Disclaimer: Opinions expressed in this article do not constitute investment advice from Bitcoin Reserve.
For years—even before the last economic crisis—hedge funds have been attempting to find the holy grail of assets. An instrument which remains uncorrelated from traditional markets, and unaffected by central bank interference. That asset is bitcoin—here's why every portfolio should hold some.
In March 2020, almost every asset manager and hedge fund fell in the red. The systemic tidal wave of coronavirus panic swept the stock market entirely under. On March 16—since referred to as Bloody Monday—the Dow witnessed one of its worst days on record, plunging almost 13%. But there was one hedge fund that managed to weather the storm.
R.G. Niederhoffer Capital has a knack of doing well when the rest of the market is in disarray. On March 26, while the U.S. stock market was down by more than 30%, the fund was up 27%.
One of the ways the fund managed to pull off such a feat is by harnessing modern portfolio theory (MPT). The paradigm dictates that allocating capital between multiple assets can maximize expected returns—regardless of the risk-return aspects of an individual asset.
How Much Bitcoin Is Enough?
For many, bitcoin fits MPT criteria better than most assets. A study from a digital asset management firm, Galaxy Digital, examined the role of bitcoin within traditional portfolio diversification, finding that the addition of bitcoin improves a portfolio's expected overall return.
Moreover, higher exposure to bitcoin at incremental levels improves a portfolio's expected returns further than merely adding volatility. According to the research, based on the Sharpe ratio—a measure of risk-return when adding volatility—the optimal allocation of bitcoin comes out at around 6%.
Interestingly, this optimal level of exposure falls precisely in line with a further study from scholarly economists Aleh Tsyvinski and Yukun Liu. The study assessed the risk-return of bitcoin compared to traditional assets, concluding—much like the Galaxy Digital report—that despite its increased volatility, bitcoin is deserving of at least a 1% allocation, regardless of whether investors are risk-averse or not. As an addendum, the paper advocates a further 6% allocation if the investor deems bitcoin will perform in the future.
Another complementary study undertaken by Bitwise Asset Management in 2018, concluded that a 5% allocation of BTC within a traditional portfolio—composed of a residual 57% allocation to stocks and 38% allocation to bonds—doubled returns compared to the traditional 60/40 split over a four year period. This, as seen below, was even in spite of bitcoin's parabolic 2017 run and subsequent collapse.
What's the Correlation?
While employing diversification principles in traditional portfolios has been proven to mitigate certain risks, there is some risk that remains undiversifiable. 2020 has been an exemplar of this type of systemic risk, which has indiscriminately plunged the equities market to record lows. However, while assets such as gold and bitcoin had a brief tumble of their own, they bounced back and proceeded to perform as expected during this crisis.
For the most part, this is thanks to a non-correlation to traditional markets. Per data from blockchain analytics firm, Messari research, bitcoin has enjoyed largely uncorrelated relationships with macro asset classes, including equities, fixed income, oil, and even its closest rival, gold.
The Sky's the Limit
Hedge funds, particularly family offices and high-net-worth individuals (HNWI) are starting to heed the message that even a small allocation of bitcoin can make a big difference.
In their 2020 crypto hedge fund report, accounting firm PwC cited that approximately 90% of all investors are either family offices (48%) or HNWI (42%).
The argument goes that there isn't much to lose with a small allocation as the risk is spread. This is further bolstered by the notion that bitcoin displays acute asymmetric risk distribution, meaning that, on the whole, its reward outweighs the majority of its risk. In other words, bitcoin embodies an almost limitless upside.
Virgin Galactic Chairman, Chamath Palihapitiya, recently highlighted this upside. During a conversation with Morgan Creek Digital Partner Anthony Pompliano, Palihapitiya contended that bitcoin holds the potential to become a global reserve currency.
In Palihapitiya's perspective, as volatility cools down—and with traditional financial infrastructure continuing on its downward spiral—bitcoin is in good stead to become a dominant currency held by the populous, rather than central banks.
The only way to break the back of inflation, explained Palihapitiya, is to return to a gold standard. However, between governments and central banks, that's an unlikely scenario as they'd never agree on an instrument or exchange rate. Instead, he argues, people could simply decide to do it themselves—with bitcoin.