Digital assets such as Bitcoin and other cryptocurrencies have grown in popularity in recent years, as shown by the fact that well-known creative firms such as Tesla invest in Bitcoin. However, a combination of a broad range of cryptocurrencies in the form of a Crypto Index might represent a sensible diversification of a portfolio that is not associated with conventional asset classes.
One thing seems to be certain at this point: Bitcoin and digital assets will continue to exist in the future. For example, publicly listed firms such as MicroStrategy and Tesla have made large investments in Bitcoin in the last year. Meanwhile, in September 2021, EI Salvador became the first nation-state to declare Bitcoin legal money.
Since then, the Latin American state has made significant investments in Bitcoin. While MicroStrategy, Tesla, and El Salvador are among the most well-known Bitcoin investors, they represent merely the tip of an ever-expanding iceberg. More and more investors, ranging from retail to institutional, are joining the digital asset market.
This is evident in the spectacular growth in total market capitalization of all cryptocurrencies: at the start of 2021, the market worth was over $763 billion. The market value of all cryptocurrencies more than quadrupled just before the end of 2021, and it even crossed the $3 trillion level in November 2021.
A New Asset Class (Alternative)
Cryptocurrencies and digital assets have long ago established an asset class in their own right for a growing number of investors. Professional market experts believe they should be classified as alternative assets alongside art, hedge funds, and commodities. Bitcoin remains the most popular cryptocurrency.
As the numbers demonstrate, Bitcoin has been the highest performing asset over the last decade. It is still the most renowned cryptocurrency, accounting for around 40% of the overall market capitalisation of this new asset class. This is also owing to the wide range of Bitcoin investment options available. For example, the first bitcoin futures ETFs were introduced in the United States in the fourth quarter of 2021.
Bitcoin: An Ingenious Portfolio Diversifier
The outstanding performance of digital assets in recent years may also be seen in the perspective of a portfolio. The portfolio comparison for portfolios with and without bitcoin allocation demonstrates that significant portfolio metrics improve with bitcoin allocation.
This can be demonstrated with a concrete example of a traditional portfolio1. This portfolio is composed of 55% equities (MSCI World Index), 38% bonds (TIPS Bond ETF), and 7% commodities (Invesco DB Commodity ITF). This diversified portfolio earned an annual return of 5.68 percent with a standard deviation (volatility) of 7.53 percent from 2015 to 2021.
Adding merely 3% Bitcoin at the cost of the stock part, which fared well on its own, has a beneficial impact on the portfolio. As a result of the Bitcoin allocation, the portfolio’s performance could be boosted to an annual return of 8.75 percent, while the standard deviation rose only little to 8.10 percent.
The beneficial impact of Bitcoin is also seen in the shift in the Sharpe Ratio, a popular portfolio indicator used to quantify risk-adjusted return.
A high Sharpe ratio shows that great performance was obtained with a minimal risk. The greater the Sharpe ratio for a chosen portfolio vs a benchmark portfolio, the better the risk/return ratio of the former versus the latter.
The Sharpe Ratio for the traditional portfolio without Bitcoin inclusion in the chosen sample is 0.62. With the inclusion of Bitcoin, the Sharpe Ratio rises to 1.08. This information enables us to draw the following conclusion: Bitcoin has low correlation with other asset classes and represents a suitable diversification of a traditional portfolio.
Other Digital Assets Have the Same Impact
Meanwhile, there are a plethora of other cryptocurrencies that are usually referred to as digital assets. Some of them have now amassed significant market capitalizations and are therefore considered seriously by professional investors. The same basic portfolio2 may also be compared to a portfolio enhanced with a mix of various cryptocurrencies.
Cryptocurrencies in the top ten in terms of market capitalization were chosen and merged to generate the Crypto Index. This is made up of the following parts: 5% of Bitcoin (BTC), 5% of Bitcoin Cash (BCH), 10% of Ether (ETH), 40% of Cardano (ADA), and 40% of Ripple (XRP).
These cryptocurrencies account for 5% of the overall portfolio and are included in the portfolio instead of equities. Because these cryptocurrencies are younger than Bitcoin, a more recent and hence shorter time span of 2018 to 2021 was evaluated.
During this time period, the conventional portfolio with no crypto investment had a return of 6.98 percent with a standard deviation of 8.64 percent. Adding the chosen cryptocurrency raised performance from 10.11 percent to 10.03 percent with a standard deviation during the same time period.
Similarly, the Sharpe Ratio rises from 0.69 to 0.99. As a result, this example demonstrates that not just Bitcoin alone, but also a mix of multiple cryptocurrencies in the form of a Crypto Index, may provide considerable diversification of a portfolio.
The Efficiency Curve Has Shifted
The efficiency curve also demonstrates the benefit of including cryptocurrency. This chart depicts the maximum potential return and the highest risk that various portfolio allocations may have. Because the return is represented on the Y-axis and the risk is indicated on the X-axis, an upward movement in the efficiency curve implied that a better return could be obtained for a matching portfolio with the same risk.
Such an upward change in the efficiency curve occurs in portfolios3 that contain digital assets allocated as an add-on.
Is it relevant in the future?
Given these portfolio theory results, the issue arises: Will the favorable impact of a cryptocurrency admixture be able to stand up in the future? It is common knowledge that acquired data is always from the past and does not give guarantees about the future.
When one looks in the rearview mirror, performance and the risk-return ratio seem to be favorable. However, why should portfolio results be applicable in the near future? Bitcoin’s rising acceptance as digital gold works in its advantage. Bitcoin’s promise of scarcity has maintained for the last twelve years, and with each year that passes, it hardens in the minds of a growing number of individuals.
When other asset classes are compared to central banks’ money supply increase, Bitcoin’s strength as an investment becomes very evident. For example, comparing the S&P 500 to the Fed balance sheet rather than its dollar value reveals that price gains are the result of a large growth of the money supply.
Prices are flat if the right denominator is used—the central bank balance sheet. The S&P 500 has increased nominally by an average of 15% every year during the last decade. Surprisingly, this corresponds to the yearly increase of the Federal Reserve’s balance sheet in the United States.
Bitcoin and other cryptocurrencies are expected to remain popular in the foreseeable future as a form of hedge against unending monetary growth by central banks. The acceptance curve’s apex is likely to be out of reach. If cryptocurrencies continue on their victorious path, Bitcoin and other digital assets will be a wise, non-correlated diversification for a portfolio in the near future.
