Does Bitcoin 2024 belong in a balanced portfolio?
Felix Fernandez
Partner at Adaptivv Financial Technologies Ltd. | Financial Riskmanagement
Introduction
Bitcoin is the first and best-known cryptocurrency and has undergone considerable development since its introduction in 2009 (1). From tech-savvy individuals to institutional investors, Bitcoin has significantly changed the way we think about money and investing.
The spectrum ranges from maximalists who use Bitcoin as a parallel currency (2) to critics who call for it to be banned (3).
The past
In the past, Bitcoin has been characterized by high volatility combined with significant gains, but also by long and painful periods of losses. This has led to a polarized view: While some investors see Bitcoin as a revolutionary asset class, others view it as a speculative instrument with dubious future potential.
Current trends and developments
The early integration of cryptoassets into the portfolios of some influential university endowments (Yale, Harvard, Brown 4) and the involvement of larger financial market participants attracted attention in the financial world.
By 2023, regulatory measures, technological progress and increasing institutional interest have significantly influenced the cryptocurrency environment. Major financial institutions have begun to include Bitcoin in their service portfolios (5) and some countries have taken steps to recognize and regulate cryptocurrencies as a means of payment or asset.
1. Is Bitcoin an investable asset?
To answer this question, it is important to understand that a Bitcoin is the result of a computationally intensive validation process. The validation participant (miner) in the Bitcoin network (6) who is the first to find the cryptographic solution to validate a block in the blockchain and thus anchor it there immovably receives compensation in Bitcoins (7).
These newly created bitcoins are available as a means of payment and can be put into circulation by the miner or exchanged for a target currency. The actual use of Bitcoin as a means of payment can be transparently read from the public blockchain. Currently, around 100,000 Bitcoin per day are processed via the blockchain, which at a price of 40,000 US dollars per Bitcoin (8) corresponds to a daily volume of four billion US dollars on the blockchain.
The volume of Bitcoin traded on exchanges independently of the blockchain is likely to be much higher. Binance alone has a daily trading volume of around USD 1.8 billion. (9) In this respect, Bitcoin is at least a relatively widely recognized means of payment or investable asset with a current market capitalization of around USD 750 billion (10). By comparison, gold has a market capitalization of five trillion US dollars (11).
The following characteristics must generally be checked for an investable asset:
Liquidity: The ease with which an asset can be converted into cash without significantly affecting its market price. Bitcoin is very liquid as it can be easily bought or sold on crypto exchanges. There is also a wide range of structured products (12) and derivatives (13).
Return on capital: This includes interest, dividends or capital gains generated by holding the asset. Bitcoin has shown the potential for high returns, albeit in conjunction with high volatility.
Risk: All financial assets are subject to various risks, e.g. market, credit, liquidity and operational risk. Bitcoin carries significant risk, primarily due to its volatility. In some countries, the still-evolving regulatory landscape is an additional risk.
Marketability: How easily the asset can be sold or bought on the market. Bitcoin is easily tradable and is traded on the blockchain and numerous platforms worldwide.
Maturity: The period until the asset yields income for the investor. In contrast to traditional financial assets, Bitcoin has no maturity date. Its value is more speculative and depends on market demand.
Diversification potential: The ability of the asset to be combined with other assets in a portfolio to reduce risk. Due to its overall low correlation with traditional financial assets, Bitcoin offers good diversification in an investment portfolio.
Regulation and transparency: On the one hand, the extent to which the asset is regulated by the financial authorities and, on the other, the transparency of information on this asset. Bitcoin operates in a legal gray area in many countries. While transactions are transparent and traceable via the blockchain, regulatory standards and supervision are less clear in some countries compared to traditional financial assets.
Inflationary: The possibility that the asset can be created and placed on the market in any quantity. Here Bitcoin shows a technical characteristic that makes it a limited good. The Bitcoin protocol stipulates that a maximum of 21 million units can be created (14).
Conclusion
In countries where cryptoassets and Bitcoin are already well regulated (15), Bitcoin can be considered an investable asset. It fulfills all the necessary characteristics and also offers other advantages such as unlimited global trading around the clock.
2. What role does Bitcoin play in a diversified portfolio?
Bitcoin is often referred to as digital gold and can play a role in a diversified portfolio. Its low correlation with traditional asset classes such as equities and bonds can help to spread risk. However, this should be considered in the context of its high volatility and long periods of loss.
The correlation between different asset classes is generally low. This can be seen both graphically in the dot clouds and in the values, which are well below 0.5 (16).
However, when analyzing the correlation, it should be noted that it generally increases during generally increases during market crises.
Conclusion
Bitcoin can generally increase the diversification of a portfolio, but this positive effect is limited in times of crisis and should be supported by a balanced strategic portfolio construction.
3. How can Bitcoin be optimally integrated into a portfolio?
When integrating an asset such as Bitcoin into a portfolio, it is important to ensure that the high volatility does not have an unfavorable impact on the characteristics of the portfolio, but instead creates added value. Empirically, an addition of one to four percent Bitcoin has proven to be sensible.
With an addition of 4 percent to a 60/40 portfolio (17), the annualized return increases from 5.2 to 8.2 percent over the observed period. The annualized volatility only increases from 10.5 to 11.1 percent. This leads to an increase in the risk-adjusted return (Sharpe ratio) from 0.5% to 0.7%, with the maximum loss rising from 24% to 26%.
Conclusion
As can be seen from the performance of the portfolio, the addition of Bitcoin to traditional assets can certainly generate added value in the long term. It is important to rebalance periodically and to take into account the rising transaction costs.
4. Is tactical risk management worthwhile for Bitcoin?
The high volatility and the associated periods of loss are the li- miting factor when adding Bitcoin. If you have the necessary technology for tactical risk management (18), our analyses show that you can actually increase the added value of adding Bitcoin.
The addition of 8 percent actively managed Bitcoin to a 60/40 portfolio almost doubles the annualized return from 5.2 to 10.3 percent, while the annualized volatility only increases from 10.5 to 11.3 percent. This leads to an increase in the risk-adjusted return (Sharpe ratio) from 0.5 to 0.9. The maximum loss increases from 24 to 25 percent.
Conclusion
Especially in the case of highly volatile assets with long negative phases such as Bitcoin, the combination with tactical management creates considerable added value. Especially with a long-term investment horizon, the additional returns are very relevant.
5. What other risks should be considered when investing in Bitcoin?
The risks from a product perspective have already been discussed. However, there is another very significant aspect of risk that needs to be considered when investing in Bitcoin: the counterparty or platform risk. As we saw in the case of the collapsed FTX (19) crypto exchange, it was not the product risks that led to considerable losses for investors, but gross negligence on the part of the operators.
In this respect, particular attention must be paid to the implementation of the investment process when investing in Bitcoin (20).
1. Direct investment in Bitcoin
Direct investment in Bitcoin is very efficient, but requires knowledge of how to use wallets and the necessary software, trading platforms and data backup. Basically, the counterparty risks are replaced by technical risks.
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2. Investment via an exchange
Bitcoin investments via exchanges are much easier to carry out, but you need to be aware of the counterparty risks (see FTX). It is generally advisable to only use exchanges that are based in your own jurisdiction and to obtain detailed information about their custody concepts.
3. Investment in structured products
This is the simplest form of Bitcoin investment, as these products can usually be purchased via the house bank and are strictly regulated. Nevertheless, it is important to check the product issuers for default risk and, if necessary, to diversify the investment across several issuers.
Final Conclusion
In conclusion, the potential added value of Bitcoin as part of a diversified investment portfolio should not be underestimated. Important aspects that emphasize the added value, especially from the perspective of an institutional investment, are diversification, inflation protection, return potential and investment in technological innovation.
Investors who are interested in Bitcoin as an asset should not be confused by the sometimes sensationalist media reports, but should carefully consider whether Bitcoin can offer added portfolio value or fits in with their own investment strategy. There is now a wide range of literature and training opportunities on this topic.
Bitcoin remains a fascinating, albeit risky, investment. Investors who wish to invest in this asset should be aware of the risks and pursue a well-thought-out strategy. Careful observation of the market, product providers and regulatory developments are prerequisites for making sound investment decisions.
About the author
Felix Fernandez has more than 20 years of experience in the financial industry and various management positions within Deutsche B?rse AG/Eurex.
After working as a research fellow at the ETH/Rmetrics Association in Zurich, Felix took on the role of CEO of Adaptivv Financial Technologies AG in November 2016.
He holds a degree in electrical engineering with a focus on technical computer science from the University of Applied Sciences Frankfurt am Main and specializes in software simulation environments.
About Adaptivv
We are a spin-off of ETH Zurich, founded in 2016 with a focus on advanced statistical methods and financial engineering.
Our technologies are based on the latest academic research developed at ETH and affiliated universities. We are engaged in the ongoing transfer of academic research into commercially viable products and services.
The ADAPTIVV SENSOR? technology provides reliable stability signals that enable a precise assessment of market risk and dynamic risk control with outstanding timing properties. This technology has now been in use for 7 years by large Swiss pension funds, family offices, asset managers and private banks.
References
This article has been already published in German at the Portfolio Journal 12-2023 (https://www.portfoliojournal.de/ ).
(5) E.g., Morgan Stanley, BlackRock, State Street, Fidelity, Goldman Sachs, DWP Bank, Commerzbank etc.
(6) On 9.12.2023, there were around 16,000 active network nodes worldwide. Source: https://bitnodes.io/
(11) https://www.gold.org/goldhub/research/market-primer/gold-market-primer-market-size- and-structure
(12) https://www.justetf.com/at/find-etf.html?assetClass=class-currency&groupField=none&in- dex=Bitcoin&sortField=fundSize&sortOrder=desc
(14) A common question is whether the 21 million threshold cannot simply be moved upwards when it is reached. This would require a majority of the Bitcoin network to agree to a protocol change, which is unlikely, as the value of Bitcoin would then fall for all participants.
(15) Japan, Switzerland, Singapore, Estonia, Malta, South Korea, the USA and the European Union
(16) Correlation values are generally between -1 and +1, with values around zero indicating a non-significant correlation.
(17) 60 percent equities, 40 percent bonds
(18) We use our own technology here, the Adaptivv Sensor?. See https://www.adaptivv.com/technology .
(20) This essentially applies to all cryptocurrencies.
Disclaimer
This material has been prepared for educational purposes only and is not intended as, and should not be considered as, an offer or solicitation of an offer or a solicitation or personal recommendation to buy or sell any stocks and bonds or other funds, securities or financial instruments or to participate directly or indirectly in any investment strategy.
All information on an investment strategy prior to its launch date is back-tested and based on the methodology in place at the launch date. Retrospectively tested performance, which is hypothetical and not actual performance, is subject to inherent limitations as it reflects the application of a methodology and the selection of constituents with the benefit of hindsight. No theoretical approach can take into account all factors in the markets in general and the impact of decisions made during the actual implementation of an investment strategy. Actual returns may differ from and be lower than the retrospectively tested returns.
Absolutely, considering a balanced portfolio! As Warren Buffett once said, "Never put all your eggs in one basket." ??[+] Diversifying with Bitcoin could be a strategic move for 2024, blending innovation with traditional investment wisdom. ?? #DiversifyYourInvestment
Absolutely, including Bitcoin in a diversified portfolio can be a wise move ??. As Warren Buffett once said, "Never depend on a single income. Make investment to create a second source.” Bitcoin, with its unique properties, could serve as that innovative avenue for diversification.? #investwisely #diversification