Bitcoin hit the world in 2009. But its mysterious creator, Satoshi Nakamoto, probably never expect it to grow to where it is today. What started as a remotely possible idea for a decentralized global currency became instrumental in the birth of a new-age digital financial ecosystem. In 2021, Bitcoin crossed the trillion-dollar mark and accounts for about half of the entire $2 trillion crypto market.
Bitcoin - The Digital Gold?
The original intent for Bitcoin to be adopted as a global currency didn't really materialize. We still use government-backed fiat currencies to go about our daily lives today. And all cryptocurrencies ultimately have value now because people are willing to pay fiat currencies in exchange for them. The demand is there as cryptos have other appeals. But as a business, you are unlikely to accept something that can swing up and down 20% in value within a day as the payment for your goods and services. And that is one reason why stablecoins exist. Stablecoins are to cryptocurrencies as the USD is to your traditional assets such as stocks. They represent a stable store of value in their own space. But I will not delve into the depths of it here.
So the pitch now is for Bitcoin to become the next Gold, an alternative store of value that is uncorrelated to the market. Why? Because Gold has a special place in the history of the global monetary system. At one point in time, our monetary system was based on the Gold standards. Countries that adopted the standards had to back their currencies with physical Gold. Even though fiat currencies are no longer linked to Gold today, Gold still preserves its characteristics as a safe haven and hedge against inflation.
Now, the reason why Bitcoin is now marketed as the next Gold comes largely from an asset allocation perspective. Because if it behaves like Gold, then complementing a traditional asset portfolio with bitcoin can have valuable diversification benefits. Let's study if that is the case
Does Bitcoin behave In Any Way Like Gold?
A simple way to find out is to see how they move relative to each other. To do that, we can track the correlation between Bitcoin and Gold from 2014* to 2022.
* Bitcoin's price data on Yahoo Finance started only on 18 September 2014.
As the results show, Bitcoin and Gold are hardly correlated to each other. Over the long term, their average correlation is only 0.06. And if we look at their rolling 6-month correlation, it goes anywhere between a high of 0.51 and a low of -0.20.
And how about the performance of these 2 assets
In terms of performance, they looked worlds apart. Bitcoin easily trounced Gold by a large margin, 80.5% vs 6.1%, in terms of CAGR. But of course, that comes on the top of significantly higher risk or volatility. At the worst point, you could have lost 83% of your money with Bitcoin. Though, on a risk-adjusted basis, Bitcoin outperformed with a higher Sharpe Ratio.
Having said that, these differences are not surprising. Bitcoin is a very young asset. It is still growing and finding its role and place in the market. And a huge portion of its phenomenal rise actually comes from the early days. It is unlikely any asset can continue with such a trajectory when it reaches a mature state.
So, no, from a statistical point of view, Bitcoin looks different from Gold. But being different from Gold, which by the way is not unexpected, does not mean Bitcoin has no diversification benefits. Because Bitcoin exhibits a low correlation with other key asset classes as well.
As investors, what we want are assets that can serve as a hedge to each other during tough times, even if not perfectly. So let's find out.
Bitcoin does not act as a hedge in stock market downturns
Most investors started with stocks which remained a key holding throughout their investment journey. And we know bonds and gold are pretty reliable safe-haven assets during times of stock market stress. How about Bitcoin? Is it a good match with stocks given their low correlation?
Let's look at the periods where stocks (represented using S&P 500) underwent a pullback of 5% or more and see how the respective asset classes did during the same period. As it turns out, most of the time, Bitcoin falls together with stocks (represented by S&P 500). And not only that, it loses more in those episodes.
So again, unlike Gold, Bitcoin isn't an effective hedge for stock market downturns. A lot of people are attracted to Bitcoin for its high returns. Some held deep convictions about its potential. But many are just in it for the ride. That is fine as long as Bitcoin continues to deliver as that will boost the overall returns of your portfolio significantly. However, if you are looking for help when your stock portfolio gets hit, don't get your hopes high.
Diversification Benefits of Bitcoin In a Multi-Asset Portfolio
Bitcoin is obviously not some safe haven and it doesn't behave anywhere like Gold. But it does exhibit a low correlation with other traditional financial assets which makes it potentially useful from a diversification point of view. So rather than force-fit it as the next digital Gold, we can see it as another class of risky asset with its own distinctive characteristics. And to bring out its benefits, we want to look at including it as part of a multi-asset portfolio rather than just pairing it with stocks alone.
Say we first construct a portfolio using stocks (S&P 500), bonds (20Y Treasury Bond), and gold. And then we add in Bitcoin and see if the performance improves. Let's call them the Original portfolio and the Bitcoin Added portfolio. We rebalanced these portfolios every month and sized up the positions such that each asset holds the same amount of risk. In that way, our portfolios are balanced as each asset drives it equally. This allocation technique is also known as risk parity. Using this approach, Bitcoin only accounts for a small slice of the portfolio. Its allocation ranges between 1% to 17% each month and averages 6%. Note that no leverage is used here.
The results look decent. CAGR almost doubled with only a small increase in risk. And that led to a markedly higher Sharpe Ratio of 1.32. Sharpe Ratio measures how much return your strategy delivers per unit risk taken. So you can kind of interpret this as the Bitcoin Added portfolio giving you 1.33% return for every 1% risk it took. And on top of all these, the Bitcoin Added portfolio also had a lower maximum historical loss. This might seemed counterintuitive as we know how risky Bitcoin is. But if we think from the perspective of diversification and correlation, then it is possible. Because Bitcoin is practically uncorrelated with the other assets in the portfolio.
The Risks behind Bitcoin
The results look promising but we also need to bear in mind the limitations of this exercise and other risks behind Bitcoin.
We don't have enough data for a full market cycle.
Our backtest only covers 2014 to 2022. While there are several periods where we saw tougher markets, it hasn't been through an extended downturn such as the Great Financial Crisis in 2008. So how Bitcoin is going to fare in the face of such regimes is a big question mark. Will it crash as investors start to dump risky assets? And will it bounce back as readily?
It is a very young asset.
Bitcoin existed for just a couple of years over a decade. Compared to stocks and bonds, it is still very much an infant. So unlike these mature assets whose behavior is more established and well studied, Bitcoin is still a wildcard. And it will also be unrealistic to expect Bitcoin to keep delivering out-of-the-world returns in the years to come.
Regulations are another big risk.
There is no doubt that Bitcoin or cryptos, in general, has secured a foothold in the financial markets. From a small and obscure existence traded by a small group of people, they grew their way into the system. Today, there are exchange-traded futures on Bitcoin and we have commercial funds and products that trade in cryptos.
While regulators are not particularly worried about Bitcoin, they do have their eyes on stablecoins. These coins, being stable and often pegged to major fiat currencies such as the USD, have the potential to gain widespread mainstream usage. If left unchecked, they can potentially disrupt the financial system and undermine a central bank's power to track and control the money supply. And as more and more people on the streets get involved with cryptos, the stakes become higher. There will also be growing pressure for regulators to tighten up the space and push for more transparency and control to safeguard investors' interests.
At this point, we have no idea what the regulators are going to come up with. But you can expect what they roll out to impact the entire crypto space.
Security risk remains a concern
Being on the blockchain means no one can easily change what is on the public record. But that does not mean your money is secure. You hear of crypto wallets falling to hackers, phishing attempts, or even founders of crypto exchanges running away with investors' funds. Billions are lost every year and in just 2021, $14 billion are lost to hacking attempts. And being a largely unregulated industry, investors had nothing to fall back on.
Operational challenges with traditional and crypto assets in a portfolio
Now, moving between cryptos and traditional assets is not a seamless process. As far as I know, we don't have a broker that serves both markets on a single account. That makes shifting funds around cumbersome. Although there are exchange-traded products such as Bitcoin futures and ETFs today, they may not be ideal. A full-fledged bitcoin future is a contract on 5 bitcoins which is a hefty amount even though you only need to put up 50% of its value as margin. Even a micro-bitcoin future is a couple of thousands in value today. That makes sizing a challenge for smaller investors. Bitcoin funds, on the other hand, suffer from tracking error issues.
So after knowing all these, some may be put off by the risks and effort required. This is up to the individual. Just for disclaimer, this is a simple study I did, I am not personally invested in Bitcoin or any other cryptos.
IBF Accredited Course
Introduction to Quantitative Investing & Hedge Fund Strategies
For those who are interested in learning more about how to use a quantitative approach to build a resilient multi-strategy portfolio, we run a skills-future eligible 3-day live online course via Zoom which is heavily subsidized (up to 90%) and accredited by the Institute of Banking and Finance. In the course, you will learn powerful and established techniques used by the fund industry such as risk parity mentioned in this post and more.
Besides this 3-day course, you will also gain access to a trove of valuable video lessons and resources on our Learning Management System and more. If you are interested to know more, click on the button below.
DD