Prospects for Bitcoin as an asset class for hedging an investment portfolio

More and more representatives of the traditional financial market are interested in the possibility of investing in cryptocurrency, both directly and through funds . This interest is due not only to the impressive profitability of long-term investments in cryptocurrencies, but also to the extremely low correlation of Bitcoin with other classes of assets, which opens up broad opportunities for diversifying investment portfolios.

So, the bitcoin portfolio of the legendary investor William Miller in the first half of 2019 grew by 46% . In addition to the first cryptocurrency, the hedge fund MVP 1 includes shares of Amazon, ADT and Avon Products.

Researchers at the Binance platform found that even a small proportion of digital gold in portfolios with traditional financial assets can significantly increase the profitability of investments with relatively low risks. We bring to your attention a shortened translation of the first material from a series of articles on the diversification of the investment portfolio using Bitcoin.

Why is bitcoin suitable for a portfolio with various assets?

Key points:

• For 10 years, Bitcoin was an extremely volatile asset, showing significant drawdowns after several of the largest rallies in the history of this cryptocurrency.
• Despite its volatility, BTC has not shown a significant correlation with other classes of traditional assets, such as commodities, stocks, or fixed income products, since its introduction in 2009.
• In the context of trading, Bitcoin is one of the most liquid instruments with consistently low spreads (the median value of which is less than 2-3 basic points), large volumes and price efficiency, since trading platforms constantly resort to arbitration .
• Binance Research has modeled various bitcoin distribution techniques in diversified multi-asset portfolios. All BTC-inclusive portfolios showed a generally better risk-return ratio than portfolios with several traditional assets. The results show that diversification through Bitcoin really provides benefits for investors using strategies with various financial instruments.
• With the development of institutionalized custodial solutions and other investment tools, Bitcoin has become an important alternative asset that can be included in a wide variety of portfolios in order to diversify them.

Low correlation with other asset classes

Correlation analysis is an important tool for investors seeking to create a diversified portfolio.

If the profitability of two assets shows a positive correlation, this means that both of these assets tend to move in the same direction. Consequently, these assets have comparable risks.

On the other hand, a negative correlation between the returns of two assets indicates that their prices are moving in opposite directions. Thus, one asset can be used to hedge another.

As a result, low-correlation assets are generally good diversifiers in the pot. At the same time, assets with negative correlation can serve as a hedge for a portfolio.

The table below provides a brief overview of the main commodity, stock and other popular indices:

The following table presents the annual indicators of the correlation between Bitcoin and the above listed financial instruments:

Bitcoin does not demonstrate any significant statistical relationship with other asset classes. Thus, the median correlation coefficient with other financial instruments is below 0.10.

Bitcoin is a liquid asset with high trading volumes and low spreads.

In 2019, the total volume of Bitcoin trading is generated by multiple platforms, both spot and derivative.

Below is the daily trading volume of termless swaps on the BitMEX exchange, the turnover on the top 10 spot cryptobirds according to Bitwise, as well as the trading volume of bitcoin futures on CME as of July 24, 2019:

As you can see, the perpetual BitMEX swaps are the most sought after pair in Bitcoin trading . Note that the result is somewhat “strengthened” by the use of leverage, which on this exchange can reach 100x.

There are also extremely large volumes on spot exchanges: more than $ 1.2 billion (as of July 24, 2019) are traded daily on the 10 largest platforms. Of these, Binance is the most liquid platform for spot Bitcoin trading – its average daily turnover exceeds $ 450 million. Coinbase Pro and Kraken also show large daily volumes in BTC / USD pairs (> $ 200 million on each of the exchanges).

The table below shows a comparison of spreads and trading volumes in pairs with Bitcoin:

CME futures also represent a significant component in the overall picture. The trading volume as of July 24, 2019 is $ 374 million. Over time, other investment tools and OTC platforms have also become very significant for the bitcoin industry and digital assets.

Thanks to several highly liquid trading platforms for Bitcoin with small spreads and significant volumes, price differences between exchanges are quickly resolved through arbitration. According to a recent Bitwise study , more than 50% of price differences over 1% are leveled in 5 seconds, and 90% of such discrepancies are within 35 seconds.

In the same research report, Bitwise analysts point out the extremely high pricing efficiency of bitcoin futures at CME. So, on this platform, the average price deviation in comparison with spot exchanges is below 0.25% from the second half of 2018.

It can be concluded that Bitcoin has become an extremely liquid asset with high trading volumes, efficient pricing mechanisms among trading platforms and extremely narrow spreads, which makes it attractive for large investors.

With the development of institutional-oriented custodial solutions, Bitcoin has become an important alternative asset that should be included in diversified portfolios.

Portfolio Management: Theory and Modeling

In modern portfolio management, diversification is defined as follows:

“ Diversification is a risk management strategy involving the inclusion of a wide range of investment instruments in the portfolio structure. The logic of this technique is that the portfolio consisting of various types of assets will, on average, give higher returns and lower risk in the long term than each individual investment object ”

A similar definition is given by Binance Academy:

“Diversification is the distribution of capital among various financial instruments and asset classes. The main goal is to reduce the risks that can arise when only one asset class is held, be it stocks, bonds, commodities, or cryptocurrency. ”

As mentioned above, one of the key concepts is related to the correlation between financial assets . If the two financial instruments are not statistically interdependent (that is, their correlation coefficients are close to 0), then these assets may be suitable for creating a diversified portfolio.

Since Bitcoin does not correlate with all other non-cryptocurrency instruments, in theory it could well complement a portfolio with various assets.

Diversified portfolios typically cover a wide range of asset classes, including stocks, bonds, currency, and alternative investments, such as real estate and infrastructure. A wide range of investment instruments usually provides a greater degree of diversification.

For the purposes of this study, Bitcoin was included in the following portfolios with various assets:

• iShares Morningstar Multi-Asset Income ETF from BlackRock (60% of bonds, 20% of shares and 20% – alternative sources of income)
• VPGDX | Managed Payout Fund from Vanguard (55% – stocks, 20% – bonds and 25% alternative investment instruments)

Wherein:

• Bitcoin share in each of the variants of these portfolios was either 1% or 5%;
• simulated portfolios were rebalanced on the last day of each month;
• The study period lasted from December 31, 2015 to June 30, 2019, that is, 3.5 years, and covered various phases of the market, including price increases, its sharp decline and the flat period.

The table below summarizes the aggregated results for monthly rebalanced portfolios:

The inclusion of Bitcoin in any of these portfolios would provide a better risk-return ratio than options without cryptocurrency.

In particular, a target distribution with 1% bitcoin with monthly rebalancing would generate an additional 5-6% return to the investor over a 3.5-year period. That is, in annual terms, the yield would increase by about 1.5%.

On the other hand, a target bitcoin weight of 5% would increase the fund's annualized volatility by about 1% and cause much deeper drawdowns.

Nevertheless, the total yield over the study period was much higher – + 59.3% for BlackRock Multi-Asset Income and + 57.2% for Vanguard Managed Payout Fund. Without BTC, profitability was 27.86% and 26.03%, respectively. Thus, the integration of Bitcoin in each of the portfolios would bring an increase in yield of about 7.5% in annual terms.

The table below shows the return on these portfolios by year:

With the exception of 2018, all monthly re-balanced portfolios with bitcoin showed much better results than those where the first cryptocurrency is not represented.

In 2018, the loss increased the monthly rebalancing (-6.54% compared to -5.65% and -5.69% instead of -4.78%). Less frequent redistribution (for example, quarterly) could reduce potential losses.

findings

Bitcoin represents a unique asset class that demonstrates almost zero correlation with all other traditional financial instruments, including stocks, bonds, or commodities.

As a component of a portfolio with various financial instruments, Bitcoin provides the advantages of diversification, regardless of the asset classes that investors prefer. Despite the high (but eventually decreasing volatility), simply incorporating BTC into a diversified portfolio leads to an improvement in the risk / return profile.

The popularity of OTC platforms and futures contracts has increased as an alternative way to trade large amounts of Bitcoin. This allowed institutions to quickly open large positions in cryptocurrency. Significant volumes on large criterions , effective pricing and low spreads are also attractive for potential investors.

Moreover, new Bitcoin-based products are being introduced :

• deliverable futures (for example, LedgerX , Bakkt );
• ETF providers trying to get approval for their products from the US Securities and Exchange Commission ( Bitwise );
• specialized custodial solutions (for example, Fidelity Digital Assets ).

These new products will help to resolve many issues of concern to traditional investors, for example, related to technological and custodial risks. As a result, these initiatives can raise the status of Bitcoin from an intriguing risk asset to an investment tool that is acceptable to most traditional managers, thanks in part to its unique diversification properties.

Despite the simplicity of the strategies described in the report, they all showed generally positive results in the context of the risk / return ratio. Consequently, there is reason to believe that more complex strategies can bring even greater benefits from the inclusion of Bitcoin in portfolios.

Publication date 07/30/2019
Share this material on social networks and leave your opinion in the comments below.