How many bitcoins should we allocate to the portfolio?

The Preface

After many years of waiting, the recent launch of the Bitcoin ETF marks an important milestone in the cryptocurrency market, making Bitcoin more acceptable to investors. Cash ETFs provide a convenient and regulated way to invest in Bitcoin without directly holding digital assets, potentially attracting a wider range of market participants. Many investors are waiting for this change to have a long-term impact on the price of the cryptocurrency, while believing in the considerable returns that Bitcoin can bring to their investment portfolios.

Looking at the entire chart from 2013 to 2023, it is easy to feel that becoming a millionaire is within reach. The strategy of holding BTC from 2013 to 2023 shows a CAR (compound annual return) of 103.77%; however, using the whole chart 1 and inferring any long-term conclusions is misleading. From 2013 to 2017, cryptocurrencies were still a little-known asset class, known only to enthusiasts. This period represented a unique chapter in the development of digital currencies when cryptocurrencies were still in their infancy and limited mainstream recognition.

Financialization

On December 10, 2017, the Chicago Board Options Exchange (CBOE) launched Bitcoin futures trading, followed by the Chicago Mercantile Exchange (CME) on December 18, 2017, marking a milestone in the cryptocurrency space. Liquid financial instruments were legalized for the first time, allowing funds and hedge funds to buy and sell Bitcoin in their portfolios without having to open accounts on unregulated (and often highly suspect) cryptocurrency exchanges. This event promoted the financialization of the cryptocurrency market, a term that describes how the market is integrated into the broader financial system and acquires characteristics similar to those of traditional financial assets.

The financialization of cryptocurrency markets reflects similar developments in emerging markets and commodities. Emerging markets and commodities were once considered as little-known asset classes, but are now undergoing a similar transformation. Initially, only specialist funds traded in these markets, but the introduction of indices and ETFs in the mid-2000s made it easier for mainstream investors to invest in commodities.

Cryptocurrencies are also expected to follow a similar path. As cryptocurrencies continue to be increasingly integrated into the global financial system and attract demand from institutional investors, they will undergo a process of financialization. This evolution may involve the introduction of more financial instruments, such as proactive ETFs and broad indices, to make cryptocurrencies more readily accepted by a wider group of investors. However, this transition must be treated with caution.

First, let's look at the first period, which lasted until 2017. The cryptocurrency experienced extraordinary growth with a compound annual return of 283.33%. However, this period also saw significant volatility, with price fluctuations of up to 95.83%; the largest decline during this period was -81.15%. This pre-financialization period provided Bitcoin with extraordinary risk-return characteristics, with a Sharpe ratio of 2.96 and a Karma ratio (CAR/MaxDD) of 3.49.

As shown below, the Chicago Board Options Exchange (CBOE) launched bitcoin futures trading on December 10, 2017, followed by the Chicago Mercantile Exchange (CME) on December 18, 2017. Next, on October 19, 2021, another milestone was reached with the launch of the first Bitcoin Futures Exchange Trading Fund (BITO). The introduction of the Bitcoin Futures ETF represents an important step towards mainstream acceptance of cryptocurrencies in traditional financial markets. Finally, on January 10, 2024, the launch of the Cash ETF marks an important milestone in the cryptocurrency market.

Compared to Bitcoin's huge rise in the early years, the compound annual return for 2018-2023 is 21.95%; volatility remains high, although lower than before, at 70.89%, indicating that Bitcoin may be steadying, but the maximum pullback is still as high as 79.75%; Bitcoin's risk-return rate in the post-financialization period is not surprising, with a Sharpe ratio of only 0.31 and a Karma ratio of 0.28;

Naturally, the question arises: how much Bitcoin should we allocate to the portfolio?

The main analysis

The main analysis examined a global diversified portfolio covering a variety of asset classes, covering a variety of geographies and investment instruments. Weighted portfolios include:

1. SPY (SPDR Standard 500 ETF) is a mutual fund with a market capitalization of US$1 billion.
2. EEM (iShares MSCI Emerging Markets ETF) is an exchange traded stock exchange.
3. EFA（iShares MSCI EAFE ETF）
4. IYR (iShares US real estate ETF)
5. IEF (iShares 7-10 year government bond ETF)
6. LQD (iShares iBoxx $ investment grade corporate bond ETF)
7. HYG (iShares iBoxx $ high yield corporate bond ETF)
8. DBC (Invesco DB commodity index tracking fund)
9. GLD (SPDR gold trust)
10. The last one is BTC (Bitcoin).

2013 to 2017

In our preliminary analysis, we looked at equally weighted portfolios between 2013 and 2017; this configuration yielded a significant return of 22.86% with a volatility of 11.76% and a maximum retracement of -18.02%; we then used portfolio analysis to analyze the correlation between different assets and Bitcoin, used the Markowitz model to find the best portfolio to achieve the highest possible Sharpe ratio, and used risk parity to find an alternative way to build a portfolio with a lower risk concentration.

List of links

First, we studied correlation tables to understand the relationship between Bitcoin and other assets. We found that during 2013-2017, Bitcoin's correlation to other assets was almost negligible, with values ranging from -0.02 to 0.03.

Markowitz model

Next, we use the Markowitz model to analyze portfolio portfolios based on expected returns and standard deviations. The long-term effective margin diagram shows portfolios of all different asset portfolios that can generate effective portfolios (i.e., portfolios with the lowest risk and the highest return under the same risk). Risk is represented on the X axis and return is represented on the Y axis.

Effective border charts also show the best portfolio of matched portfolios that achieve the highest Sharpe ratio, the least differentiated portfolio - the least risky portfolio, and the equivalent risk portfolio (ERP), showing how your portfolio (in this case, our equally weighted portfolio) will perform better at assuming the same risk.

The cut-through portfolio (TP) is the best portfolio to achieve the highest Sharpe ratio and represents the highest risk-adjusted return, telling us that 14.42% will be allocated to Bitcoin. This cut-through portfolio will bring us about 48.7% of returns, with a volatility of 14.97% and a Sharpe ratio of 3.25.

The cost of risk

Next, we looked at risk parity, which is an investment management strategy that focuses on risk allocation. The main goal is to find the asset weights selected in the portfolio manager to ensure that all assets have the same level of risk. To allocate the correct risk parity we must measure their risk (e.g., historical 126-day volatility). This approach helps to reduce risk on a few concentrated assets and enhances diversification.

Next, let's look at the equity curve of a plain risk parity strategy versus our equity portfolio. Plain risk parity or plain risk parity weighting uses an inverse risk approach instead of an equal weighting. This approach assigns a lower weight to higher risk assets and a higher weight to lower risk assets, ensuring that each asset shares the same risk. As can be seen from the plain risk parity performance chart, this approach significantly reduces the volatility of the strategy (from 9.38% to 5.26%). However, this reduction of risk comes at the cost of lower returns (from 13.43% to 5.61%).

This approach ensures that no single asset (including Bitcoin) dominates the risk profile of the portfolio. Therefore, the high volatility of Bitcoin leads to a lower allocation of risk parity in the portfolio to maintain the balance of risk for all assets. What is the average allocation of risk parity to Bitcoin?

2018 to 2023

In the second part of the analysis, we examined the equally weighted portfolios of ten assets, including Bitcoin, from 2018 to 2023; this arrangement resulted in an annual return of only 9.05% (compared to 22.86% in the previous period), a high volatility of 13.93% (compared to 11.76% in the previous period), and a maximum drawdown of -24.92% (compared to -18.02%) in the previous period. Similar to the first part of our analysis, we conducted a study in the period from 2018 to 2023, studying the correlation table, applying the Markowitz model, and implementing a simple risk parity strategy.So how many bitcoins should we allocate to the portfolio based on post-financialization data?

Basic component analysis

In addition, at this stage of the analysis, we conducted a fundamental component analysis to examine the individual performance of the various assets in our weighted portfolio. This enabled us to understand the contribution of each asset to the portfolio's performance over the years.

The Sharpe ratio after bitcoin's financing is 0.31, which makes it an average asset. It performs below the S&P 500, commodities and gold, and falls into roughly the same category as high-yield bonds, MSCI EAFE or U.S. real estate investment trusts. Bitcoin performs better, but is the riskiest asset in the entire portfolio.

List of links

In the previous section (in 2013-2017), we found that the correlation of Bitcoin to other assets in the correlation table ranges from -0.02 to 0.03 ‒ we can see that they vary greatly from one period to another ‒ Bitcoin only maintains the same low correlation with the IEF ‒ the iShares 7-10 year Treasury ETF ‒ and the highest correlation with the SPY (SPDR S&P 500 ETF) and the EFA (iShares MSCI EAFE ETF) is 0.25 ‒.

This higher correlation suggests that Bitcoin is more synchronously moving or dependent on these traditional market assets. Such findings are not surprising and highlight the continuing evolution of the relationship between Bitcoin and mainstream financial instruments. Commodities and emerging markets also have low correlations in the pre-financialization period, which increase significantly in the post-financialization period.

Markowitz model

When applying the Markowitz model analysis to portfolios from 2013 to 2017, the Tangency Portfolio (TP), which represents the best risk-adjusted return portfolio, suggested allocating about 14.42% of the funds to Bitcoin to maximize the Sharpe ratio. However, the analysis shifts from 2018 to 2023, and the Tangency Portfolio suggests allocating only 2.94% of the funds to Bitcoin. This adjustment reflects changes in market conditions, risk conditions and expected returns over a given period.

The cost of risk

As we see in the equally weighted benchmark volatility contribution chart for 2018-2023, Bitcoin remains a significant contributor to the overall portfolio volatility in equally weighted portfolios. What happens if we run simple risk parity during this period?

Simple risk parity strategies reduced some of the risks, reducing portfolio volatility from 14.27% to 9.84% compared to equally weighted portfolios. Similarly, the reduction in risk was accompanied by a decrease in returns, from 14.00% to 6.54%.[14]

The result of the simple risk parity strategy was again a significant reduction in the allocation of bitcoin (down again to about 2%). This adjustment reflects the strategy's focus on allocating more weight to lower risk assets and reducing the leverage for higher risk assets. By reducing the allocation of bitcoin, the strategy aims to mitigate the impact of bitcoin volatility on overall portfolio risk.

Conclusions

A comparison between the two periods 2013-2017 and 2018-2023 reveals a significant shift in the investment landscape of Bitcoin and cryptocurrencies. In the early stages, the approach adopted (e.g. Markowitz model) may suggest allocating a significant portion of the investment portfolio to Bitcoin because of its high returns despite its inherent volatility and high risk. At the same time, the lack of productivity correlation with other assets highlights the diversified advantages offered by Bitcoin during this period.

When optimizing portfolios for 2018 to 2023, Bitcoin is now considered average and relatively high risk compared to other asset classes. Thus, while Bitcoin may show extraordinary growth and returns early on, changing market dynamics and increased institutional involvement have altered its risk-reward profile, and our analysis suggests that it is wise to limit the allocation of Bitcoin (or the entire cryptocurrency pool as an asset class) to within 2-3% of the portfolio. A higher allocation for this new asset class may not be reasonable and will carry unnecessary risk.

The analysis emphasizes the need for caution and realistic expectations when interpreting historical data and drawing long-term conclusions. While past performance may provide valuable insights, it does not guarantee future outcomes, especially in the fast-paced and volatile cryptocurrency market. It is important for those interested in learning how to buy Bitcoin to thoroughly study and understand the risks involved, ensuring that any investment is consistent with their financial objectives and risk tolerance.

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