In a bull market, it’s all about rebalancing

Bitcoin’s latest bull market is its strongest since 2021. It started in the summer of 2023 after some of the world’s largest financial institutions submitted applications to launch spot bitcoin exchange-traded funds (ETFs), and it continued in anticipation of the fourth halving. The rally was so powerful that bitcoin hit a new record high of $71,000 in March 2024.

Many investors have benefited from this bull market, but it may also have skewed the weightings in their portfolios and increased their risk exposure. This article explains how to return a portfolio to its original asset allocation, a risk management strategy known as rebalancing.  

The Significance of Rebalancing

Asset allocation is a strategy that involves building a portfolio with whichever assets help an investor reach their goals. While a standard allocation of 60% shares and 40% bonds is suited to an investor with a moderate risk appetite, a recent graduate planning for retirement might increase the weighting to 80% shares because they have longer to weather stock market fluctuations.   

The benefit of diversification is if one asset underperforms, it shouldn’t disproportionately impact the portfolio’s overall returns. But sometimes an asset outperforms. When this happens, the asset allocation becomes skewed, and a portfolio’s risk profile may exceed the investor’s appetite.

For instance, if a share rallies, a standard allocation may shift to 70% shares and 30% bonds. To return the portfolio to its original allocation, the investor would need to sell shares and buy bonds.

This process is known as ‘rebalancing’. The approach described above is called threshold rebalancing because it occurs when the portfolio diverges from the original allocation by a certain percentage. Calendar rebalancing is the other main approach, which involves checking a portfolio at regular intervals, say monthly or quarterly, and readjusting the allocation when necessary.  

Rebalancing is particularly important when holding crypto because of its volatility. To put this in context, let’s compare the strongest rallies by shares, using the S&P 500 as a proxy, from 2019 to 2022. After initially falling by 30%, the S&P 500 set off on a bull run that rose by 100% between the trough in March 2020 and the peak at the end of 2021. However, bitcoin rose by 500% between October 2020 and April 2021.

The Optimal Allocation: 4% Rule (in a ‘global’ investment portfolio)

When building a diversified portfolio with bitcoin, research by CoinShares suggests that a 4% allocation is optimal.

CoinShares tracks the performance of model portfolios and reports on their returns in its Bi-Weekly Digest. Here’s the asset allocation for several of these portfolios:

• A standard allocation

• A standard allocation with 4% bitcoin (rebalanced quarterly)

• A standard allocation with 4% bitcoin (not rebalanced)

• A standard allocation with 4% gold

As the table below shows, the portfolio with 4% bitcoin (rebalanced) outperforms the standard allocation and gold portfolio based on annual returns, and its maximum drawdown and volatility are roughly in line. It’s also less correlated with the standard allocation than the gold portfolio, which refers to the degree to which its performance moves in the same direction. Meanwhile, the unbalanced bitcoin portfolio delivers the strongest returns, but it’s the most volatile.

Bear in mind, while the rebalanced portfolio holding 4% of bitcoin might be the most efficient, this isn’t investment advice. Investors should allocate assets according to their investment goals.

Learn more about diversifying a portfolio with crypto.

Identifying the Need for Adjustments (in a crypto portfolio)

Cryptocurrency prices are influenced by a range of factors, some common to traditional holdings and others that are unique to this emerging asset class.

Like shares, market sentiment impacts crypto prices. Crypto is sensitive to social media noise, which can lead to ‘fear of missing out’ or knee-jerk reactions, depending on the nature of the coverage. Macroeconomic and geopolitical events also drive crypto prices, especially bitcoin’s digital gold narrative. Bitcoin demonstrates many of the characteristics of a store of value, and some consider it even more effective than gold given its digital form. So when investors seek a safe haven, they may shift funds into bitcoin. 

In terms of factors unique to crypto, the underlying infrastructure is significant. Improvements to blockchain technology, like Ethereum boosting functionality by introducing  smart contracts, or built-in mechanisms, such as the bitcoin halving, can affect a native token’s price. Of course, security breaches like hacks lower investor confidence and can be detrimental.

Regulations are also a key influence on crypto prices. As a relatively young asset class, the rules governing crypto’s use and the companies providing its infrastructure are constantly evolving. To make matters more complex, countries have implemented their own regimes. For instance, the EU has introduced the Markets in Crypto Assets (MiCA) regulation, but US politicians are struggling to agree on legislation, despite the Securities and Exchange Commission approving spot bitcoin ETFs at the start of 2024.

Leveraging Index Rebalancing Products

Rebalancing a portfolio takes time, especially when using the calendar-based approach, and increases trading costs. An alternative option is to invest in products that automatically rebalance on the holder’s behalf as they ensure that the risk profile remains consistent, while also providing exposure to a broad range of assets. 

CoinShares issues two exchange-traded products (ETPs) which automatically rebalance:

• The CoinShares Physical Top 10 Crypto Market ETP holds the top ten cryptos based on market capitalisation.

• The CoinShares Physical Smart Contract Platform ETP holds ten of the biggest crypto infrastructure providers (such as Ethereum, Solana and Cardano) by market cap.

These products use a hybrid approach to rebalancing- they readjust on a quarterly basis, and CoinShares has set a cap, which means that each asset’s weighting can’t exceed 35%.

Conclusion

Rebalancing is a risk management strategy that involves returning a portfolio to its original asset allocation in response to under or overperformance by an asset or asset class. It’s particularly important when investing in an asset as volatile as crypto. Research by CoinShares shows that a 4% allocation to a standard portfolio is most effective in terms of annual returns and correlation.

Rebalancing takes time and increases trading costs, so investors should consider holding products that automatically revert to their original allocation. CoinShares issues two of these: the Physical Top 10 Crypto Market and Physical Smart Contract Platform ETPs.