Cryptocurrency as a New Asset Class Part 4
In Part I of this series we went into the value propositions for some of the popular crypto assets. In Parts II & III we looked into the returns, volatility, and correlation of bitcoin compared with traditional asset classes. In this article, we will put it all together by determining the optimal allocation of crypto assets within a portfolio.
Portfolios
We must first build a traditional portfolio that we will use as a baseline for our analysis. Our base portfolio will be 60% equity and 40% fixed income. This portfolio was chosen to represent a standard allocation for the average person.
Equity ETFs: Mid cap growth mixed with the broader market
- First Trust Mid Cap Growth AlphaDEX ETF (FNY)
- Vanguard Total Stock Market Idx I (VITSX)
Fixed Income ETFs: Constituting corporate and municipal debt
- First Trust Preferred Sec & Inc ETF (FPE)
- SPDR Nuveen Blmbg Barclays Muni bd ETF (TFI)
Below is the allocation of our base portfolio. (Portfolio tool provided by Portfolio Visualizer)
We will now introduce Bitcoin (BTC) allocations of 1% and 3% to our portfolio.
Settings
Our analysis is based on the assumption that $10,000 was invested in the portfolio on 1/1/2015 and rebalanced each quarter.
As in the previous articles, BTC was used instead of a crypto index because of the length of time that reliable BTC price information is available; 2015 is the year in which said data became reliable.
Analysis of Returns
We will first look at the returns of each of the three portfolios.
These two charts reflect what was expected for the returns of the portfolio. Just a 1% allocation to BTC both improved the Compound Annual Growth Rate (CAGR) by more than 1% and returned 55% (15,510 / 10,000–1) over the five years as opposed to 46% (14,613 / 10,000–1) from the base portfolio.
Also, the losses in 2018 were greater with more BTC allocated into the portfolio. Interestingly, 2020 was an exception to this even though 2020 is only reflecting Q1. The BTC allocated portfolios have fared slightly better than the base portfolio. We will be keeping a close eye at how BTC performs into 2020, especially with the volatility being seen across all financial markets.
Volatility and Correlation
The standard deviation of the portfolio increases as more BTC is introduced, however with a 1% increase to BTC we see the standard deviation in the period only 0.1% greater than the base portfolio. This shows that a 1% allocation to BTC may not increase the volatility of a portfolio as much as one may expect.
Perhaps the most important metric is the increase of the Sharpe and Sortino ratio through increases in BTC allocation. The increased return we are seeing is more than enough to compensate for the increased volatility.
The correlations with the US mkt did not seem to change much with a 1% allocation to BTC, going from 0.96 to 0.95. However, the 3% allocation saw this drop to 0.91. This decrease of market correlation without sacrificing expected return is exactly what an uncorrelated asset like bitcoin is supposed to do.
Verdict
Based on these results, we believe the extra returns provided by BTC to be greater than the increased volatility. A 3% allocation to BTC may prove to have more volatility than a risk-averse investor is willing to take on. However for a more aggressive investor, a 3% or greater allocation to BTC may be appealing.
I highly recommend trying this out on your own. Odds are, adding incremental allocations of BTC to your portfolio will see your risk-return profile increase and your correlations go down.
Disclaimer: The views expressed in this article are solely opinions of the author and do not represent financial or legal advice whether to buy, sell or hold shares of a particular cryptocurrency, cryptographic asset, stock or other investment vehicle. Prior to trading, investing or purchasing any assets, individuals should consult with their own tax, financial or legal advisor. Past performance is no guarantee of future price appreciation.
