The Role of Crypto in a Broader Portfolio

By Anton Altement, CEO of Polybius and OSOM Finance

Diversification has always been an integral part of smart risk management. Allocating between risk-on and risk-off assets to hedge against undue volatility is one of the oldest tricks in trading. However, not even the lauded 60/40 rule can protect a portfolio against systematic risk.

For decades, hedge funds have sought an asset that can protect against such undiversifiable hazards—an asset unperturbed by volatility in the wider market. For many, cryptocurrency is the answer.

Regular Diversification Won't Save You

As coronavirus-ushered financial friction continues to filter through the markets, systematic risk, or undiversifiable risk, as it's sometimes known, is precisely what investors are facing. Systematic risk essentially acts as a domino effect, rippling through markets and taking them down one by one. Between global quantitative easing and a potential stock market bubble, the chances of market-wide breakdown are reaching a fever pitch. On top of this, most traditional assets, including stocks and bonds, remain correlated—meaning that even the highly extolled 60/40 rule can't shield investors in the event of system-wide failure.

Hedge funds have touted the 60/40 rule for decades. The concept advises investors to allot a respective 60/40 percent split between higher-risk investments such as stocks, which historically yields a better return and lowers risk assets, including government bonds, which are traditionally safer but typically provide a smaller yield. The theory goes that a combination of high and low-risk assets will smoothen out volatility and produce a more significant profit. But amid the current economic fallout and a highly correlated market—there is little refuge should the worst occur.

The 60/40 rule originated from Modern Portfolio Theory (MPT), a paradigm stipulating that investors should allocate capital among multiple assets—regardless of their risk-return profile—to maximize return and minimize risk. MPT is based on the premise that markets are more efficient than their investors and leans on diversification to spread uncertainty. In other words, the theory advises against putting all your eggs in one basket.

But, as noted, some hazards remain uncontrollable, particularly within traditional asset classes. But what about the not-so-traditional asset market?

Putting crypto in its place

Cryptocurrencies, such as Bitcoin and Ethereum, together with a new trend known as decentralized finance, has helped to turn digital currencies into this year’s best-performing asset by far. The entire crypto market cites a 71% advance year-to-date (YTD). The impetus behind the market's move up comes primarily from the unconventional global posture toward monetary and fiscal policy.

In the U.S., this stance is particularly noticeable. U.S. national debt has ramped up to $26.7 trillion as of August—a $6.7 trillion increase since January. Moreover, the U.S. fed is sticking to its dovish attitude, opting to keep interest rates flat for the next few years. As such, more investors have been eyeing the crypto market as a hedge against potential inflation.

In February, speaking on CNBC, Virgin Galactic chairman and veteran investor Chamath Palihapitiya argued that everyone should hold 1% of their assets in bitcoin, as it stands as a hedge against monetary devaluation.

By May, Wall Street luminary Paul Tudor Jones was singing the same tune. Within a letter penned to his investors, Jones advocated for exposure to bitcoin amid an "unprecedented expansion of money."

More recently, Microstrategy,  the world's largest publicly-traded business intelligence company, upped the ante on both Palihapitiya and Jones, swapping out the Greenback for a sum total of $425 million in bitcoin. Much like the others, the Microstrategy's CEO, Micheal Saylor, argued that while quantitative easing and other macroeconomic factors have a depreciating effect on fiat, bitcoin remained unscathed.

Indeed, while fiat currencies such as the U.S. dollar can be arbitrarily inflated on the whims of a few, bitcoin, much like gold, has a finite supply and remains uninfluenced by the same kind of macro risks plaguing the broader financial markets. 

But the desire for crypto exposure didn't pop up overnight. Analysts, hedge funds, and investors have been advocating an allocation in crypto for years. There is a myriad of research on the effectiveness of the asset class within a broader portfolio.

In 2018, a study undertaken by crypto fund manager Bitwise Asset Management found that a portfolio consisting of 5% bitcoin, 38% bonds, and 57% stocks increased returns twofold compared to the traditional 60/40 split over 4 years.

Another related study from the National Bureau of Economic Research delved into the role of bitcoin within portfolio diversification, assessing its risk-return and comparing it to traditional assets. Researchers submitted that regardless of an investor's risk appetite, a minimum allocation of 1% in an overall portfolio was prudent.

Moreover, the study observed that a higher allocation resulted in better overall returns, ultimately concluding that based on bitcoin's Sharpe —a measure of risk-adjusted return—the ideal bitcoin allocation stands at around 6%. 

Not bitcoin alone

While many tend to lean toward bitcoin when it comes to crypto exposure, a maximalist mindset may be just as detrimental as sticking solely to traditional assets.

Despite approval from some of the biggest companies, hedge funds, and investment gurus,  bitcoin has actually underperformed compared to some altcoins. For example, while BTC is up an admirable 46% this year, Chainlink—a token powering a decentralized price oracle network—is currently up around 350% YTD. And Ethereum, the second-largest cryptocurrency by market cap, is also beating bitcoin with a 140% YTD rise.

The problem remains that while bitcoin enjoys relative legitimacy, having established itself over the course of a decade, countless altcoins remain relatively unproven. There are leagues of cryptocurrencies, each touting disruptive use cases and generally promising a great deal. But evaluating this can prove extremely tricky.

In order to do so, one needs to practice careful due diligence with what they place money in. Evaluating a cryptocurrency based on its price history, liquidity, and use case are an essential part of the picture when looking for exposure to the market. Beyond the technical indicators, one should also consider the fundamental factors such as the problem a given cryptoasset is solving as well as the team behind it. Get it wrong, and the risk can be immense. Get it right, however, and the rewards will speak for themselves.

About The Author

Anton Altement, CEO of Polybius and OSOM Finance developers of Autopilot, an AI-powered quant trading algorithm that automatically manages and finds growth opportunities for portfolios within digital assets. Prior to starting OSOM, Anton spent close to ten years with Credit Suisse as an investment banker in London and Zurich. He is focused on building a currency-agnostic ecosystem to facilitate the convergence of fiat and crypto. 

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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