**Crypto Assets: The allocation of crypto in a balanced portfolio**

**By Hugo Van Veen, CIO**

In traditional finance, structuring a portfolio in terms of the most “efficient frontier” represents a fundamental step in the allocation process. The efficient frontier details the best possible return one can expect from their portfolio, given the level of overall risk. However, at least in retail audiences, the concept rarely influences allocation in crypto assets.

A portfolio with this emergent asset class demonstrates a materially superior efficient frontier than one without. As crypto assets establish themselves, this fact will become difficult to ignore.

Research concludes that portfolios on the efficient frontier include crypto assets. Lower-risk portfolios include a 2–5% allocation in crypto and higher-risk portfolios can have as much as 25% exposure to crypto assets.

# A Note on Asset Allocation

Financial professionals almost universally acknowledge asset allocation as the most critical decision in the entire investment process. Consensus research has proven that 80–90% of a portfolios’ risks and returns can be attributed to asset allocation. However, the allocation process is often the most ad hoc and ignored step in investment decision making.

Many investment advisors want to exclude cryptos from the allocation process as they consider the assets “too risky”. But one must evaluate the benefits of the asset class when combined with more traditional allocations. *If cryptos can enhance the portfolio’s ability to achieve greater returns for a given level of risk, in other words augment the efficient frontier, then they should be included.*

# Considering Crypto as an Asset Class

The total current market capitalization of crypto approximates at $200–400 billion, which represents less than 0.2% of the total global asset base. A maturing regulatory environment coupled with the rapid adoption of blockchain technology could spur this relatively small capitalization to exponential explosion. A market capitalization of several trillion USD in the near future is easily achievable. This creates the possibility of 10x or even 20x potential for growth in crypto assets with the maximum possible loss of 100% of capital. Complete capital loss sounds jarring, but if allocated as a marginal percentage, the limited downside and multiple capital appreciation creates a highly favourable asymmetric return profile.

The extremely lognormal probability distribution of returns together with the uncorrelated nature of crypto, make the assets a very useful addition to a diversified portfolio.

The historical inclusion of as little as 1% of crypto assets in a diversified portfolio substantially increased returns. Crucially, if full capital loss transpired, then the downside would hardly affect the overall portfolio.

**Constructing a Sensible Crypto Portfolio**

When dealing with crypto, one must consider allocation across the entire risk spectrum, from a low-risk conservative portfolio, to a high-risk aggressive portfolio. This will determine crypto’s relevancy in portfolio construction and the sensible percentage of exposure.

Somewhat surprisingly given their controversial perception, regardless of a portfolio’s varying risk mandate, crypto assets invariably enhance the efficient frontier. Optimal crypto allocation increases linearly from 3% in low-risk portfolios to up to 25% in more aggressive portfolios.

# Forecast Error

The above asset allocation analysis done by SwissOne, makes assumptions about crypto’s forecasts of risk, return and correlation. For a more comprehensive analysis, one needs to account for the inherent forecast errors in the variables by adjusting the assumptions and determining the new crypto weighting. In effect this will take account of the forecast error inherent in any allocation process to arrive at a plausible allocation range.

**Return Expectation**

The crypto return expectations were adjusted while keeping the crypto risk constant. The mean return was changed from 25% per annum to 200% per annum while keeping the crypto risk and correlation constant. Crypto risk has been defined as a 90% capital loss. The results showed that the return expectations did not materially alter the portfolio exposure/allocation to crypto assets.

## Crypto Risk

Throughout the aforementioned analysis worst case scenario crypto risk was defined as a 90% loss in capital.

For the next analysis, crypto return expectations were kept constant at 50% p.a, and optimal allocations were calculated for a crypto risk of 90%, 70%, 50% and lastly 30% loss of capital. Analysis demonstrated material changes to the allocation of crypto assets to all portfolios along the efficient frontier. As the crypto risk (ie % loss of capital) decreases, the optimal allocation to crypto assets exponentially increases from 2–10% in low-risk portfolios, and 25–70% in very high-risk portfolios.

## Correlation

The efficient frontier allocation analysis assumed that cryptos are uncorrelated to other asset classes. The short data history of cryptos corroborates the uncorrelated assumption. If the assumptions about correlations are altered whilst the risk and return expectations are kept constant, then it is evident that there is a material change to the allocation. As correlation is changed from — -0.3 to +0.3 the optimal allocation to crypto assets linearly increases from 2–10% in low-risk portfolios, and 25–38% in very high-risk portfolios.

# Conclusion

Ultimately the objective of any portfolio is to achieve the highest probability of excess returns, within given parameters of risk. This is best done through asset classes that exhibit:

● Uncorrelated performance to the other asset classes

● High possibility of excess returns per unit of risk

While crypto assets are regarded as a high-risk asset class — and indeed show such behaviour — they do meet the above criteria. Therefore, crypto is a desirable asset to be included within a diversified multi-asset portfolio as is evidenced by the results of SwissOne’s analysis. The quantum of allocation is more difficult to determine, and the use of an asset allocation methodology is necessary to assist in the process.

Overall, the analysis vindicates an allocation of 2–5% in crypto assets as a sensible investment for low-risk portfolios, and allocation can increase as much as 8–20% in higher-risk models.

The net result is that cryptos are always included in any risk portfolio on the efficient frontier. The analysis also shows that this holds true for a range of risk, return and correlation assumptions.

*** XMap Asset Allocatiion methodology and software was used in the above SwissOne allocation analysis. XMap is a methodology based on Mean Variance Optimization with closed form solution enhancements such as fuzzy logic to be able to deal with assymetric return distributions, non static correlations and forecast errors.*