This is a sponsored article from WisdomTree Europe.

With cryptocurrencies’ growth potential, diversification credentials, and ease of investment through regulated investment vehicles, it is becoming increasingly hard for investors to ignore this asset class.

Contrary to commonly held belief, not allocating to cryptocurrencies is not a neutral positioning. It is a bet against the space. A passive investor should allocate 1% to crypto if emulating the market portfolio.

Cryptocurrencies in the market portfolio: 1% is a neutral positioning

The market portfolio consists of the weighted sum of every asset in the market. For most investors, it can be considered the ‘neutral’ allocation over which they can overlay strategic/tactical market views.

Looking at the market portfolio, we note that equities weigh 52.3%, bonds weigh 35.4%, and alternatives weigh 12.3%; a classic portfolio similar to the 60/40 structure. However, we notice that cryptocurrencies weigh 1.3%.

This means that an uninformed investor should invest around 1% in cryptocurrencies. By not doing so, managers are actively underweight digital assets, reflecting a belief that they will shrink or disappear.

Figure 1: The liquid market portfolio

Source: Bloomberg, WisdomTree. As of 28 March 2024. Market caps are shown in billions of US dollars. You cannot invest directly in an index.

Cryptocurrencies, an asset class that stands out: an exceptional source of growth

With a 15-year track record, it is now possible to study Bitcoin’s behaviour. Ranking asset classes by performance gives an incredible picture of Bitcoin’s potential (see Figure 2 below).

In seven out of ten years, Bitcoin was the best-performing asset. While it was the worst-performing asset in the remaining three years, this highlights how powerful Bitcoin can be in generating extra performance for multi-asset managers.

It is also worth noting that those ‘bad years’ are spaced four years apart, exactly mid-way between halvings – periodic events where Bitcoin’s supply and miners’ block rewards are halved.

Figure 2: Asset class ranked by calendar year performance

Source: Bloomberg, WisdomTree. From 31 December 2013 to 31 December 2023. In USD. You cannot invest directly in an index. Historical performance is not an indication of future performance and any investment may go down in value.

Cryptocurrencies, an asset class that stands out: a risk-on diversifier

While performance is key, diversification is even more important in multi-asset portfolios. Correlation between assets, more so than returns, is what can make an asset valuable in this context.

Cryptocurrencies’ unique nature hardly fits in existing financial boxes. Users and developers are not typical actors and while this may be disconcerting, it enhances cryptocurrencies’ decorrelation. Most asset classes in the table (Figure 3) correlate to at least one other asset class except for digital assets. Cryptocurrencies’ correlation with any traditional asset class remains below 30%.

Figure 3: Bitcoin Correlation to remaining asset classes is exceptionally low

Source: Bloomberg, WisdomTree. From 31 December 2013 to 31 March 2024. In USD. Correlation based on weekly returns. You cannot invest directly in an index. Historical performance is not an indication of future performance and any investment may go down in value.

It is important to note that the correlation structure has not changed much with Bitcoin’s increased adoption. The weekly returns correlation matrix over the last two years shows correlations around or below 20% with all other asset classes. This correlation paints Bitcoin as a great addition to the alternative bucket, adding to its strong potential.

The impact of adding 1% of Bitcoin to a classic multi-asset portfolio

How can small levels of Bitcoin impact a portfolio? Here, we consider constant mix illustrative portfolios which are rebalanced monthly.

The control portfolio (the 60/40 Global Portfolio) allocates 40% to global bonds, represented by the Bloomberg Barclays Multiverse Total Return Index, and 60% to global equities, represented by the MSCI ACWI Net Total Return Index. Our constant proportion portfolios will then add 1%, 3%, 5% and 10% of Bitcoin (the 1% Bitcoin Portfolio, 3% Bitcoin Portfolio, etc.).

Figure 4 shows the cumulative historical performance of the 60/40 Global Portfolio and the four Bitcoin Portfolios in which 1% to 10% of the portfolio has been allocated to Bitcoin.

The higher the allocation to Bitcoin, the higher the historical return. The 1% allocation led to a 0.69% outperformance while the 5% allocation outperformed the 60/40 Global Portfolio by 3.45%. For multi-asset managers, 1% of extra performance over a given year can distinguish between beating or trailing peers.

Figure 4: Historical performance of portfolios, including increasing proportions of Bitcoin

Source: Bloomberg, WisdomTree. From 31 December 2013 to 31 March 2024. In USD. Based on daily returns. All computations are simulated in USD and for illustrative purposes only. You cannot invest directly in an index. Historical performance is not an indication of future performance and any investment may go down in value.

The statistics table hints at interesting insights:

• Volatility increased slightly for Bitcoin Portfolios, but much less than expected, since the 1% allocation only added 7 bps volatility.
• Underperformance of Bitcoin Portfolios in drawdowns seems contained, with an increased drawdown of only 50 bps for the 1% portfolio.

Adding Bitcoin to a portfolio significantly improved the historical risk-adjusted performance

Bitcoin’s higher performance was accompanied by higher volatility over the period. However, the low correlation limited this increase. The 1% and 5% Bitcoin Portfolios exhibited excess volatility of 6 bps and 83 bps, respectively. While Bitcoin’s volatility is around 70% without diversification effects, we would expect the 1% and 5% Portfolio’s volatility to increase by 70 bps and 350 bps, respectively, but the actual results are very different.

Figure 5: Annualised excess volatility of the Bitcoin portfolio versus the 60/40 Global Portfolio

Source: Bloomberg, WisdomTree. From 31 December 2013 to 31 March 2024. In USD. Based on daily returns. You cannot invest directly in an index. Historical performance is not an indication of future performance and any investment may go down in value.

When balanced with strong performance gains, this leads to a very strong gain in risk/return efficiency. By adding Bitcoin to multi-asset portfolios the Sharpe ratio strongly increases across the board. For example, the 1% Bitcoin Portfolio exhibits only 0.7% tracking error compared to the 60/40 Global Portfolio.

Looking purely at the characteristics of cryptocurrencies, it is clear that they can bring value to a multi-asset portfolio. With their growth potential, their diversification credentials and ease of investment through regulated investment vehicles, it is becoming increasingly hard for investors to ignore them.

With a 1% investment, investors would take a neutral stance on the space, ready to benefit from potential upside and manage the risk by limiting the downside risk to a single percent.

For more information on the impact of adding a small amount of cryptocurrency to a multi-asset portfolio please see our latest research paper on the subject.
 

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This is a sponsored article from WisdomTree Europe.