How adding crypto improves a traditional investment portfolio
When Bitcoin and the entire cryptocurrency asset class first gained real media attention in the bull-run of late 2017 it, was easy for asset managers to ignore this new asset class. Now it is nearly 5 years later, and it seems pretty clear that crypto is here to stay. Allocating money to cryptocurrencies can be a bit daunting, as it comes with high volatility and sharp drawdowns, which are unrivaled in the traditional finance asset space. But this high risk is not without its reward. In the sample period from 2018–2022 we have seen three major growth periods for bitcoin, with price increases from $3,124 to $13,870, $3,880 to $64,898 and $28,754 to $68,997, for 343%, 1572% and 140% returns respectively. In the figure below we can see the cumulative returns for Bitcoin and Ethereum over our sample.
Now that larger institutions start to take crypto more serious and institutional infrastructure has significantly improved over the last few years, allocating to this new asset class should be on the agenda of every investment officer. Once decided investments should follow, the first follow up question would be how much to allocate. In this article we will take a look at the effects of adding crypto exposure to a traditional investment portfolio.
For this article we choose to use a sample period from 01–01–2018 until 31–07–2022. One could argue that before 2018 it was not likely for an asset manager to allocate serious capital to cryptocurrencies, as the space was still in its infancy. This starting date is also in the beginning of a major bear market. Therefore the results will be a bit worse then when starting at the end of a bear market, but also more realistic, as most people do not enter a market like this at the bottom.
Adding crypto to a classic investment portfolio
There are many multi-asset approaches one can take to construct a balanced portfolio. In this case we will be looking at one of the most popular and well known investment portfolios, the ‘60/40’ portfolio, as our benchmark. This portfolio consists for 60% stocks and 40% bonds. We construct this portfolio using ETFs as proxies, where we invest 60% in the S&P 500 ETF (SPY), and 40% in the US Aggregated Bond ETF (AGG). We will be using adjusted closing prices to get the total return of these ETFs.
We compare this to a portfolio to which we add 5% crypto exposure. This consists of 60% Bitcoin, the first, most well known and biggest cryptocurrency, and 40% Ethereum. Which has since its inception in 2015 grown to the second largest cryptocurrencies. They have a combined market cap of $584 billion compared to the S&P 500 market cap of $31.9 trillion at the time of writing. Our portfolios will be rebalanced at the end of every quarter to their strategic weights. We assume zero transaction costs.
The figure below shows the cumulative returns for the portfolio with crypto exposure and for our benchmark. In the first year our benchmark performs better, which is not strange considering that crypto was in a bear market that year. After the initial slump we can see clear outperformance for our portfolio containing crypto.
This outperformance is shown even better in the figure below, which shows the yearly returns of our two portfolios. Adding the crypto exposure almost doubles the losses in 2018, but the following years make up for that, especially 2020. We can see that while the returns have the same sign for both of our portfolios, adding crypto increases the magnitude of the gains/losses.
While higher returns are definitely useful, they do not tell the entire story in portfolio evaluation. Therefore we look at a couple of different metrics to decide whether it is worthwhile to allocate to crypto.
- CAGR (Compound annual growth rate)
- Annualized volatility (standard deviation of returns)
- Annualized Sharpe ratio (risk adjusted returns)
- Max drawdown (maximum observed loss from a top)
- Value at risk (VaR) (maximum daily loss we expect with 95% certainty)
- Expected shortfall (average return in the 5% worst days)
When looking at the values for the Sharpe ratio we can see that it improved quite a lot as well by adding crypto exposure. This indicates that per ‘unit’ of risk the crypto exposure gives more return than our benchmark portfolio. This is good, as it indicates that there is an actual improvement in risk adjusted returns. If the Sharpe ratio was lower one would be better off using leverage on the benchmark portfolio to get the same volatility as the portfolio with crypto, while having higher returns.
We see that the last three metrics get worse when adding crypto exposure. This is to be expected, as an asset with higher volatility will most likely also face larger drops, so the tail risk will be higher, which shows in the lower values of expected shortfall and VaR. Especially the expected shortfall increases considerably when going from 5% crypto allocation to 10%.
Even though the Sharpe ratio is higher for a 10% allocation, we see diminishing results compared to 5% allocation. This while the risk metrics (volatility, drawdown, VaR and expected shortfall) increase more from 5% -> 10% than from 0% ->5%. Hence, we argue that 5% allocation may be preferential over a 10% allocation.
Scaling volatility
One downside of the portfolio with added crypto exposure is the increased volatility. As not everyone is willing to take on that extra volatility, it is interesting to look at the performance if we scaled the volatility ex post to the volatility level of our 60/40 benchmark portfolio. This is done by holding some percentage of the portfolio in cash. We do not assume this cash to generate yield.
By matching the volatilities we can better compare the different risk metrics for the two portfolios. The table below shows the summary statistics for the benchmark, our volatility scaled portfolio and the unscaled portfolio.
We see that scaling did not result in a completely identical volatility, but it is very close. The CAGR and Sharpe are both still higher than for our benchmark, although lower than for our unscaled portfolio with crypto. This is as expected, as we scaled the positions.
The most interesting result of the volatility matching is in the drawdown, VaR and expected shortfall. We see that by scaling the portfolio, all three of these metrics give better results than our benchmark portfolio. The scaled portfolio performs better or equal to the benchmark in every one of our metrics. So by scaling down the portfolio volatility, we can have the same volatility as our benchmark, while returns are higher and risk metrics give better results.
Conclusion
To conclude, adding 5% crypto exposure (Bitcoin/Ethereum) to a traditional US 60/40 portfolio results in a higher Sharpe ratio over our sample, but also deteriorates risk performances according to multiple risk metrics. By scaling this portfolio to match the volatility of our benchmark portfolio we can still get excess returns, while improving the max drawdown, VaR and expected shortfall.
Data sources
[1] Glassnode
[2] Yahoo finance
