Is Bitcoin only for investors?
The short answer is no! There are a lot of possibilieties like using BTC to gamble in cryptocurrency casinos or buy luxury fashion. For some, Bitcoin is a savior. For others, the cryptocurrency is a red rag. But something is happening.
Even mainstream investors are making friends with the idea of betting on Bitcoins. However, we explain what it is all about in the end. Let’s assume you are an investor of the classical school and have learned your trade from Benjamin Graham or Warren Buffett. You fell into a slumber, let’s say, in 2007 and only woke up this morning. Over your first cup of coffee, you read about an asset called Bitcoin in the newspaper for the first time. You are curious and start researching.
What would be your approach?
Right. You tap this asset for its cash flow capabilities. Does Bitcoin generate earnings that allow it to pay dividends or whatever cash? No? Hmm. Is there perhaps a chance that Bitcoin will eventually generate earnings to pay out dividends? (You vaguely remember growth investing from the 1990’s).
Neither? If you’re a Warren Buffett fan, you’ll discard Bitcoin as a pipe dream and go golfing for the first time in 14 years.
Investors have been through quite a few style-defining crises since 2007
Here’s the problem: You didn’t live through the great financial crash of 2008. Nor the repeated euro crises, nor the decade of ultra-loose monetary and now fiscal policy. This macro melange has made Bitcoin a star, a quasi-religion that has long had an immense pull, and not just among critics of the so-called fiat money system.
(We won’t go further into the basics and mechanics of Bitcoin here. A good summary with a skeptical assessment of the Bitcoin investment thesis can be found here; Robert Shiller in his book “Narrative Economics” has provided what I think is the most impressive intellectual justification for the breathtaking rise of cryptocurrency in the public consciousness).
Those who make the gold comparison quickly get caught up in the Bitcoin orbit
Bitcoin still divides minds. Most investors of the classical school do not have to have fallen into a slumber to reject Bitcoin. The ur-cryptocurrency (there are now a good 10,300 others, according to the website Coinmarketcap) is a horror to them because it is a pure speculative asset. Many make the analogy to gold.
But at the latest with the gold analogy, this logical construct threatens to get confused by fundamentally oriented investors. The precious metal, like Bitcoin, is put to virtually no commercial use. Gold also does not generate cash flows. Nevertheless, gold is considered the store of value per excellence. For thousands of years. Worldwide. Gold is still recognized as a currency in most countries, even if the gold standard has long since become passé.
Especially in times when investors fear inflation or political turmoil, the gold price rises. Looking at today’s monetary and fiscal policy environment, the current Bitcoin hype becomes understandable.
Inflation makes investors nervous
More and more investors fear that inflation will come back – by the way, you don’t need crash prophets for that. The core inflation rate in the U.S. rose five percent in May compared to the same month last year, the highest monthly jump in twelve years.
That makes an asset that is not under the control of governments and central banks seem pretty appealing.
However, the most compelling arguments for Bitcoin are as follows:
- Plus 1,375 percent (2011)
- Plus 5,380 percent (2013)
- Plus 1,390 percent (2017)
- Plus 300 percent (2020)
No investor in the world will be left cold by the kind of performance that Bitcoin and other cryptocurrencies have put in over the past few years. Investors are impressed by past performance. Therefore, cryptocurrencies are becoming investable not only for crypto disciples, but also for more and more Otto Normal investors.
Recently, Bank MM Warburg made a remarkable case for mixing cryptocurrencies into a stock-bond-securities portfolio. Admittedly, this was done somewhat tentatively (“At least from a statistical perspective, bitcoins … can be an attractive building block …”). But in terms of magnitude, the analysis was highly revealing: the Warburg optimizers, set on identifying the highest level of portfolio diversification, determined an optimal Bitcoin ratio of no less than twelve percent.
Equity bond funds with a difference
We did the test and built three different portfolios: A classic 50:50 stock-bond portfolio. To this MSCI World-REX TR portfolio we added once 20 percent gold and once 20 percent Bitcoin (in the form of an investable ETN). In addition to the return, we also calculated the risk (in the form of volatility) and the risk-adjusted return (in the form of Sharpe ratio) also for the three portfolios for the past five years. The coloring of the cells is explained as follows: the greener the coloring, the better the performance and the Sharpe Ratio or the lower the volatility.
The upper table initially shows a rather unspectacular picture for the 50:50 equity bond portfolio. Per year, the blended portfolio has performed 6.3 percent per year since June 2016 with volatility of 6.7 percent per year. Results in a decent Sharpe ratio of 0.78. That’s not bad.
A 20 percent addition of gold to the securities portfolio would not have made much difference at first glance. The return increased slightly to an annualized 6.6 percent. Meanwhile, the risk was significantly reduced by adding gold, from 6.7 percent to a volatility of 5.76 percent per year. This results in a Sharpe ratio of 0.88, which is also quite respectable.
Adding bitcoins yields a dramatic difference. The annualized return since 2016 increases to just under 44 percent; the risk-adjusted return shoots up to a Sharpe Ratio of 1.5. Last year, the performance of the portfolio doped with bitcoin was up just under 49 percent; more than ten times that of the original 50:50 portfolio. Wow. Bitcoin as a gamechanger in the portfolio context.
A few details: the volatility of the stock-bond-Bitcoin portfolio shoots up to 25.6 percent per year instead of six to seven percent. This is due to Bitcoin volatility averaging 93 (sic!) percent per year since 2016. In May, the Bitcoin price corrected by just over 36 percent. As a result, the stock-bond-Bitcoin portfolio suffered a one-month loss of a whopping 10.8 percent. (The traditional blend portfolio and the equity-bond-gold portfolio hovered around zero).
Now let’s look at the diversification effects. Which direction does the securities portfolio take with the addition of bitcoin? The chart below shows the correlation behavior of the three portfolios derived from the movements of the portfolio components.
As the top graph shows, gold had very little diversification effect on the 50:50 equity-bond portfolio between 2016 and today. This is shown by the correlation of 0.91. What is striking is the effect of a 20 percent addition of bitcoin. The correlation to the 50:50 portfolio drops to 0.37. This is due to the very low correlation of the three assets to each other: bitcoin, stocks, bonds and gold: this was a perfect diversification triad.
On to new shores with stocks, bonds, gold and bitcoin
What’s next? A 20 percent Bitcoin ratio is too high for you? No problem, let’s try a bitcoin ratio of ten percent. That’s more pleasing – by the way, it’s also more pleasing to managers of traditional securities funds, who are allowed to invest up to ten percent of the fund’s assets in certificates/other assets.
The result is portfolio number four, which weights equities and bonds at 45 percent each and contains ten percent Bitcoin. How would the moderately mixed portfolio have performed between 2016 and May 2021?
The upper table shows that a ten percent Bitcoin quota would have significantly reduced the risk. Instead of a portfolio volatility of 25.6 percent, the fourth portfolio fluctuated only 15 percent around its performance mean since 2016. While the absolute return is down significantly, the Sharpe ratio remained nearly constant at just under 1.5 compared to the portfolio with 20 percent Bitcoin. This moderate variant also retains its diversification effect, even though the correlation is higher compared with an equity portfolio.
But let’s come back to the classic Warren Buffett follower. Is there no more serious way to do it? After all, behind Bitcoin is blockchain technology, and surely this could be used throughout the corporate world in perspective?
New blockchain equity funds on the market
Right. They actually already exist, the blockchain equity funds. We found two products with a slightly longer (two-year) history. The Invesco Elwood Global Blockchain ETF provides access to companies “that participate or could participate in the blockchain ecosystem in the future.” The index is designed, Invesco says, to “reflect the advancement and potential growth of blockchain technology.”
So far, so woolly. In the specific case, the ETF includes stocks such as Kakao Corp, a South Korean company that operates a search engine and provides web services. GMO internet, a Japanese Internet infrastructure developer, as well as Taiwan Semiconductor or Banco Santander and Oracle can also be found in the index fund. The correlation to the MSCI World is accordingly this nevertheless quite mainstream-suspicious fund with 0.72 quite high.
A second blockchain equity fund, BNY Mellon Blockchain Innovation, also targets companies that are either using blockchain to develop new business areas or are using it to increase their operational efficiency and reduce their costs. However, the fund has been running very much in tandem with the MSCI World since inception, as evidenced by a correlation of over 0.9. Thus, equity risks are largely reflected here, which reduces the attractiveness for portfolio constructors.
The BNY Mellon fund also backs Cocoa stock, but also invests in software companies such as Square, Okta and Salesforce. However, swashbucklers like Daimler, Enel and Starbucks also find their way into the fund.
Crypto equity funds or half eggs don’t roll
After all, two of the top positions in the BNY Mellon fund are directly related to cryptocurrencies: Grayscale Bitcoin Trust and Coinbase. The former is a closed-end fund from the US that invests directly in bitcoins. Coinbase is a trading platform for cryptocurrencies. For that, the fund takes quite a few detours overall.
This brings us to the conclusion that the supposed blockchain equity funds are rather more or less broadly diversified digitalization funds.
So for now, investors who want to participate in the crypto story have no other choice: they have to invest in cryptocurrencies: either via their own wallet or via the detour of certificates. “Ain’t nothing like the real thing,” stop.
The higher cryptocurrency prices go, the stronger the pull for mainstream investors is likely to be. Currently, the global market capitalization of all cryptocurrencies is $1.6 trillion, according to Coinmarketcap. That represents about 15 percent of assets invested in regulated funds worldwide.
This magnitude argues against regulators banning this market segment nolens volens or even wanting to. The SEC and others are skeptical about crypto competition, and in the medium term cryptos will almost certainly be threatened with some form of government regulation. But they are not likely to be flattened.
And if you listen closely, you will hear interesting nuances in the debate. A few days ago, for example, SEC Commissioner Hester Peirce warned of the negative consequences of greater regulation for investors, the Financial Times recently quoted her as saying. This shows how much the SEC fears instability in the capital markets. One does not want to be the one responsible for the cause of the bursting of the gigantic asset price bubble. So the reasons are increasing to look into Bitcoin, Ethereum, Tether or Binance.
But we all have to be very strong now and first admit the following:
- We’re not primarily concerned with Bitcoin diversifying our portfolios and thus putting them on more stable footing. We want Bitcoins because it feels totally awesome when our stuffy stock-retirement portfolio pops 40 percent in a lean stock year. That’s what we want. That’s what we need. Us, as well as the crypto disciples.
- So let’s pay homage together to the mystical (god-like?) Satoshi Nakamoto. And let his prophet be Elon Musk. So let us join the phalanx of Bitcoin investors. Just like the members of criminal gangs, the money launderers, the environmental agnostics, the crazy prophets of the end times; Welcome to the Club of the Bad Beta Boys!