Investors allocating 4 per cent of their portfolios to bitcoin could see a number of benefits including enhanced returns and greater decorrelation, according to CoinShares’ James Butterfill, who argues that the cryptocurrency is becoming a more mainstream asset.
While bitcoin is still a relatively young asset (having launched in 2009), its lifespan now straddles two economic crises - the European sovereign debt crisis and Covid-19 pandemic - noted Butterfill, an investment strategist at the digital asset specialist.
The strategist (pictured) said the growth in bitcoin's popularity has been spurred by the financialisaton of digital assets – a process that commodities underwent in the early 2000s – with the creation of infrastructure and products for trading. But it still remains an enigma to some.
"Many attempts have been made to fit bitcoin into pre-existing frameworks of current asset classes, but due to its unique collection of similar yet often non-overlapping attributes, it never quite fits any established mould,” he said.
“Parsing out which fundamentals are the ‘true’ drivers of bitcoin’s performance might be impossible so long as speculative demand remains the primary driver of price action.
“This leads us to the situation of bitcoin evolution, where it may have been one thing in the past, another thing now, and will be yet another thing in the future.”
He added: “Nevertheless, in terms of its investability, we believe bitcoin must be classified according to its performance in a mature state, where investors are more settled as to its identity performance through the economic cycle.”
In its growth phase, the cryptocurrency has behaved like a tech stock having gone from zero to trade at around $12,000 per bitcoin currently.
Performance of bitcoin since launch
“As a disruptive technology, bitcoin’s risk profile is rather similar to that of a technology stock,” said Butterfill. “If it reaches its potential, the value could be immense, but at the same time, there is a chance it fails entirely, leaving the value of bitcoins close to zero.”
This has influenced the type of investors (speculative, risk-on) who have moved into the currency and pushed prices higher.
Latterly, in its more mature phase, the cryptocurrency has come to be seen as a store of value as the risk of failure continues to recede.
“As more value is transferred into the bitcoin ecosystem, its volatility will likely reduce,” he said. “This could cause bitcoin to act more like a stable safe haven and store of value.”
Comparisons can be drawn with gold, which took off after the 1970s when the US made it legal to own and trade physical gold. This led to increased financialisation, which helped reduce volatility in trading the precious metal, something that worries current investors in bitcoin.
“This was not a straight line down due to high inflation in the late 1970s, however, its downwards trend remains intact,” Butterfill explained. “Recently, short-term bitcoin volatility has been lower than in many key developed market equity indices.”
He added: “Bitcoin’s supply was designed to be similar to the supply growth rate of gold and is hardcoded in its algorithm. The supply of bitcoin is therefore genuinely limited, whereas the supply of other assets such as the US dollar are potentially infinite. During periods of economic uncertainty and if the US dollar weakens, bitcoin is likely to benefit in the same way as gold.”
Given its increased role as a store of value, Butterfill said an allocation of just under 4 per cent in a traditional 60/40 equities-bond portfolio could bring a number of benefits for investors.
Having performed a back-test of its performance, Coinshares found that bitcoin can enhance returns and increase diversification.
For comparison, Coinshares considered comparable assets such as gold; social networking index SOCL (Solactive Social Media Total Return Index), which includes tech giants such as Facebook and Google-parent Alphabet; and the CRB (Commodity Research Bureau) index, an indicator of global commodities.
Yet, the analysis found that bitcoin has an outsized positive impact on risk-adjusted returns – as measured by the portfolio’s Sharpe ratio – and increased diversification, relative to the other assets.
“Our analysis highlights that despite bitcoin’s volatility it has enhanced annualised returns by 9.8 per cent,” said Butterfill. “The Sharpe ratio is 1.65 while the correlation falls by 15 per cent.
“Over the same period, none of the other comparable assets or indices offer the same diversification benefits.”
He added: “What also stands out is the asymmetric return profile. Despite bitcoin’s volatility, a 4 per cent portfolio weighting does not materially increase the maximum drawdowns relative to other assets, while its annualised returns are close to double that of the comparisons.”
Nevertheless, Butterfill noted that this type of analysis is backward-looking and that assets perform and behave differently in the future than they have in the past.
Yet, as the below chart shows – over different backtest lengths – correlation of a bitcoin portfolio relative to a traditional 60/40 portfolio remains consistently lower than the comparison assets.
“Even through exceptionally volatile periods for bitcoin, its correlation and annualised returns have remained remarkably consistent,” said Butterfill. “Even if bitcoin was added to a portfolio at the 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.”
While a bitcoin allocation does increase volatility, a 4 per cent weighting in portfolios should limit any increase to 100 basis points.
However, when looking at the impact on the Sharpe ratio, backtested results over almost five years suggest that a 10 per cent allocation to the cryptocurrency has seen the most significant improvements in risk-adjusted returns.
“This highlights that even a small addition of bitcoin has a big impact on the Sharpe ratio,” said Butterfill. “We have also included other comparable assets and indices, over the same time period they have had little impact relative to bitcoin on the Sharpe ratio, even when extreme weights are applied.”
And a little bitcoin can also go a long way in terms of diversification with just 4 per cent weighting reducing correlation to a 60/40 portfolio by 15 per cent.
While gold has a similar impact on diversifying a portfolio, weights above 20 per cent are required for any substantive impact on diversification.
“Given these benefits, bitcoin may well be suited to fill the current gap in available diversifiers troubling portfolio managers,” finished Butterfill.
Nevertheless, the issues that continue to plague the cryptocurrency – such as volatility and the inability to work out its value – remain big concerns for many advisers and asset allocators.
Gavin Haynes (pictured), co-founder of investment consultancy Fairview Investing, said it may be too early yet for bitcoin to be considered a mainstream asset class.
He said: “It’s still very difficult to find any intrinsic value in bitcoin and actually be able to make a judgment on what price it should be trading at.
“You have seen it act as a store of value at a time when people have been looking for something that’s detached from the real world really and these are driven by supply & demand rather than underlying value.”
Haynes added: “I’m very cautious because the price is driven by speculative demand and you just have to look back at the charts to see how volatile and how dramatic those swings [in value] are.”
The Fairview co-founder said his preferred alternative currency was gold, which has a longer track record as a diversifier in portfolios and is better understood than younger cryptocurrencies.
“Bitcoin is probably more for speculators than investors,” said Haynes. “You really only have to look at more professional investment portfolios and multi-asset funds and you’ll see it’s not an asset that features.
“My argument would be that if the professionals aren’t using it then it’s not something that private investors want to dip their toe in.”