Investing in crypto-assets before 2017 was a very niche activity, largely limited to technologists, libertarians, and some speculative investors. This is changing. Goldman Sachs, perhaps the most storied name in finance, has confirmed their intention to trade bitcoin. Closer to home, the ASX announced that by 2020, they will switch to a blockchain-based distributed ledger that will clear and settle the $2 trillion Australian equity market.
Crypto assets are tokens that are needed to run decentralised blockchains. Blockchains are fundamentally a new way of organising our society based on decentralisation. Instead of having big corporations, like Facebook and Google, owning our digital data, blockchain technology enables individuals to take ownership of digital goods directly. Bitcoin was the first crypto asset, the first asset that enabled outright digital ownership. The Bitcoin blockchain is used to transfer value over the internet while disintermediating financial institutions. Today, blockchains are being built not just around money, but other private data, like identity, medical records, supply chains, and much more. Blockchains also have the ability to support a new kind of decentralised application; Ethereum is an example of a blockchain enabling that. Blockchains have three core characteristics that set them apart from other digital assets: they are censorship resistant (built on open source code), trustless (we don't have to trust a third party) and their are permissionless (anyone can join these open networks).
While crypto-assets are now started being accepted by an increasing part of the investment community, the asset class remains nascent and extremely volatile. Even if the proportion of individuals and institutions with investments in crypto-assets increase, crypto is likely to remain a minority of their overall portfolio in the short to medium term. There’s therefore a pressing need to understand how these assets perform when placed within a diversified portfolio of traditional assets, and not just as an independent asset-class. This article attempts to shed light on some of these dynamics.
Bitcoin, the oldest and most famous crypto-asset, is studied here as a proxy to the broader market. Our analysis uncovers that bitcoin is a very compelling alternative investment given its high potential for capital growth, low correlation to traditional assets (diversification benefits) and highly liquid nature.
Capital Growth & Volatility
From a capital growth perspective, bitcoin has performed extraordinarily well: US$1000 invested in bitcoin on May 3 2013 would now (May 3 2018) be worth ~US$104,000.
Bitcoin Price Chart (July 2013 - Present Day)
Bitcoin’s extraordinary growth trajectory, however, has not been linear. Relative to other assets such as stocks, bonds or commodities, bitcoin’s standard deviation of returns (‘volatility’) has been materially higher. The following graph shows the 30-day rolling daily volatility for bitcoin compared to other assets on an annualised basis:
Crypto’s extreme volatility is driven by numerous factors. Crypto remains relatively unregulated and speculative. It has also been driven by retail investors. A retail investment market, with little institutional or regulatory input, is likely to be more volatile than one where institutional money has a stake. We are now seeing institutional money enter the market, and with it more market confidence and certainty. Regulatory bodies around the world are rapidly adjusting to the crypto paradigm. For example, the USA’s SEC recently deemed that Ethereum is not a security, and in February Switzerland’s Financial Regulator, FINMA, released their ICO guidelines.
The emergent crypto-asset valuation techniques are also a likely cause for volatility. A widely accepted behavioural finance paper by Barker and Wurgler (2006) argues that market-wide sentiment should exert stronger impacts on stocks that are difficult to value. The broader issue here is that crypto-assets are digital and new, meaning their fundamental value is harder to comprehend. We may expect a decrease in volatility as crypto markets mature, and investors gain deeper knowledge and conviction about valuation techniques.
Correlation with Traditional Assets & Diversification Benefits
Alternative investments are frequently used for diversification and hedging reasons. The below table is a summary of bitcoin’s correlations with more traditional assets, namely the S&P 500, Global Equities, and US Bonds. Gold is also included as a comparative alternative investment. The data is based on weekly returns from July 2016 to September 2017. Both gold and bitcoin experienced low correlations to other assets during this period (see table below). Bitcoin correlated even less than gold to most asset classes, especially when compared to US Bonds.
How do these metrics, namely capital growth, volatility, and non-correlation, play out when placed in diversified portfolio of traditional assets? According to the below analysis, including crypto in a portfolio could result in diversification benefits for the investor.
The below graph illustrates a global diversified portfolio with 60% global equities and 40% US bonds compared with a portfolio with 59% global equities and 39% US bonds and 2% Bitcoin, with both portfolios rebalancing weekly. The data was based on weekly returns from July 2016 to September 2017.
We’ve seen that Bitcoin is independently highly volatile, but interestingly when added to a this diversified portfolio it actually decreased overall volatility, while increasing overall returns. This was due to the non-correlative nature of the asset and its high historical capital growth.
Liquidity of Bitcoin
Alternative investments typically demonstrate lower liquidity when compared to more traditional assets such as stocks or bonds. For example, it is more difficult to find a buyer for a $100,000 bottle of wine than, say, the equivalent amount in Apple stock. This is not true of crypto-assets. In fact, crypto-assets are traded on exchanges that are accessible anywhere in the world (with an internet connection and/or a VPN) and are open 24/7. Today’s (June 25 2018) 24 hour volume of bitcoin was more than US$4.5 billion; over the same period, volume for the crypto-asset market was almost US$17 billion. There are certainly threats to bitcoin and crypto-asset liquidly, such as exchange closure, hostile regulation, and acceptance, but these do not seem to be affecting the markets currently.
Crypto as an asset class
Bitcoin is only one of over 1500 crypto-assets, each of which have different characteristics and uses. For simplicity, we have limited analysis to bitcoin. However, it is critical to think of crypto as more than bitcoin: the applications of these assets go far beyond the vertical of money. The universe of crypto is expanding and the diversity of assets will require further studies into their performance as part of a diversified portfolio. The dynamics of non-correlation and diversification have been shown exist when the alternative investment is extended to a diversified portfolio of crypto-assets. Academics David Lee, Li Guo, and Yu Wang writing in the Journal of Alternative Investments in 2018, concluded that concluded that
‘…cryptocurrencies can be a good option to help diversify portfolio risks because the correlations between cryptocurrencies and traditional assets are consistently low and the average daily return of most cryptocurrencies is higher than that of traditional investments’.
Apollo Capital believes firmly that a diversified and actively managed portfolio of high potential crypto assets is the best way to achieve diversification and non-correlative results over the long run. We will soon publish another piece on this subject with recent data.
Crypto-assets present a compelling alternative investment opportunity, but it is clearly not the faint hearted. Bitcoin’s extreme high volatility may indicate that placing all one’s wealth in it may be foolish. However, including an amount in a diversified portfolio of traditional assets has been shown to increase returns and lower overall volatility, while the alternative investment remains very liquid. Time will tell if these relationships hold. But with institutional money about to enter the space, and mass market psychology close to a nadir, this might be the moment to take a closer look.
Apollo Capital is Australia’s Premier Crypto-Asset Fund. We professionally manage a diversified portfolio of crypto assets, offering investors exposure to the fast growing crypto market.