted basis. risk to the optimal portfolio.
Cryptocurrencies have grown in popularity largely due to their mind-blowing returns and investors’ fear of missing out. Institutions have taken note and have started implementing crypto strategies that have increased accessibility but also the questions that financial advisers need to answer. After digging deeper into the investment analyzes behind Bitcoin, this longtime crypto-skeptic discovered some answers and some positive impacts of including Bitcoin in globally diversified investment portfolios.
Ryan Nauman is Market Strategist at Zephyr of Informa Financial Intelligence. Informa Financial Intelligence and Wealthmanagement.com are both owned by Informa Plc.