7 min readFor decades, investors have relied on an asset allocation of 60% shares and 40% bonds to deliver returns in the form of growth and income and to limit risk through diversification. This standard portfolio performed well during the 1980s and 1990s and when the markets rebounded after the 2008 financial crisis.
However, it has underperformed in recent years. This article explains why and explores the alternatives before showing how a bitcoin allocation of as little as 4% could improve the performance of well-established portfolios designed by top investment professionals.
Standard portfolios are obsolete
In 2022, the standard portfolio experienced one of its worst years, as shares and bonds both underperformed. The correlation between these two asset classes (the amount of time they move in the same direction) rose to 42%, its highest rate in more than 20 years. This elevated correlation reduced the level of diversification, a strategy intended to reduce risk by allocating capital across different asset classes, in standard portfolios and contributed to underperformance compared with portfolios that regularly adjust the allocation.
The correlation has remained high in the intervening years, influenced by three factors:
Rising inflation reduced the value of the income paid by bonds while it also slowed consumer spending and increased the cost of raw materials, which weighed on share prices.
Monetary policies designed to stimulate sluggish economies like quantitative easing (the purchasing of government bonds by central banks to increase the money supply) boosted the price of shares and bonds simultaneously.
The increasing number of investment products and funds trading shares and bonds at the same time.
Given that inflation and growth are expected to remain strong, this strategy is unlikely to be effective for the foreseeable future, so investors need to consider alternatives.
What are the alternatives?
Professional investors have started diversifying their portfolios with alternative assets, such as gold and commodities. In terms of bitcoin, research by CoinShares shows that hedge funds and private equity have the biggest holdings. Some traditional investment vehicles, such as larger pension funds, are also adding bitcoin to their portfolios, while there’s evidence that the industry is warming to CoinShares’ digital gold thesis. Gold exchange-traded products (ETPs) have experienced $20 billion of outflows this year, while inflows into US bitcoin exchange-traded funds have hit $16 billion.
Holdings among investment advisors, one of the largest categories in the industry by assets under management (AUM), are also low. This suggests that they’re testing the waters and may increase their allocation as they grow in confidence. Other traditional financial institutions like banks have yet to invest.
To calculate the optimal holding in a standard 60/40 equity bond portfolio, CoinShares analysed the impact of replacing 4% of the share allocation with bitcoin and then repeated the exercise with other popular alternative asset classes. In the case of Bitcoin, the portfolio’s Sharpe ratio - a metric that compares reward with risk - increased significantly, far outstripping other alternatives despite the relatively small allocation. A higher Sharpe ratio means an investor receives a larger reward for each unit of risk undertaken.
One avenue of research suggested an allocation of 72%, which is unrealistic considering bitcoin’s volatility and the potential drawdowns a portfolio could experience (the maximum fall in its value). However, the optimal allocation for the last 8 years or so appeared to be 10% because adding any further bitcoin delivered little improvement in the Sharpe ratio despite continuing to add risk.
How would bitcoin complement real-world portfolios?
Given the ineffectiveness of the standard allocation and no clear alternative, CoinShares performed a similar analysis on three proven portfolios to simulate bitcoin’s potential impact on returns and diversification.
Ray Dalio, manager of the world’s largest hedge fund by AUM, designed the All Weather portfolio to withstand every economic scenario. It holds 30% shares, 40% long-term bonds, 15% medium-term bonds, 7.5% natural resources and 7.5% gold. CoinShares replaced the gold holding with bitcoin.
The Cockroach portfolio is the brainchild of Dylan Grice, co-founder of hedge fund Calderwood Capital, whose aim was similar to the All Weather Portfolio (hence the name). It holds equal allocations to global shares and global bonds and 25% to gold. CoinShares only reallocated 7% of the gold holding to bitcoin to allow comparison with the other two portfolios.
The Yale Endowment strategy, launched to support the US university’s financial wellbeing, is known for its innovative asset allocation and long-term investment horizon. While the exact allocation is hard to source, CoinShares aimed to replicate it with 25% in absolute return strategies (which aim to deliver a return regardless of market conditions), 19% in private equity, 13% in US shares, 11% in global shares, 8% in emerging market shares and 7% each in commodities, global bonds and real estate investment trusts (REITs). CoinShares replaced REITs with bitcoin in this case as the strategy doesn’t hold gold.
As the table below shows, based on data from 2017 onwards, adding bitcoin to each of these portfolios boosted annualised returns and the Sharpe ratio (against cash), which more than doubled in the standard allocation and increased as much as fourfold in the others. It also reduced the correlation of the bitcoin portfolios with the standard allocation, particularly the Yale Endowment strategy which improved by nearly 15%. The downside is the increased volatility experienced by the bitcoin portfolios, although this metric remained aligned with the standard allocation. That said, this higher risk could be acceptable given the rise in returns. One final observation about the bitcoin portfolios: the maximum drawdown increased by less than 1% in the standard allocation, and it fell by nearly 1% in the Yale Endowment strategy, but rose by about 4% in the other two.
Conclusion
A standard portfolio consisting of 60% shares and 40% bonds served investors well in the 1980s and 1990s and after the 2008 financial crisis. But it has become less effective in recent years as high inflation, economic stimulus measures and a herd mentality in the investment industry have contrived to reduce the correlation between shares and bonds.
As investors seek to diversify their portfolios with alternative assets, research by CoinShares suggests that a bitcoin holding of between 4% and 10% could have a positive impact in the future. To prove this thesis, CoinShares simulated the performance of several model portfolios based on real-life strategies, adding 4% bitcoin to the standard allocation, replacing the gold holdings in the All Weather and Cockroach portfolios with bitcoin, and replacing REITs in the Yale Endowment strategy. The results show that annual returns significantly improve and correlation falls compared with the standard allocation, although volatility increases slightly.
To learn more about adding bitcoin exposure to a portfolio, explore the CoinShares range of ETPs.