Should you add crypto to your investment portfolio?

Investing in crypto assets before 2017 was a very niche activity, largely limited to technologists, libertarians, and some speculative investors. This is changing, and fast.

Goldman Sachs, perhaps the most storied name in finance, has confirmed their intention to trade bitcoin. And just last week Larry Fink, the CEO of the largest asset manager in the world, BlackRock, confirmed that they have a assembled a working group to look into cryptocurrencies and blockchain technology.

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. General purpose blockchains such as Ethereum could dis-intermediate many other industries. Today, there are 1,600 crypto assets, trading 24/7. 

Here we try to understand how these assets perform when placed within a diversified portfolio of traditional assets, and not just as an independent, emerging asset-class. 

Crypto in Australian Portfolios

This article analyses a portfolio of crypto assets together with Australian stocks and bonds. 

The four hypothetical portfolios analysed here are:

   1.    60% Australian equities; 40% Australian Bonds;

   2.    59% Australian equities; 39% Australian Bonds; 2% CryptoAssets;

   3.    57.5% Australian equities; 37.5% Australian Bonds; 5% Crypto Assets;

   4.    55% Australian equities; 35% Australian Bonds; 10% Crypto Assets.

We tested these portfolios from December 31 2016 until April 31 2018  using monthly rebalancing. This period includes a sharp downturn in crypto prices.

Results

Even the portfolios with a minor allocation of crypto performed significantly better than the portfolio without exposure. 

 For this time period, there has been a direct correlation between increasing crypto exposure and outsized investment returns. 

For this time period, there has been a direct correlation between increasing crypto exposure and outsized investment returns. 

 Source: Apollo Capital

Source: Apollo Capital

The return with 0% allocation to crypto assets was 17.10%; with 10% crypto allocation, the portfolio returned 124.40%

    •      Allocating 2% crypto in the portfolio was responsible for almost 50% of investment returns; 5% translated to 72.89% of returns; with 10%, 86.22% of returns. 

    •      The Sharpe Ratio increased in line with increasing exposure of crypto assets. The Sharpe Ratio determines how much an investor is compensated per unit of risk taken on. It is calculated by determining the average return earned in excess of the risk-free rate (in this case the 10 year Australian government bond return) per unit of volatility. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return. It’s a really useful way to analyse crypto assets because while the returns have been substantial, so has the asset class’ volatility.

We can see that for these portfolios investors have been compensated generously for any added volatility in the portfolio due to crypto assets.

Three Take-Aways

1. Non-correlation

Crypto asset class have a low correlation to other asset classes and can thus provide a diversification benefit. The below correlations were completed for the time period June 2, 2017 to June 8, 2018. 

 The correlation of crypto with other crypto assets and asset classes. Source: Apollo Capital

The correlation of crypto with other crypto assets and asset classes. Source: Apollo Capital

“Diversification is the one free lunch of investing, and when you see a free lunch, the only rational thing to do it eat” — Cliff Asness, Managing Principal and CIO at AQR Capital Management 

2. Efficient Frontier, Optimised 

An ‘efficient frontier’ of portfolios can be built, where returns are optimised per unit of risk. 

As we’ve seen, crypto assets aren’t correlated with other asset classes, and they have experienced significant capital growth. These attributes make it ideal in portfolio construction. Despite this, the vast majority of portfolios fail to include even a small amount. We believe that this omission means that current portfolios are less than ideally constructed. 

We believe that the efficient frontier shifts up if we include crypto assets in our portfolio. In other words, the risk-return profile can improve with the inclusion of crypto assets. 

3. Barbell Investing with Crypto assets

The barbell investment thesis was made famous by Nicholas Nassim Taleb, the investor and author.

The barbell theory’s prime directive is unambiguous: Stay as far from the middle as possible. Taleb invests in emerging, even speculative, investment products with very high potential upside; his other investments are the safest possible assets to invest in. 

“If you know that you are vulnerable to prediction errors, and … accept that most “risk measures” are flawed, then your strategy is to be as hyperconservative and hyperaggressive as you can be instead of being mildly aggressive or conservative.” — Nicholas Nassim Taleb

Crypto fits very comfortably into the barbell investment thesis. Crypto assets remain a small asset class that still shows very high volatility. Because crypto has the potential to reengineer large swathes of the economy, we believe an investor has high potential upside.

Screen Shot 2018-08-03 at 9.17.35 am.png

All the while, by keeping an investors position small, to between 2–10%, the downward risk is minimised while remaining sufficiently exposed. 

Conclusion

This analysis has demonstrated that including a small portion of crypto assets in a diversified, Australian portfolio of stocks and bonds has greatly benefited investors. This is not only from a capital growth perspective but also from a risk/reward perspective. 

Even when the downside is limited (2% of a diversified portfolio), the upside has been shown to be very substantial (responsible for almost 50% of total returns). As large international investors are waking up to the opportunity of crypto assets, we believe now its time to pay attention.
 

Apollo Capital is Australia’s premier crypto fund, allowing sophisticated wholesale investors to gain access to investment opportunities within the crypto asset market. This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions. Past performance not indicative of future returns.

Published: Friday, July 27, 2018

[This article was originally published in Switzer]