Bitcoin and Digital Assets in a Portfolio Context
MicroStrategy, Tesla or Salvador may be among the most famous investors in Bitcoin, but they are just the tip of an ever-growing iceberg. According to Coinmarketrate.com more and more investors, from retail to institutional, are buying the digital asset market.
In the eyes of an increasing number of investors, cryptocurrencies and digital assets have long become an independent asset class. According to professional market analysts, among alternative investments, they should take a place next to art, hedge funds or commodities.
Bitcoin still stands out among cryptocurrencies. As the impressive numbers show, Bitcoin has become the most efficient asset over the past decade. Remaining the most famous cryptocurrency, it accounts for about 40% of the total market capitalization of this new asset class. This fact is also explained by the variety of Bitcoin investment products. For example, the first Bitcoin futures ETFs were launched in the US in the last quarter of 2021, and now in Australia.
Bitcoin: Smart Portfolio Diversification
The impressive performance of digital assets in recent years can also be viewed in the context of a portfolio. A comparison of portfolios with and without Bitcoin distribution shows that the corresponding portfolio parameters improve with the distribution of BTC.
This can be seen in a concrete example of a classic portfolio (this is a sample portfolio, and therefore all information is not a guarantee). It contains 55% of stocks (MSCI World Index), 38% of bonds (TIPS Bond ETF) and 7% of commodities (Invesco DB Commodity ITF).
For the period from 2015 to 2021, this diversified portfolio provided an annual return of 5.68% with a standard deviation (volatility) of 7.53%.
Adding only 3% of Bitcoin at the expense of a portion of the shares, which itself has shown good results, has a positive effect on the portfolio. Thanks to the distribution of Bitcoin, the portfolio indicators have grown to an annual yield of 8.75%, while the standard deviation has grown minimally to 8.10%. The positive effect of Bitcoin can also be seen in the change in the Sharpe ratio, a frequently used portfolio indicator that demonstrates risk-adjusted returns.
A high Sharpe ratio indicates that high performance was achieved with relatively low risk. The higher the Sharpe ratio for the selected portfolio compared to the reference portfolio, the better the risk-return ratio of the first compared to the second.
For the selected example, the Sharpe coefficient for a classic portfolio without adding Bitcoin is 0.62. The addition of BTC increases the Sharpe coefficient to 1.08. This fact allows us to draw the following conclusion: MTC correlates little with conventional asset classes and represents a reasonable diversification of the classic portfolio.
Other digital assets have the same effect
Meanwhile, there are countless other cryptocurrencies that are also commonly referred to as digital assets. Some of them have already reached a significant market capitalization and are therefore taken seriously by professional investors.
The same classic portfolio (this is an approximate portfolio, all information is not a guarantee) can also be compared with a portfolio supplemented with a combination of various cryptocurrencies. Cryptocurrencies that can be found in the top ten by market capitalization have been selected and combined to form a crypto index. It consists of the following components: 5% Bitcoin (BTC), 5% Bitcoin Cash (BCH), 10% Ethertum (ETH), 40% Cardano (ADA) and 40% Ripple (XRP).
Together, these cryptocurrencies make up 5% of the total portfolio, which are included in the portfolio instead of shares. Due to the smaller age of these cryptocurrencies compared to Bitcoin, a more recent and, accordingly, shorter period from 2018 to 2021 was considered.
The classic portfolio without the distribution of cryptocurrencies achieved a yield of 6.98% with a standard deviation of 8.64% over this period. The addition of selected cryptocurrencies increased the figures for the same period to 10.03% with a standard deviation of 10.11%. Similarly, the Sharpe coefficient changes from 0.69 to 0.99. Thus, this example shows that not only Bitcoin individually, but also a combination of a variety of cryptocurrencies in the form of a crypto index can represent a reasonable portfolio diversification.
Offset of the efficiency curve
The advantage of adding cryptocurrencies is also illustrated by the so-called efficiency curve. This shows the maximum possible return and maximum risk that different portfolio distributions can have. Since the return is shown on the Y axis and the risk is shown on the X axis, the upward shift of the efficiency curve means that a higher return has been achieved for the corresponding portfolio with the same risk.
Such an upward shift of the efficiency curve occurs for those portfolios (again, this is just an example of a portfolio) to which digital assets have been added. In other words: with the same level of risk, you can achieve higher returns by adding cryptocurrencies, or reduce the risk by adding them at the same yield.
Relevant for the future?
In connection with these conclusions from the portfolio theory, the question arises: will the positive effect of adding cryptocurrencies be preserved in the future?
As you know, the collected data always refers to the past, and does not give any guaranteed statements about the future. If you look in the rearview mirror, the indicators and the risk-return ratio will seem positive. But why should the portfolio conclusions be applied in the near future?
In favor of Bitcoin, its gradual formation as digital gold speaks. The promise of a shortage of Bitcoin has persisted for the past 12 years, and with each new year it is strengthened in the minds of more and more people.
The strength of Bitcoin as an investment becomes especially evident when other asset classes correlate with the growth of the central bank’s money supply. For example, if we compare the S&P 500 not with its dollar valuation, but with the balance sheet of the Fed, it becomes clear that the price increase is due to a strong expansion of the money supply.
If you choose the right denominator – the balance of the central bank, prices will be even. Over the past ten years, the S&P500 has nominally grown by an average of 15% per year. Interestingly, this almost coincides with the annual expansion of the balance sheet of the US Federal Reserve System.
As a kind of hedge against the perpetual monetary expansion of central banks, Bitcoin and other cryptocurrencies are likely to continue to be popular in the near future. The end of the acceptance curve is probably far from being reached yet. If cryptocurrencies continue their triumphant march, Bitcoin and other digital assets will also prove to be a reasonable, uncorrelated diversification for the portfolio in the foreseeable future.