Bitcoin as a portfolio asset
With the start of bitcoin futures trading on the CME this asset is now available to many institutional portfolios which previously could not hold it. We’ll start with the basics and look at the correlation of bitcoin to other major assets. With an understanding of modern portfolio theory we’d like to add assets with low correlation to the existing assets in a portfolio.
The above correlation matrix is derived from the last 180 daily returns for these assets. As you can see across the top row the correlation of bitcoin to other major assets is close to 0 (the difference from 0 is not statistically significant in other words). If we have a belief of any positive return in bitcoin we would want to have at least some exposure to bitcoin given the 0 correlation.
We can compare a standard portfolio of stocks and bonds to a 3 asset portfolio of bitcoin, stocks, and bonds. The portfolio optimizer would tell us that our optimal allocation would be 53.3% S&P 500 and 46.7% treasury bonds, well in line with a standard allocation of 60% equities and 40% bonds.
If we were to run a basic portfolio optimization with three assets: bitcoin, S&P 500, and 10 year US treasury bonds, using the empirical means of each asset since 1/1/2014 it would tell us the optimal portfolio is 1.8% bitcoin, 52.4% stocks, and 45.8% bonds. We may believe that as bitcoin matures the spectacular gains seen so far are unlikely to be repeated. In that case we could take 1.8% as the maximum it would make sense to rationally allocate. The high volatility of bitcoin actually means less risk as we only need to allocate 1.8% of our capital to get an uncorrelated stream of returns that accounts for ~20% of our overall portfolio’s volatility.
The above analysis doesn’t change too much if we swap in a cap weighted basket of cryptocurrencies for bitcoin as bitcoin was responsible for most of the historical returns in such a basket. One of the challenges of large asset managers is finding assets that aren’t correlated to “the market”. They are often willing to pay a premium to hold hedge fund products offering uncorrelated returns. The crypto asset class offers those sought after uncorrelated returns for very little notional exposure and without any of the management or incentive fees that come with uncorrelated hedge fund products requiring active management.
