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- A Bit of Bitcoin Considerations for an Allocation
- According to financial site Trading View, cryptocurrencies now represent around 0.70% of the portfolio comprising all investable assets globally. Too big to ignore, they have earned their right to be considered by well-diversified investors.
- The debate around cryptocurrencies is real, until it comes time to think about allocation. Then, it’s the data that matters. We use empirical data to formulate reasonable assumptions for return, risk, and correlation, and report the portfolio impacts that result
- Bitcoin and Ethereum have a role to play in the asset allocation process for well-diversified investors – not for risk reduction, but potentially for changing the balance of portfolio risks, or as Sharpe ratio enhancers.
Illuminating the Crypt
There’s no doubt that cryptocurrencies are a divisive topic, with a litany of vocal supporters, and detractors, standing ready to make their case at the slightest provocation. At DWS, we recognize that tension. Indeed, profit-motivated disagreement over the merits of all financial assets goes to the very heart of price discovery, and market efficiency. And, of course, capital markets reflect those changing sentiments every second of the day.
“It’s part of our job as stewards of capital to understand and evaluate these innovations”
Björn Jesch, Global Chief Investment Officer, DWS
However, although disagreement is extremely important in finance, in this paper we intend to sidestep the fundamental discussion about cryptocurrencies. We will focus instead on the cold, hard numbers, and examine the return, risk, and correlations of the two cryptocurrencies with the largest market shares – Bitcoin and Ethereum. We will then use those numbers to provide some insights into whether they justify an allocation, and to what extent. And we will examine that in the context of three industry standard approaches to portfolio construction – the Global Market Portfolio, Risk Parity, and Optimization. Each have their own merits and idiosyncrasies, and each will attack potential allocations to cryptocurrencies from a slightly different angle. Sure, it might not be as much fun as a full-blooded and torrid debate, but it will be based on facts and well-researched forecasts, and not opinions – surely not a bad thing for investors. Figure One alludes to one of the many ways in which digital assets are disrupting traditional finance. It shows the indexed returns to several traditional assets (global stocks and bonds, denominated in US dollars), as well as the returns to Bitcoin and Ethereum, the two largest cryptocurrencies to date which together account for approximately 70% of the space. Note that we use post-2017 data to accommodate for data availability, mainstream media awareness for the asset class, and growing institutional interest (e.g., Bitcoin CME futures launching in 2017).
However, before you conclude that Bitcoin and Ethereum have generated returns broadly like traditional assets, but with a more volatile path, take another careful look at the chart. You will see that we have had to present the returns on a compressed scale on the left-hand side of the chart (technically known as a “semi-log scale”). And the reason is that because the cryptocurrency returns have been so extreme (effectively exponential) that showing everything on a more usual linear scale would reduce the bond and stock market returns to, effectively, a flat line.
