As Bitcoin (and other crypto currencies) push to new all-time highs we re-examine the characteristics of the asset itself it, as well as its historical impact on a diversified portfolio. For the purposes of this analysis we focused solely on Bitcoin given the (relative) maturity of its institutional markets, the multiple vehicles for investing (direct, ETFs, funds, etc.), and utilized data starting in 2015 (Note: although Bitcoin has been in existence for longer institutional caliber data only started to be available in recent years).
Bitcoin characteristics: correlation to “traditional” assets
Before analyzing the historical impact of Bitcoin inside a traditional portfolio we first examined its risk/return characteristics, especially relative to other assets.
We started with a historical regression of daily price movements of Bitcoin (to USD) vs. the S&P 500 and the Bloomberg Barclays Agg. As the rolling correlation graph below suggests, Bitcoin has historically exhibited largely uncorrelated performance to both US equities and fixed income. In fact, since 2015 the rolling 1 year correlation has averaged nearly zero.
| Average Correlation (Daily, Rolling 1YR since 2016) | |
|---|---|
| Bitcoin to S&P 500 | 0.07 |
| Bitcoin to Barclays Agg | 0.05 |
| S&P 500 to Barclays Agg | -0.14 |
We then analyzed the equity Beta of Bitcoin relative to other S&P 500 stocks. For this analysis we plotted the Beta/Return of Bitcoin vs. top 15 stocks in the S&P 500. Surprisingly, despite the correlation benefits of Bitcoin relative to the S&P 500, Bitcoin carries a similar beta profile as that of other “high flying” technology stocks in the S&P 500.
All of this would suggest to us that while there could be some benefit to including Bitcoin in a portfolio, on a day to day basis the investment may perform similar to the broad equity market. Still, while the investment itself appears to have a similar equity beta as that of other large-cap technology stocks, the correlation benefits are hard to ignore. As such, Bitcoin does appear to offer the potential to provide some level of overall portfolio diversification.
Bitcoin’s historical returns, both absolute and risk-adjusted, are impressive
Next we examined the trailing risk/return of Bitcoin vs. the S&P 500 and Barclays Agg over the past five years. While the significant total return outperformance was no surprise, the fact that Bitcoin generated a higher Sharpe ratio (even with a 10x higher drawdown) was surprising.
| Bitcoin | S&P 500 | |
|---|---|---|
| Total return | 5203.50% | 111.63% |
| Annualized total return | 116.45% | 15.69% |
| Max drawdown | -82.60% | -33.80% |
| Risk (standard deviation) | 94.60% | 15.20% |
| Sharpe ratio | 1.21 | 0.91 |
Given the rise of Bitcoin over this period we decided to reanalyze the risk/return profile over shorter periods of time to see if they still held up. So, we looked at rolling 1 year Sharpe Ratios.
And again, Bitcoin historically outperformed the broader equity market on a risk-adjusted basis since 2016.
Placing Bitcoin inside a diversified portfolio
For our historical analysis we chose to (temporarily) ignore fundamental arguments over whether Bitcoin truly has any value, should be viewed as an asset class, currency, etc., and instead viewed it as a single, independent investment inside a portfolio (similar to a direct company investment). From a portfolio construction approach we view placing Bitcoin inside a portfolio in a similar manner to adding another fund, ETF, company, or potential diversifier.
For our analysis we started with a generic 60/40 portfolio that was allocated to 60% equity (S&P 500) and 40% fixed income (US Barclays Agg). Given the volatility and risk profile of Bitcoin we decided to utilize it as an equity substitute, and therefore took an allocation away from equity for Bitcoin.
We utilized an allocation of 2.5% directly to Bitcoin, which we felt appropriate given the amount of volatility of Bitcoin, liquidity profile, and non-correlated nature to existing investments.
Our initial analysis focused on absolute return – did adding Bitcoin to a diversified portfolio create absolute value over the past five years? Given the rise in Bitcoin over the past five years we expected adding it would increase overall return, but the actual magnitude surprised us. On a cumulative basis, the addition of just 2.5% to Bitcoin drove a 68% increase in overall portfolio value.
Given the high beta of Bitcoin to the S&P 500 we decided to see if similar results could be achieved through a direct allocation to another high Beta, high performing stock in the S&P 500. We decided to replace Bitcoin with Tesla stock (TSLA) and run the same regression. Once again the results showed an increase in overall return, although this time within a tighter timeframe (2019-2021YTD).
These results suggest to us that historically Bitcoin did offer a differentiated return source inside a portfolio. However, Bitcoin also appears to have been an amplifier of equity market performance, magnifying the impact on both the upside and the downside.
Assessing the risk/reward of Bitcoin in a portfolio
Absolute value generation is important, but from a portfolio construction standpoint the real benefit comes from the ability for value creation combined with a reduction in risk.
To determine the historical overall benefit of adding Bitcoin to a portfolio we analyzed the Sharpe ratio impact of adding Bitcoin. The results suggested a meaningful increase in the overall risk-reward of the portfolio.
| Basic 60/40 (2.5% allocation to Bitcoin) | Basic 60/40 (No Bitcoin) | |
|---|---|---|
| Total return | 139.16% | 70.82% |
| Annualized total return | 18.48% | 10.97% |
| Max drawdown | -21.30% | -21.00% |
| Risk (standard deviation) | 11.40% | 9.00% |
| Sharpe ratio | 1.4 | 1.04 |
| Sortino ratio | 3.06 | 1.81 |
Implications of Bitcoin in a portfolio
These results are clear – there was a benefit to holding cryptocurrency inside a portfolio over the past five years, on both an absolute and risk-adjusted basis. It’s worth noting that there could potentially have been a higher Sharpe ratio increase at higher allocation levels, but we did not attempt to optimize the allocation to Bitcoin, as we believe the allocation needs to be prudent for the investor.
Now, while this historical analysis is interesting, it also fails to capture many of the true risks associated with Bitcoin investments. From fundamental arguments that Bitcoin has no inherent value, to the risk associated with loss of principle due to custodian hacks or “lost” crypto-keys, there are considerable risks to consider before investing in cryptoassets. In addition, an investor in Bitcoin would have had to withstand a decline of nearly 82% in the value of their Bitcoin over the past five years – nearly 2.5x the magnitude of an S&P 500 investment.
As we noted at the beginning of this post, cryptocurrencies are a relatively new investment option, especially at the institutional level, and as more investors begin to invest market dynamics and trends could change. Furthermore, much of the current rise in pricing may be attributable to momentum alone, a trend that may not persist in the future. With no definitive way to value Bitcoin or other cryptoassets it’s nearly impossible to determine if current prices or trends are sustainable.
A historical analysis is interesting, but we stress to potential investors that it is simply that, historical. Hindsight is always 20/20, and there is no guarantee that Bitcoin (or other cryptoassets) will continue to hold any value going forward. For qualified investors that are interested in investing in the space we suggest utilizing a multi-faceted, diversified approach to investing. This includes sizing investments appropriately (we suggest estimating a 100% loss of capital), the use of multiple storage options, custodians, and diversification across exchanges.
ENDNOTES
Disclosures
Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice. Investing involves risk including the potential loss of principle. Different types of assets may be impacted by different types of risk. No investment strategy, or asset class, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Indices cannot be invested in directly, are unmanaged and do not incur management fees, costs and expense.
This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
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A word on risk
All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.