The importance of rebalancing when investing in crypto

As demand for crypto grows, investors are adopting many of the techniques used to manage portfolios holding traditional asset classes.

One of these techniques is risk management, which aims to preserve capital and prevent emotions from influencing investment decisions. Asset allocation is a key risk management strategy, but from time to time individual holdings may outperform and skew the weightings. If this happens, the portfolio needs to be rebalanced, which means returning it to its original allocation.

Risk management particularly matters when investing in volatile asset classes, so this article explores crypto’s role in a balanced portfolio and how rebalancing works.

Understanding Crypto Market Volatility

Crypto is among the most volatile asset classes, as demonstrated by the frequency of peaks and troughs in the chart below.

A number of factors drive these price fluctuations:

• Market sentiment - Crypto is subject to the whims of investors who allow emotions like fear or greed to influence their decisions. These emotions are often triggered by media hype or social media noise.

• Regulatory developments - As a relatively immature asset class, rules governing the crypto markets are inconsistent and constantly evolving, which puts off some investors. But regulatory clarity can work both ways (as explained below).

• Tech advances - As a digital currency, advances in the underlying infrastructure and threats to it can affect market sentiment.

• Macroeconomic events - Investors increasingly treat bitcoin as a store of value when faced with economic or political uncertainty and a hedge against inflation. Some even refer to it as ‘digital gold’.

• Correlation - BTC/USD is the most common trading pair, so bitcoin weakens when the US dollar strengthens and vice versa.

A good example of regulatory clarity causing outflows is when China stopped financial institutions and payment providers from processing crypto transactions in May 2021, sending bitcoin down by 30% in the space of a day. China then banned all crypto trading and mining four months later, which was significant because it hosted 70% of the world’s mining activities. Bitcoin dropped more than 9% in response.

The factors listed above can also act as catalysts. Roughly every four years, the rewards earned by miners (who complete complex mathematical puzzles to validate transactions) halve as part of a mechanism designed to support the scarcity of bitcoin (the total circulation is limited to 21 million). The last ‘halving’ had been priced in when it occurred in April 2024, as bitcoin rose from $52,000 to $64,000 in the preceding three months (source: Glassnode). 

The Basics of Asset Allocation

When constructing a portfolio, investors use a strategy known as asset allocation to ensure their holdings match their goals and risk appetite. In traditional markets, this process typically involves splitting capital between equities and bonds, although other asset classes may feature such as cash or alternatives like property and commodities.

The main benefit of asset allocation is it ensures a portfolio is diversified. Equities and bonds have low correlations (they move in different directions), so underperformance by one offsets outperformance by another. A diversified portfolio tends to deliver more consistent returns.

Committing to an allocation also encourages investors to take a long-term view because they’re less likely to make decisions based on emotions.

Crypto’s Role in a Portfolio

Bitcoin has increasingly become a prominent component in investment portfolios due to its low correlation with traditional asset classes. To understand Bitcoin’s impact on portfolio returns, we can examine a study recently conducted by the CoinShares Research Team. The report, entitled The Bitcoin Advantage: Enhancing Real-World Portfolios, assesses the monthly performance of several sample portfolios:

• A standard allocation of 60% equities and 40% bonds

• A standard allocation with 7.5% Bitcoin replacing gold in the All Weather Portfolio

• A standard allocation with 7% Bitcoin replacing a portion of gold in the Cockroach Portfolio

• A standard allocation with 7% Bitcoin replacing REITs in the Yale Endowment Portfolio

The portfolios undergo quarterly rebalancing to reflect realistic investment practices. The results, as of May 2024, highlight the following key points:

1. Enhanced Returns: Adding Bitcoin to traditional portfolios significantly improved annualized returns. For instance, the Yale Endowment portfolio with 7% Bitcoin saw annualized returns increase from 6.8% to 18.8%.

2. Improved Sharpe Ratios: Bitcoin inclusion enhanced the Sharpe ratio across all portfolios, indicating better risk-adjusted returns. The All Weather Portfolio, for example, saw its Sharpe ratio increase from 0.33 to 1.38 with the addition of Bitcoin.

3. Volatility Management: While the addition of Bitcoin did increase portfolio volatility slightly, this was offset by the substantial improvement in returns. The standard 60/40 portfolio’s volatility rose modestly from 11.0% to 11.9% with Bitcoin.

4. Diversification Benefits: Bitcoin’s low correlation with traditional assets helped reduce overall portfolio correlation, enhancing diversification. For example, the Cockroach Portfolio’s correlation decreased by 9-15% with the inclusion of Bitcoin.

5. Drawdown Mitigation: In some cases, Bitcoin also helped reduce maximum drawdowns, as seen in the Yale Endowment portfolio, where the maximum drawdown was lower with Bitcoin than without.

These findings underscore the potential benefits of including Bitcoin in a diversified investment portfolio, provided it is regularly rebalanced to manage risks effectively.

Performance Metrics and Analysis

In addition to standard performance metrics, several additional indicators can help investors track and evaluate their portfolios:

• Sharpe Ratio: This metric assesses the risk-adjusted return by comparing portfolio performance against a risk-free asset, such as US Treasury bonds.

• Market Value to Realised Value (MVRV): This ratio compares the current price against the volume-weighted average of all previous prices to gauge market sentiment.

• Moving Average (MA): This indicator calculates the average price of an asset over a specified period, smoothing out short-term fluctuations.

• Relative Strength Indicator (RSI): This momentum oscillator measures the speed and change of price movements, comparing average gains and losses over a defined interval.

• These metrics provide a comprehensive view of portfolio performance, assisting investors in making informed decisions.

Methodologies and Risk Considerations

The analysis cites Bloomberg and CoinShares own research as sources, and the methodology involves back-testing portfolio performances from historical data, which includes quarterly rebalancing to reflect realistic investment practices. However, investors must consider several risk factors:

• Historical Data Limitation: Past performance may not accurately predict future results due to changing market dynamics and unforeseen economic events.

• Volatility: Bitcoin’s high volatility can significantly impact portfolio performance, especially in periods of market turbulence.

• Correlation Dynamics: The low correlation of Bitcoin with traditional assets may change over time, affecting its diversification benefits.

• Liquidity and Market Risks: Bitcoin and other cryptocurrencies may face liquidity constraints and regulatory challenges, impacting their market value and investment viability.

Conclusion

Incorporating Bitcoin into traditional investment portfolios can potentially enhance risk-adjusted returns and diversification. However, it’s crucial to maintain a balanced approach through regular rebalancing and to remain aware of the associated risks. Investors should consider their individual goals and risk tolerance before allocating assets to cryptocurrencies. Always seek professional financial advice to tailor investment strategies to personal circumstances.

The Basics of Portfolio Rebalancing

Investors can employ various strategies to manage risk, such as diversification and dollar cost averaging. Another worth implementing is rebalancing.

When one particular asset or class outperforms for an extended period, it skews the weighting of a portfolio’s holdings. Rebalancing restores the original asset allocation.

For example, take a standard allocation of 60% equities and 40% bonds. If equities outperform and their weighting rises to 70%, the portfolio’s overall risk exposure increases (as equities are more volatile than bonds). In this case, the investor would sell equities until the weighting returns to 60%.

Rebalancing also takes place when a change of goals needs to be reflected in the portfolio’s risk exposure. If the time horizon extends, the investor can afford to hold a higher proportion of equities because they have longer to ride out market fluctuations.

There are two key approaches to rebalancing:

• Calendar-based occurs at a certain frequency, usually yearly but also quarterly or even monthly.

• Threshold-based happens when a portfolio diverges from its original asset allocation by a specific percentage. This approach involves close monitoring of performance, sometimes daily, which isn’t always practical for retail investors.

Regular rebalancing (either too frequently or using a small divergence) incurs higher transaction costs, so a hybrid approach may prove most efficient - check the portfolio on a set schedule and adjust the holdings if it has deviated from its original allocation by a predetermined percentage.

Of course, rebalancing a portfolio with crypto can be complex due to its relative inaccessibility compared with traditional asset classes. To hold crypto, investors typically need to purchase it through an exchange which may be unregulated or underregulated and then find a secure way to store it. However, they can also gain exposure through exchange-traded funds (ETFs). ETFs are traded on mainstream exchanges and sit in portfolios alongside traditional asset classes.

Conclusion

Risk management is important when investing in volatile assets like crypto because it helps to preserve capital and takes the emotion out of decisions.

Rebalancing is a risk management strategy which restores a portfolio to its original asset allocation. The main benefit of maintaining a balanced portfolio is it ensures diversification across asset classes and delivers more consistent returns.

Demand for crypto has increased because of its frequent low-correlation with traditional investment classes. Research by CoinShares suggests a portfolio with exposure to bitcoin is more efficient than a standard allocation or exposure to gold. That said, investors should allocate assets according to their goals and risk profile.