Know the strategies for the inclusion of bitcoin in an investment portfolio

Key facts:
  • With small percentages of bitcoin in a portfolio, an attractive return could be obtained.

  • A simulation of a portfolio of securities and bonds, with 4% bitcoin, doubled its return in 5 years.

The growth of Bitcoin is spreading beyond the activity of cryptocurrency exchanges. A growing number of bitcoin enthusiasts are engaged in the trading or they go to the main cryptocurrency as a store of value, but institutional investors are beginning to look for investment alternatives, either through bitcoin-based funds or venturing into the trading of futures and options of this cryptocurrency, among others.

However, a popular investment alternative such as mutual funds or pension funds have stayed out of this rising wave of institutional investment in bitcoin. Investors do not seem to have enough information on how to include bitcoin in an investment portfolio, what is the optimal percentage of bitcoin that should be allocated, or how to deal with bitcoin volatility so that it does not affect the return of the portfolio.

CoinShares, an institutional investment management firm in cryptocurrencies, published an analysis on the role of bitcoin in an investment portfolio. The study shows what is the effect of the inclusion of bitcoin in an investment portfolio. “Our analysis highlights that Bitcoin not only improves returns, it also increases diversification, regardless of when an investor decides to invest.”

Including bitcoin in an investment portfolio

CoinShares built a database for analysis with real information on the daily returns of bitcoin since 2015, as well as the returns of the stocks and bonds chosen to integrate the portfolio. Be part of the data from 2015 onwards, CoinShares explains, since it was in 2015 that Bitcoin became available as a financial product, specifically an ETP, or product traded on an exchange.

The composition of the portfolio comprised 60% stocks and 40% bonds, a frequently used ratio. Bonds generally have a lower yield than stocks, but its inclusion mitigates the risk of a portfolio that consisted only of stocks.

Once the portfolio was integrated, 4% of bitcoin was included, for which the shares of bonds and stocks were proportionally reduced. For purposes of comparison of the effect of the inclusion of bitcoin with other assets, three additional portfolios were evaluated that included, respectively, 4% of gold certificates and 4% of shares corresponding to two stock indices, SOCL and CRB. The former measures the performance of social media companies, while CRB is a representative indicator of social media markets. commodities or goods.

The following table shows the results of the CoinShares research:

Comparison of the effect of the inclusion of bitcoin in an investment portfolio against gold and other assets. Source: CoinShares.

The original portfolio is used as a reference to evaluate the effect of the inclusion of bitcoin against other assets. Its yield, since October 2015 is 9.6%, based on annual returns. The volatility of the portfolio taken as a standard is 8.6%, while the key metric to evaluate its performance is the Sharpe ratio or Sharpe quotient. This parameter measures the performance of an investment or asset, compared to an asset with little risk. It is defined as the difference in the returns of both assets divided by the standard deviation of the investment, and in the case of the portfolio evaluated, its Sharpe ratio is 0.82.

The inclusion of 4% of bitcoin in the portfolio studied doubles the returns, despite the volatility of the cryptocurrency, highlights CoinShares. The Sharpe quotient also doubles, which qualifies the bitcoin portfolio as a better investment than the original portfolio. Compared to bitcoin, the other assets produce a very small increase in profitability or Sharpe ratio.

Another notable difference from the inclusion of bitcoin is its correlation with the assets that make up the portfolio. As seen in the table, bitcoin has the lowest correlation with portfolio assets, while the other three assets tested are highly correlated with them. This means that bitcoin offers significant diversification to the portfolio.

The volatility of bitcoin is higher than in the case of the inclusion of gold and the indices mentioned, but it is not very far from the volatility of the original portfolio. This is because to a portfolio adjustment strategy that was carried out quarterly, known as ‘rebalancing’, according to CoinShares. This adjustment consists of a moderate change in the portfolio percentages. For example, increase the percentage of the bonds by 1% and keep 3% of bitcoin if its volatility exceeds a preset threshold. Also, if the volatility of bitcoin falls, as it did for more than three months from May of this year, the share of bitcoin in the portfolio may be slightly increased.

First, portfolio managers must decide the periodicity of the adjustment, quarterly, semi-annually or annually, or even not carry out a rebalancing, according to CoinShares. Also the decision of the percentage of bitcoin to include in the portfolio is important, and it can affect final returns. Last May, CriptoNoticias published an analysis similar to that of CoinShares, performed by BitWise, in which the effect of varying the percentage of bitcoin to be included in the portfolio was evaluated.

Bitwise tested three scenarios with a 60-40 portfolio, similar to that made up of CoinShares. He compared the inclusion of three percentages of bitcoin: 1%, 2.5% and 5%, assuming a quarterly rebalancing. The results are shown in the following table:

bitwise balance volatility case
The inclusion of 5% bitcoin in an investment portfolio resulted in better returns than lower percentages. Source: Bitwise.

The best accumulated and annualized returns were obtained by including 5% of bitcoin, more than double the returns of the original portfolio. The Sharpe quotient also increases significantly in this case. The increase in portfolio volatility is less than 1%, with a quarterly rebalancing.

Bitwise introduces an interesting variable when it highlights that, in the period studied, from the beginning of 2014 to March 2020, bitcoin had a very noticeable boom (even considering the historical fall of Black Thursday), from USD 755 to USD 6,479 on March 31 of this year. Noting that Bitcoin has not had bearish periods of more than two years, Bitwise poses a study scenario of maximum decline.

What would have happened if you started an assignment [de bitcoin a un portafolio] on December 16, 2017, date of the ATH of USD 19,397 and maintains the study period until March 30, 2020, when bitcoin closed at USD 6,479? This represents a 66.6% drop for bitcoin.

Bitwise. The case of Bitcoin in an institutional portfolio.

Even in this adverse scenario, Bitwise notes that a bitcoin allocation, rebalanced quarterly, would have resulted in a positive impact on investment, although of a small magnitude. For example, an allocation of 2.5% of bitcoin would have increased the cumulative percentage return by 0.6% and benefited the Sharpe ratio with an additional 0.2 percentage points.

The answer to this apparent paradox, that an asset with a 66.6% drop can improve the performance of a portfolio, comes from the very nature of bitcoin, says Bitwise, since combines significant volatility with lack of correlation with other assets.

Variables to take into account to include bitcoin in an investment portfolio

When evaluating the inclusion of bitcoin in an investment portfolio, three important variables emerge from the studies addressed: the period of allocation of the investment in bitcoin, the frequency of rebalancing the portfolio and the percentage of bitcoin allocated.

Regarding the first, the contribution of bitcoin to returns is positive in all periods studied. Bitwise found that there was a positive impact on one-year period returns, in 74% of the periods studied. The positive impact grew with periods of two years and three years, reaching 100% of the periods studied.

Regarding the percentage of inclusion of bitcoin and the frequency of rebalancing, the various tests suggest that 5% of bitcoin to the portfolio, offers the best returns, with quarterly rebalancing. Beyond 5%, in Bitwise studies, even though the returns increased with a higher percentage, the risk also increased above the risk of the original portfolio.

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