9 min readIn 2020, we published a seminal article titled A Little Bitcoin Goes a Long Way, discussing how Bitcoin can enhance risk-adjusted returns in a 60/40 equity/bond portfolio. Since then, it has become increasingly clear that the traditional 60/40 model is obsolete. In this article, we explore why this is the case, examine alternative approaches to multi-asset investing, and demonstrate how Bitcoin can continue to diversify and improve risk-adjusted returns. Our findings indicate that many well-known portfolios, such as the Yale Endowment Portfolio, would experience significantly improved Sharpe ratios with a small allocation to Bitcoin.
The 60/40 Portfolio is Obsolete
For decades, many financial planners and stockbrokers relied on a 60/40 portfolio, allocating 60% to equities for capital appreciation and 40% to bonds or other fixed-income investments for yield, risk mitigation, and diversification. This balanced approach performed well during the 1980s and 1990s. Following the Global Financial Crisis, a simple mix of 60% US large-cap stocks and 40% investment-grade bonds continued to meet investors' expectations as equities soared and interest rates plummeted.
However, following a series of bear markets and historically low-interest rates, the appeal of this strategy has diminished. In 2022, the 60/40 portfolio experienced one of its worst years, with both asset classes under significant pressure. The high positive correlation between equities and bonds, at times reaching 42%, undermined the benefits of diversification and caused the portfolio to underperform compared to more dynamically allocated portfolios. Rising interest rates further increased volatility, prompting many to question the effectiveness of the traditional 60/40 portfolio.
The chart demonstrates the reversal of the previously inverse correlation of equities and bonds. Looking at data since the beginning of the 21st century, the Sharpe ratio of the 60/40 portfolio has almost always been positive. This changed in 2022, and has now seen 3 consecutive years of negative Sharpe ratios. Coinciding with the reduction in Sharpe ratios, correlation between the two asset classes has turned positive in 2022 for the first time this century, and remains high today.
This high correlation can be explained by several phenomena.
Rising inflation has hurt bond prices by eroding fixed interest returns and has also negatively affected equities by reducing consumer spending and increasing input costs.
By injecting liquidity into the markets, QE and other unconventional monetary policies have driven up the prices of both bonds and equities simultaneously.
The proliferation of investment strategies and financial products that link equities and bonds, such as balanced mutual funds and pension funds with mixed asset portfolios, have contributed to higher correlations. These funds can buy or sell both asset classes together, impacting their prices similarly.
AQR recently wrote a white paper that eloquently explained some of the reasons for this high correlation from a quantitative perspective, highlighting that it depends not on the level of inflation, but on the relative volatility of growth and inflation and the correlation between them. Empirically, this model explains around 70% of long-term variation in the US stock–bond correlation.
Considering the 12-year experiment with QE and the incomplete reversal through QT, it is likely that growth and inflation volatility will remain high. This suggests that the 60/40 portfolio will not be an effective investment strategy for the foreseeable future, and it is therefore imperative for investment managers to find effective alternatives.
What are the alternatives?
Most investment managers have already taken action and diversified by adding alternative investments to their 60/40 portfolios. Most common is gold and broader commodities, while others have added hedge funds, real estate and private equity funds. Adding bitcoin has remained on the sidelines despite it offering far more superior risk adjusted returns. We can see that despite the US$16bn of inflows into US bitcoin ETFs this year, allocation from investment managers remains particularly low according to 13f filing data.
The most significant allocations are primarily to hedge funds or private equity. Encouragingly, there are some isolated allocations to large pension funds, indicating that less niche funds are also investing in bitcoin. However, the allocations highlighted by 13f filings only represent 25% of the total holdings, so we expect to receive much more detail by the July 15th deadline. There is also evidence of investors diversifying their diversifiers, over the last year we have seen over US$20bn outflows from Gold ETPs, while bitcoin has seen over US$16bn inflows, we suspect some investors are reallocating their gold positions into bitcoin.
Interestingly, allocations held by investment advisors, which, by AUM comprise one of the largest categories, are very low, suggesting that investors are just dipping their toes into the market and may allocate more as their confidence increases. Banks and Pension funds are yet to make any meaningful allocations. Our recent Fund Manager Survey highlights similar findings.
At the most basic level, our analysis shows that adding bitcoin has improved Sharpe ratios, as previously demonstrated in A Little Bitcoin Goes a Long Way. In that work, we reallocated equally from both equities and bonds. To understand better which investment bucket bitcoin should be allocated from, we conducted separate analyses, reallocating exclusively from equities and then from bonds. We found minimal changes in Sharpe ratios in both scenarios. However, minor improvements (Sharpe ratio rises from 1.05 to 1.06 with a 4% position) were observed when reallocating from equities, due to their higher volatility compared to bonds.
Greater reallocations from equities would improve these Sharpe ratios further, but how far can one go before it becomes detrimental to risk adjusted returns? The efficient frontier in portfolio management represents a set of optimal portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given level of expected return. Depicted as a curve on a risk-return plot, with the frontier illustrating the trade-off between risk and return. Our analysis in adding bitcoin demonstrates that employing the efficient frontier approach suggests an extremely high allocation to bitcoin of 72%.
We believe this is an unrealistic approach in determining what would be the best allocation size, particularly given drawdowns and volatility would deviate so much from the traditional 60/40 portfolio. The results are also vague, with there being a potential tangential at around the 4% mark too. Flexing Sharpe ratios in a portfolio delivers more realistic results, with an optimal portfolio weighting of 10%, we note that adding allocations greater than this sees little improvement in risk adjusted returns.
How Would Bitcoin Compliment Realistic Portfolios?
The problem with the 60/40 portfolio is that it doesn’t reflect the real world, and is now less relevant given that it does not diversify and deliver adequate risk adjusted returns. But what is the alternative?
There likely isn’t a typical portfolio, so we modelled 3 well known portfolios that focus on resilience across all points in the economic cycle, to understand how bitcoin would act as a diversifier and enhance risk adjusted returns.
All Weather Portfolio
We first looked at Ray Dalio’s All Weather Portfolio, comprising 30% equities, 40% long term bonds, 15% medium term bonds and 7.5% natural resources and 7.5% gold. The All Weather Portfolio is designed to survive all economic environments, using different types of assets that perform differently during those different seasons. Appropriately, it is also sometimes referred to as the All Seasons Portfolio. Dalio chose asset classes that performed well in each of these different seasons, with the goal being diversification that allows for consistent growth and small drawdowns.
We felt that bitcoin would be well suited to this style of portfolio and decided to replace the gold position with bitcoin due to it being the closest match in terms of being limited in supply.
The Cockroach Portfolio
The Cockroach Portfolio, first formulated by Dylan Grice, is designed to withstand all economic conditions by combining offensive and defensive asset classes. This portfolio aims to be "all-weather," much like a cockroach that can survive extreme conditions. The portfolio includes a diverse mix of equally weighted assets: global equities to benefit from periods of economic growth, global bonds to perform well during deflationary periods, gold to hedge against sharp market sell-offs and provide stability during high volatility, and cash.
We have written in the past about bitcoin’s similarities and differences, to gold and how a combination of both gold and bitcoin can complement each other. Therefore reallocated 7% of the gold holding to bitcoin, it may have made sense to go higher given gold represents 25% of the portfolio, but we wanted to keep it vaguely comparable to the other portfolios we are analysing.
The Yale Endowment
The Yale Endowment investment strategy, famously associated with David Swensen, is known for its innovative approach to asset allocation and long-term investment horizons. Here are the key elements of the Yale Endowment investment strategy:
Yale's endowment follows a diversified asset allocation model designed to achieve high returns while managing risk. The portfolio includes the following asset classes:
Absolute Return: Investments in hedge funds and other strategies that aim to achieve positive returns regardless of market conditions.
Domestic Equity: Investments in U.S. stocks.
Foreign Equity: Investments in international stocks, including emerging markets.
Private Equity: Investments in private companies, venture capital, and buyouts.
Real Assets: Investments in real estate, natural resources, and other tangible assets.
Fixed Income: Investments in bonds and other debt securities.
Cash: Short-term liquid assets.
The Yale Endowment investment strategy is characterised by its focus on diversification, active management, long-term perspective, and innovative approaches to investing in illiquid and alternative assets.
Yale Endowment's high-frequency performance data and weightings are difficult to source. Therefore, we have attempted to replicate the performance of the Yale Endowment using a fixed weighting, quarterly rebalanced approach: 25% in absolute return strategies, 19% in private equity, 13% in US equities, 11% in global equities, 8% in emerging market equities, and 7% each in commodities, REITs, and global bonds.
Due to there being no gold holdings in the fund, we replaced the 7% weighting in REITS with bitcoin.
The Results
The standard 60/40 portfolio achieves a Sharpe ratio of 0.48 when examining data from 2017 onwards. By incorporating a 4% quarterly rebalanced position in Bitcoin, the Sharpe ratio doubles to 1.05, while the correlation decreases by 5%. Replacing Bitcoin with a basket of listed bitcoin mining equities offers similar returns, but due to their higher volatility compared to Bitcoin, results in a lower Sharpe ratio of 0.86.
Including bitcoin in the Yale Endowment, All Weather, or Cockroach portfolios significantly increases annualised returns and improves Sharpe ratios. For instance, the Sharpe ratio for the All Weather portfolio improves from 0.33 to 1.38. These portfolios, already well-diversified, saw a further reduction in correlation by 9-15% with the addition of bitcoin.
The downside is a slight increase in volatility by 2-3%, aligning these portfolios with the standard 60/40 benchmark of 11%. In our view, this increase in volatility is acceptable given the substantial improvement in annualised returns, and this is indeed reflected in the large Sharpe ratio improvements. Interestingly, in the Yale Endowment portfolio, bitcoin also helped reduce maximum drawdowns.
In summary, adding bitcoin to real-world portfolios has consistently enhanced risk-adjusted returns, improved diversification, and boosted annualised returns over the medium to long term. According to our analysis, optimal weightings appeared to be between 4-10%, depending on risk appetite.
We find that bitcoin is proving to be a valuable asset for diversifying away from the challenges associated with the now obsolete 60/40 portfolio. Given the challenges presented to investment managers under the current financial conditions, we believe a thorough investigation into the beneficial properties of bitcoin allocations in portfolio construction is not only warranted but recommended.