Bitcoin and digital assets in a wallet context

The fact that digital assets such as Bitcoin and other cryptocurrencies have become increasingly relevant in recent years is illustrated, among other things, by the fact that well-known innovative companies such as Tesla are also investing in Bitcoin. One thing is clear: Bitcoin and digital assets are here to stay.

Not only Bitcoin alone, but also a combination of different cryptocurrencies in the form of a crypto index can represent significant diversification of a portfolio that does not correlate with conventional asset classes. Over the past year, large listed companies such as MicroStrategy or Tesla have invested in Bitcoin significantly. Meanwhile, El Salvador became the first nation-state to make Bitcoin legal tender in September 2021.

MicroStrategy, Tesla or El Salvador are among the most illustrious Bitcoin investors, but they are only the tip of an ever-growing iceberg. More and more investors – from retail investors to institutional players – are buying into the digital asset market.

A new alternative asset class

In the eyes of a growing number of investors, cryptocurrencies and digital assets have long since become an asset class in their own right. According to professional market analysts, this is found in alternative investments alongside art, hedge funds or commodities.

Bitcoin still stands out among cryptocurrencies. As the numbers impressively show, Bitcoin has been the best performing asset of the past decade. Still the most important cryptocurrency, it represents around 40% of the total market capitalization of this new asset class. This circumstance is also due to the variety of Bitcoin investment products. The first Bitcoin futures ETFs were launched in the United States in the last quarter of 2021.

Bitcoin: significant portfolio diversification

The impressive performance of digital assets over the past few years can also be placed in a portfolio context. The portfolio comparison for portfolios with and without the addition of Bitcoin shows this clearly: relevant portfolio parameters improve with an allocation of Bitcoin.

This can be determined using a concrete example of a classic wallet (this is a sample wallet, all information is subject to change). It comprises 55% equities (MSCI World Index), 38% bonds (TIPS Bond ETF) and 7% commodities (Invesco DB Commodity ITF). For the period from 2015 to 2021, this diversified portfolio achieved an annual return of 5.68% with a standard deviation (volatility) of 7.53%.

Adding just 3% of Bitcoin at the expense of the equity portion, which itself performed well, has a positive impact on the portfolio. Thanks to the bitcoin allocation, the performance of the portfolio could be increased up to an annual return of 8.75%, while the standard deviation increased only minimally to 8.10%. Bitcoin’s positive effect can also be seen in the change in the Sharpe ratio, a frequently used portfolio measure to show risk-adjusted return.

A high Sharpe ratio indicates that high performance has been achieved with relatively low risk. The higher the Sharpe ratio is for a selected portfolio compared to a reference portfolio, the better the risk/return ratio of the first compared to the second. For the chosen example, the Sharpe ratio for the classic wallet without the addition of Bitcoin is 0.62. Adding Bitcoin increases the Sharpe ratio to 1.08. This fact allows the following conclusion: Bitcoin is poorly correlated with classic asset classes and represents a sensible diversification of a classic portfolio.

Other digital assets – same effect

There are now countless other cryptocurrencies that generally fall under the term digital assets. Some of them have now reached a considerable market capitalization and are therefore also taken seriously by professional investors.

The same classic wallet (This is an example of a wallet, all information is subject to change) can also be compared to a wallet that has been supplemented with a combination of different cryptocurrencies. Cryptocurrencies that are in the top 10 by market capitalization have been selected and assembled into a crypto index. This is composed as follows: 5% Bitcoin (BTC), 5% Bitcoin Cash (BCH), 10% Ether (ETH), 40% Cardano (ADA) and 40% Ripple (XRP). Together, these cryptocurrencies represent 5% of the total portfolio, which are included in the portfolio instead of stocks. Due to the younger age of these cryptocurrencies compared to Bitcoin, a more recent and therefore shorter period from 2018 to 2021 was considered.

The classic portfolio with no crypto allocation achieved a return of 6.98% with a standard deviation of 8.64% over this period. By adding the selected cryptocurrencies, the performance could be increased to 10.03% over the same period with a standard deviation of 10.11%. Similarly, the Sharpe ratio goes from 0.69 to 0.99. This example shows that not only Bitcoin alone, but also a combination of different cryptocurrencies in the form of a crypto index can represent significant diversification of a portfolio.

Shift of the efficiency curve

The advantage of adding cryptocurrencies is also illustrated by the so-called efficiency curve. This shows the highest possible return and greatest risk that different portfolio allocations can have. With return on the Y axis and risk on the X axis, shifting the efficiency curve upwards meant that a higher return could be earned for a matching portfolio with the same risk.

Such an upward shift in the efficiency curve occurs for wallets (this is an example wallet, all information is subject to change) to which digital assets have been added as a complement. In other words, for the same level of risk, adding cryptocurrencies may yield a higher return – or adding them may reduce risk for the same return.

Relevant for the future?

In view of these insights from portfolio theory, the question arises: will the positive effect of adding cryptocurrencies to the mix be sustained in the future? It is well known that the data collected always comes from the past and does not provide any guarantee as to the future. A look in the rear view mirror makes performance and the risk/reward ratio positive. But why should portfolio technical results apply in the immediate future? Bitcoin’s gradual establishment as digital gold speaks for itself. Bitcoin’s promise of scarcity has held true for the past 12 years, and with each passing year it is cemented in more and more people’s minds.

Bitcoin’s strength as an investment becomes particularly evident when other asset classes are compared to the increase in central bank money supply. For example, if you compare the S&P 500 not with its dollar valuation, but with the balance sheet of the Fed, you can see that the price increases are due to a strong expansion in the money supply. If you choose the correct denominator, i.e. the balance sheet of the central bank, prices are stable. Over the past ten years, the S&P500 has grown at an average annual rate of 15% in nominal terms. Interestingly, this is roughly the same as the annual expansion of the US Federal Reserve’s balance sheet.

As a form of insurance against continued monetary expansion from central banks, Bitcoin and other cryptocurrencies are expected to continue to gain traction in the near future. The end of the acceptance curve is far from being reached. If cryptocurrencies continue their triumphant march, then Bitcoin and other digital assets will also prove sensible, uncorrelated diversification for a portfolio for the foreseeable future.

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