Just the right amount of Bitcoin

In our last piece we established that bitcoin enhances risk adjusted returns in a traditional 60/40 equity/bond portfolio. Here we ask, ‘Historically, what’s the right amount of bitcoin?’

• Small weightings of bitcoin have had an outsized positive impact on both risk-adjusted returns and diversification relative to other alternative assets.

• Increasing risk (annualised volatility of the portfolio) by 1.2% suggests a portfolio weight of just under 4% in a traditional 60/40 equity/bond portfolio.

• Quarterly rebalancing of Bitcoin back to the original invested weight helps contain volatility.

Bitcoin has been a volatile asset since its inception in 2009, keeping some investors wary of investing. We believe, with relatively limited risk, an allocation to Bitcoin can be made that has a meaningful impact on portfolio performance.

In this article, we highlighted the potential diversification benefits that an allocation to bitcoin can provide to a traditional 60/40 equity/bond portfolio. In particular, Bitcoin’s lack of correlation to other assets potentially makes it a far more useful alternative asset for investors looking to reduce exposure to economic cycles, especially when compared to other popular alternative investments, such as gold or a broad basket of commodities.

So, how much should you invest in bitcoin?

Whilst there is no one-size-fits-all approach, we believe that Bitcoin is steadily evolving into a store of value, and a backtest of bitcoin price performance in a portfolio can still deliver valuable insights for long-term investors. We also believe that informing investors on the best Bitcoin portfolio allocation in their portfolio, according to their risk appetite, is essential.

To help investors understand how bitcoin can help or hinder a portfolio we created a database of daily returns starting from 2015 when the investors were first able to invest in the asset via an Exchange Traded Product (ETP). We started with a traditional balanced portfolio with 60% equities and 40% bonds and then added a notional amount of bitcoin, detracting from both equities and bonds equally.

As bitcoin is an asset in an early growth phase, most investors would allow its portfolio weight to drift to some extent. We decided to rebalance on a quarterly basis––despite its potential hindrance on enhancing returns––because we believe rebalancing helps moderate volatility. You can read more about the composition of this portfolio in this report.

Adding Bitcoin to a portfolio does increase portfolio volatility. So how much should be added to a portfolio? There are several ways to approach this. One method is volatility targeting, and the chart below highlights how much Bitcoin in a portfolio contributes to risk.

As a guide, the chart highlights a 4% weighting in a portfolio would increase the overall portfolio volatility by just over 1%.

An alternative approach is to blend the risk and reward by analysing the impact on the portfolio Sharpe ratio (a measure of returns relative to the level of risk taken on) in varying Bitcoin portfolio weights.

The backtested results over almost 5 years produce the above chart. Movement to the right indicates higher risk-adjusted returns while movement up reflects a higher allocation to bitcoin over the test period. This analysis indicates that the most significant improvements in the Sharpe ratio are gained through an allocation of up to 10% bitcoin in the portfolio. This highlights that even a small addition of bitcoin has a big impact on the Sharpe ratio. We have also included other comparable assets and indices over the same time period, and they have had little impact relative to bitcoin on the Sharpe ratio, even when extreme weights are applied.

Investors could argue that this 5 year period is overly favourable, and given that Bitcoin rallied over this period any analysis would look great. To address this concern we also included analysis from the Bitcoin price peak on 18th December 2017 to date, a period where Bitcoin negatively contributes to overall returns. The results highlight that Sharpe ratios remain positive, although understandably not to the same degree. This may seem nonsensical but this is due to our quarterly rebalancing strategy, where Bitcoin is reset back to its original weighting every quarter. We have found that regular rebalancing can reduce potential for higher returns, but is prudent in containing Bitcoin’s volatility.

Gold has a similar impact in diversifying a portfolio, although portfolio weights above 20% are required to achieve any substantive impact on diversification. Bitcoin is converse to this, with minimal weights having a far greater impact.

In conclusion, bitcoin’s investment characteristics have historically made it attractive both as a driver of returns and a portfolio diversifier. Compared to other common alternatives and diversifiers, bitcoin has delivered outsized positive impacts on returns, Sharpe ratio and diversification, even at very low allocation sizes.

As to answering the question:“how much should I invest in Bitcoin?” this very much depends on your appetite for risk. By our analysis, however, allowing a modest increase in overall portfolio volatility of 1.2% would suggest a Bitcoin portfolio weight of just under 4% in a traditional 60/40 equity/bond portfolio, although investors should always be mindfulto regularly rebalance back to the original investment weight.

The information contained in this document is for general information only.Nothing in this document should be interpreted as constituting an offer of (or any solicitation in connection with) any investment products or services by any member of the CoinShares Group where it may be illegal to do so. Access to any investment products or services of the CoinShares Group is in all cases subject to the applicable laws and regulations relating thereto.

This document is directed at professional and institutional investors. Investments may go up or down in value and you may lose some or all of the amount invested. Past performance is not necessarily a guide to future performance.This document contains historical data.Historical performance is not an indication of future performance and investments may go up and down in value.You cannot invest directly in an index. Fees and expenses have not been included.

Although produced with reasonable care and skill, no representation should be taken as having been given that this document is an exhaustive analysis of all of the considerations which its subject-matter may give rise to. This document fairly represents the opinions and sentiments of CoinShares, as at the date of its issuance but it should be noted that such opinions and sentiments may be revised from time to time, for example in light of experience and further developments, and this document may not necessarily be updated to reflect the same.

The information presented in this document has been developed internally and / or obtained from sources believed to be reliable; however, CoinShares does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions and other information contained in this document are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Third party data providers make no warranties or representation of any kind in relation to the use of any of their data in this document. CoinShares does not accept any liability whatsoever for any direct, indirect or consequential loss arising from any use of this document or its contents.

Any forward-looking statements speak only as of the date they are made, and CoinShares assumes no duty to, and does not undertake, to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Nothing within this document constitutes (or should be construed as being) investment, legal, tax or other advice.This document should not be used as the basis for any investment decision(s) which a reader thereof may be considering. Any potential investor in digital assets, even if experienced and affluent, is strongly recommended to seek independent financial advice upon the merits of the same in the context of their own unique circumstances.

CoinShares Capital Markets (UK) Limited is an appointed representative of Strata Global Ltd. which is authorised and regulated by the Financial Conduct Authority (FRN 563834). The address of CoinShares Capital Markets (UK) Limited is Octagon Point, 5 Cheapside, St. Paul’s, London, EC2V 6AA.

The CoinShares Astronaut is a trademark and service mark of CoinShares (Holdings) Limited.

Copyright © 2020 CoinShares