Bitcoin As An Asset Class

The price of bitcoin shot up again and that hasn’t gone unnoticed. Interestingly, the rise of the ‘crypto-currency’ is, at least partly, attributed, to recent developments in traditional financial markets. The best example being the ongoing depreciation of the Chinese yuan, which persuades the Chinese to circumvent capital controls by getting capital out of the country using bitcoin. But also political uncertainty (US elections, Brexit) and the extremely accommodative stance of central banks are mentioned. Hence, when it comes to explaining its price movements, bitcoin is increasingly treated as an asset class. But, how does bitcoin stack up as such?

Size

To get an idea, I first looked at some general features of traditional asset classes, like size, risk and return. Let’s start with size. At a price of USD 700 the ‘market cap’ of bitcoin equals roughly USD 11 billion. While that’s surely a significant number, it’s nothing compared to the value of traditional asset classes. This is shown in the graph below, which is derived from the (well-recommended) research by Doeswijk, Lam and Swinkels (2014) on the value of the global multi-asset market portfolio. The chart shows the investable market capitalization for the major asset classes. For example, the total market value of global equities is approximately USD 40 trillion (or 40 000 billion), which means that equities have a market cap that is 3600(!) times bigger than that of bitcoin. But even the value of the ‘smallest’ of the major asset classes enclosed in the global multi-asset portfolio, high yield bonds, eclipses the value of bitcoin. The market cap of high yield bonds, at USD 1715 billion, is still 156 times bigger than that of bitcoin. If bitcoin were added to the global multi-asset portfolio it would represent just 0.01% of total market value.

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Risk and return

More risk equals higher return. Long-term, this tends to hold for traditional asset classes. But what about bitcoin? The chart below shows the average annualized return of bitcoin and of traditional asset classes since July 2010 (when bitcoin started trading on an exchange). Over this period, bitcoin’s annualized return is an incredible 325%. Such a massive average return suggests that bitcoin is pretty different from traditional asset classes. But we should take into account that bitcoin’s history is very brief, long-term data are not available. In addition, traditional asset classes can record pretty incredible short-term returns as well. Between October 1998 and March 2000 the NASDAQ Composite realized an average annualized return of 144%. Still, 325% is pretty extraordinary by any standard.

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So what about risk? Well, just look at the chart below. Bitcoin’s risk profile is pretty extraordinary as well. Starting in July 2010, bitcoin has an average annual volatility of 132%. This is perhaps even more remarkable than the realized return. Again for comparison, during the height of the IT bubble the NASDAQ’s annual volatility equaled 26%, less than one-fifth of the volatility of bitcoin.

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It’s often mentioned that bitcoin’s volatility profile has become more stable as the bitcoin market space developed. But, while the chart below certainly confirms bitcoin’s volatility is now lower and more stable, the level of risk remains much higher than that of any other class. During the last 52 weeks, the annualized volatility of commodities, the second riskiest asset class, is just over one-third of that of bitcoin. Moreover, bitcoin’s annualized return is also down markedly since volatility dropped in early 2015.

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Sharpe

The Sharpe-ratio (return divided by risk) is often used as a measure to determine the attractiveness of an asset class. It reflects the amount of return per unit of volatility. As can be derived from the chart below, bitcoin scores extremely well on Sharpe. Since July 2010, bitcoin’s annualized Sharpe ratio is 2.47, more than a full point above the number two, global treasuries. In general, a Sharpe ratio north of 1 is considered very attractive. Concerning bitcoin, the impressive movements in price are compensated by an even more impressive return, pushing the Sharpe-ratio up. If you ‘forget’ to look at the underlying data, bitcoin would be considered an extremely attractive asset class.

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Correlation

Within a multi-asset portfolio correlation is key. Two asset classes that behave exactly the same way don’t offer any diversification benefits, while two assets that behave in the exact opposite way often results in little risk but also in little return. The table below shows the correlation between weekly returns of bitcoin and traditional asset classes. As may have been expected, since bitcoin is such an outlier on both return and risk, the correlation is very close to zero. There is no significant relationship between the returns of bitcoin and those of other asset classes. Worth noticing is that, while bitcoin is regularly referred to as a kind of digital safe haven or digital gold, the correlation between bitcoin and gold is also statistically insignificant from zero. This suggests that gold and bitcoin are two very different asset classes.

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Portfolio Behavior

Nor correlation, nor Sharpe can tell the whole story of how bitcoin behaved in a multi-asset portfolio. The available price and return data do, at least from a historical perspective. Suppose you invest in a traditional multi-asset portfolio of 50% equities and 50% government bonds and decided to add 1% of bitcoin. This may sound as a very minimal allocation, but the chart below tells us the opposite is true.

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If you created a multi-asset portfolio in July 2010 consisting of 49.5% equities, 49.5% bonds and 1% bitcoin you would have realized an average annualized return of 104% with an average annualized volatility of 86%. For comparison, I also added the return and risk of the traditional 50% equities and 50% bonds portfolio. As you can tell from the graph these two portfolios are in no way comparable to each other.

That is, only if you did not rebalance your portfolio. This is a very important notion as the weight of bitcoin in the portfolio would have grown to 98% by now. For a traditional buy-and-hold portfolio bitcoin doesn’t really suit.

Now, surely most investors would have rebalanced their portfolio, especially with a chosen starting weight of just 1%. Therefore, let’s take another look at the multi-asset portfolio that invests 1% in bitcoin, but this time rebalances every week. If the weight of bitcoin is brought back to its original 1% every week, things look totally different. Rebalancing at this frequency means bitcoin’s weight would never have surpassed 2%, which means its extreme risk-return profile did not get the chance to dominate the entire portfolio. In fact, weekly rebalancing resulted in an investment portfolio with the exact same volatility as a traditional 50% equities and 50% bond portfolio, but with higher realized return (7.3% v 5.1%), as is shown in the graph below. Hence, adding a stringent rebalancing frequency prevented bitcoin from dominating the portfolio without giving up on the return potential due to the low correlation of bitcoin with other asset classes.

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Obviously, there is one caveat with this strategy. The chart above does not take into account trading costs. Trading cost differ greatly between markets and investor types. But especially for retail investors weekly rebalancing is likely to significantly impact returns as they often pay a fixed amount for each transaction and make less use of derivatives.

Summary

First, if bitcoin is an asset class it’s a very small one, and one not available to every investor. When all investors, that together hold the global multi-asset portfolio as mentioned above (total value USD 100 trillion), want to invest 1% of their portfolio in bitcoin, its market value would have to grow 90-fold (to USD 1 trillion) instantly to make that possible. Second, bitcoin as an asset class comes with an extreme risk-return profile. So, while its Sharpe ratio is way better than that of any other asset class, and the correlation with these other asset classes is basically zero, the sheer magnitude of both volatility and return should be taken into account. Which brings me to my final point, adding bitcoin to a traditional multi-asset portfolio requires a rigorous, and potentially costly, rebalancing scheme. In the example of adding 1% bitcoin to a traditional multi-asset portfolio, a weekly rebalance frequency was required to prevent bitcoin from dominating the total portfolio. Still, this last example does show that for those who were able to rebalance at minimal cost (hence use derivatives) bitcoin could have added value. To conclude, bitcoin as an asset class remains an outlier for now, but maybe that’s also because it’s really a technology.

Disclosure, I own bitcoin

Source: Doeswijk, R., Lam, T., and Swinkels, L., 2014, “The Global Multi-Asset Market Portfolio, 1959–2012”, Financial Analysts Journal 70(2), pp. 26-41.

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