A recent report from digital asset management firm Coinshares suggests that investors could benefit from a small percentage of exposure to Bitcoin in their overall investment portfolios.
Any person that has had any experience with trading cryptocurrencies or even just buying and holding Bitcoin will know that the preeminent cryptocurrency and its various alt coin siblings are subject to volatility.
While there are some periods of relative stability, the price of Bitcoin and other cryptocurrencies generally fluctuates fairly often and can be daunting for investors looking to add some digital assets to their portfolios.
The key takeaways from the Coinshares report are that a small percentage of Bitcoin in an investor’s portfolio ‘have an outsize positive impact on risk-adjusted returns and diversification relative to other alternative assets.’
Furthermore Coinshares explains that due to Bitcoin being uncorrelated to other financial assets and instruments, it has become an alternative asset that can shield investors from mainstream economic cycles and occurrences.
Conventional wisdom is that bitcoin has had great returns but it does that by adding substantial risk (volatility) to a traditional equity/bond portfolio. The final brief takeaway is that making quarterfly adjustments of one’s Bitcoin holdings back to its desired percentage of a portfolio can limit volatility and make better returns.
Bitcoin enhances returns, increases diversification
Coinshares’ report highlights a number of points from its analysis that show that Bitcoin enhances returns and increases diversification of a portfolio irrespective of when investments were made.
In order to reach these conclusions, Coinshares created a database of daily returns from 2015 when Bitcoin became available as an exchange-traded product. The company created a ‘traditional balanced portfolio with 60% equities and 40% bonds’ and added a ‘modest amount of Bitcoin’ away from an equal percentage of equities and bonds.
Given that it sees Bitcoin as an asset in an early growth phase, Coinshares rebalanced their holdings of BTC on a quarterly basis in order to moderate volatility.
The experiment and data suggests that Bitcoin, although volatile in its market value, improved yearly returns from 9.3% to 18.8% when continuously rebalanced to a 4% share of an investment portfolio. Coinshares used the Sharpe ratio in order to ascertain the true value of returns made on investments:
“The Sharpe ratio of an investment portfolio tells us how good or bad returns have been relative to the risk taken on by the investor. Usually, any Sharpe ratio above 1 is considered to have a positive impact on a portfolio. In this case we see a Sharpe ratio of 1.69 while the correlation to the base portfolio falls significantly by 15%.”
Bitcoin outperforms other diversifying assets
Coinshares also made data-driven comparisons between Bitcoin and other traditional assets that are used to diversify a portfolio from adverse market cycles and conditions.
Comparisons were made to physical Gold given the parallel between the two, the SOCL index which is a social networking index as well as the CRB index which represents global commodity market conditions.
The data shows that over the same period of time, Bitcoin outperforms the other diversifying assets:
“What also makes Bitcoin stand out is its asymmetric return profile, that is, the upside it provided versus the downside. Despite bitcoin’s volatility, a 4% portfolio weighting does not materially increase the maximum drawdowns (i.e. the maximum possible loss from peak to trough) relative to other assets, while its annualised returns are close to double that of the other alternatives.”
Coinshares also conceded that this data and the conclusions reached are heavily weighted to a backward-looking analysis. Making future market predictions is a difficult task given that investments vary in behaviour outcomes in the future.
In order to provide some credence to their insights, Coinshares looked to provide evidence of Bitcoin’s effect on a portfolio regardless of when an investor first bought BTC. Using the chart below to illustrate various backtest lengths, the firm believes that Bitcoin is a great portfolio diversifier.
“Interestingly, even if Bitcoin was added to a portfolio at peak, in December 2017, when prices fell dramatically, it would still enhance portfolio returns with a reduced, but significantly better Sharpe ratio, relative to other portfolio diversifiers such as gold or commodities.”
Mitigating large price corrections in a market is carried out by quarterly rebalancing an investors holding of Bitcoin to the ascribed 4 percent of their portfolio.