Cryptocurrencies: Growth of a New Asset Class
Summary:
-Despite Being Met with Warranted Skepticism, Cryptocurrencies or Digital Assets are Here to Stay.
-A Growth Asset and Macro Hedge
-Bitcoin in a Modern Portfolio
This has been an unprecedented year for markets, with no asset class exempt from economic disruption and market volatility. While the overall market has largely rebounded from its March low, digital assets continue to outperform their traditional counterparts and represent an even greater opportunity on a go-forward basis. The case for bitcoin specifically is stronger than ever—now is the time to invest.
The fundamental shift in the macroeconomic landscape has created a supportive backdrop for bitcoin. Broadly, paradigm shifts occur when external forces challenge the status quo. Specifically, there are two trends that make bitcoin an increasingly compelling offensive and defensive play. Bitcoin provides investors upside exposure to digitization: the world is digitizing at a breathtaking pace, and bitcoin is well-positioned to grow alongside that trend. Bitcoin also provides potential downside protection as a compelling macro hedge.
In a Portfolio
Modern portfolio theory (MPT) is a trusted analysis often used by investors to model scenarios of optimal portfolio allocations to various assets. Investors assessing the role of bitcoin in their portfolios are encouraged to utilize the same MPT approach for a quantitative-based analysis of bitcoin.
MPT demonstrates that bitcoin’s history of positive returns and uncorrelated nature make it an attractive addition to traditional portfolios. Despite its volatility, adding a small portfolio allocation to bitcoin generally increases the overall expected return and improves the portfolio’s expected risk-adjusted returns. It also potentially diversifies some of the systemic risk that exists in modern portfolios.
Most modern portfolios present a fair degree of inherent systemic risk in the financial system. Adding bitcoin to an investment portfolio diversifies away some of this systemic risk and offers additional portfolio benefits. Our study shows that a hypothetical portfolio’s Sharpe ratio is optimized somewhere near a 6% allocation to bitcoin. However, the strongest marginal improvement to a portfolio’s Sharpe ratio occurs in the 0.5% to 2.5% range. This demonstrates that even a small percentage allocation to bitcoin in a portfolio can have a major impact.
What’s Next?
Conclusion:
We are not surprised that heightened interest in bitcoin across all investor types coincides with the broad acceleration of digitization. Microsoft’s CEO recently said that the company has experienced two years of digital transformation in two months, and Gary Cohn wrote in the FT that the Coronavirus is speeding up the disappearance of cash. In the context of Cohn’s piece, it makes sense that early drafts of the CARES Act contemplated distributing stimulus payments to US citizens rapidly and directly via digital wallets. We have also closely followed the revamped, yet still significant, plans to launch the Facebook-backed Libra project and bring digital wallets to Facebook’s 2.5 billion users. We believe in a future in which digital money (USD, Chinese RMB), digital payments (Libra), and digital stores of value (bitcoin) exist side-by-side. Each of these projects will require sustained investment in digital payment rails and infrastructure, a reality which offers material support to the bitcoin as a digital store of value thesis. Bitcoin’s future is bright, and now is the time to start incorporating it into portfolios.
If you’re interested in learning more, please contact us at info@commonfinancialsense.com
