Future Returns: Why Investors May Want To Consider Bitcoin Now (#GotBitcoin?)
Cryptocurrency is a divisive topic among investors. It’s either the currency of the future or the tulip bulbs of our time. Yet last week’s sudden and mysterious surge in Bitcoin value suggests that it just might be more than a fad. Future Returns: Why Investors May Want To Consider Bitcoin Now (#GotBitcoin?)
After hitting all-time highs of nearly US$20,000 in December 2017, Bitcoin plunged to half its value in a matter of months, reaching a 2018 low of about US$3,400 in December. The widely followed digital currency had hovered below US$4,000 for most of this year. Then it surged to more than US$4,961 on April 2.
Without a doubt, Bitcoin is a speculative asset that is virtually impossible to value, inherently volatile, and difficult to buy.
Even so, digital currencies—as well as the blockchain technology on which they’re built—will likely play a role in the future.
“This is really one of the first big innovations in currency in a very long time,” says Tim Courtney, chief investment officer at Exencial Wealth Advisors, an independent investment advisory headquartered in Oklahoma City.
Like any currency, Bitcoin produces no cash flows on its own, and its price is entirely driven by supply and demand. Yet, one could make the case that traditional currencies are just as risky, if not more.
“One of the weaknesses of many of the global currencies is that the central banks can print more of it, and that can drive down the value of the currency,” Courtney says. “Bitcoin and other cryptocurrencies have limits on supply, which should, all things being equal, be an advantage.”
There are legitimate reasons driving demand. It offers a frictionless, low-cost way of transferring assets, and in many countries, it’s gaining traction as a stable alternative to local currency. “Some of the natural buyers of Bitcoin and cryptocurrencies are people looking for some kind of store of value that won’t degrade and will not be inflated away,” he adds.
The idea of digital ledgers stored across a network of computers may seem foreign, but from an investment standpoint, digital currency may not be that different from any other currency. “In our portfolios, we like to have assets that are denominated in multiple currencies for diversification’s sake, and this would be kind of a natural extension of that,” Courtney says.
Still In The Early Stages
Investors should have an open mind about Bitcoin’s role in the future of money—but they should also be realistic about its many shortcomings.
First, there is the valuation question. Even if you subscribe to the idea of supply and demand, the real value of Bitcoin is anyone’s guess. During the Bitcoin bubble in 2017, some experts predicted that it could go to US$1 million and higher.
And while Bitcoin is the preeminent player in a universe littered with cryptocurrencies, that doesn’t mean it won’t ultimately be displaced by a more superior technology.
Probably the biggest knock against Bitcoin as an asset is that it isn’t easy to buy. “This is where I think the interest gets much lower because most of the primary ways in which modern investors access asset classes is just simply not there for the cryptocurrencies,” Courtney says.
The primary way for investors to buy and sell digital currency is through a wallet, such as Coinbase or Trezor. For many investors, this is reason to sit on the sidelines. In addition to the security and estate-planning issues of owning digital currency—which is based on a unique code—there are practical hurdles.
“It’s an issue of inconvenience because the last thing you want to do is have another thing to track another asset,” Courtney adds.
Despite a good deal of buzz about exchange-traded funds offering exposure to cryptocurrency, the U.S. Securities and Exchange Commission recently said it will be delaying a decision on Bitcoin exchange-traded fund applications.
Grayscale Investments offers nine single-currency investment trusts, which provide exposure to Bitcoin (BTC), Ethereum (ETH), and other cryptocurrency. But these securities tend to trade at premiums to their underlying net asset value, and changes in regulations and other factors can cause their prices to fluctuate more than the coins themselves, which is saying something.
Of course, this may be all the more reason to take a flier on Bitcoin. While progress has been slow, major exchanges and institutions, including Fidelity Investments, have plans in the works for making it easier for investors to buy, sell, and manage cryptocurrency.
“When you have financial institutions embrace it, then the floodgates will be open,” says Jeff Sica, CEO and CIO at Circle Squared Alternative Investments in New Jersey.
Sica was an outspoken critic of Bitcoin when it was trading near US$20,000 in 2017, but he now thinks investors should consider allocating up to 5% of their alternative assets to Bitcoin.
“At US$5,000, I see the potential for very volatile yet sustainable appreciation from here,” he says. “As cryptocurrency begins to integrate into our everyday lives, it makes it less of a speculative or obscure currency, but something that has legitimate use.”
Bitcoin is a unique, uncorrelated asset class that is not strongly affected by the macroeconomic factors that drive most asset classes.
Doing this analysis has given me conviction that bitcoin should be a part of my passively held, long only portfolio. First, there aren’t that many store of value assets in the first place. There’s gold, US sovereign debt, safe haven currencies, and that’s it. Second, it’s surprising that bitcoin’s correlation is this low, even among other store of value assets.
At the same time, there are strong theoretical arguments that bitcoin will serve as a hedge against harmful geopolitical events due to its decentralized nature. There’s a growing body of empirical evidence of this also with bitcoin price spiking in response to both Brexit and Donald Trump’s win.
Bitcoin is uniquely positioned to hedge against geopolitical risks but remain unaffected by the macroeconomic factors that drive other store of value assets.
Crypto Asset Diversification Vs. All Eggs In One Basket
What’s an effective way to diversify a crypto portfolio? Are crypto assets able to be diversified at all? These are the questions that many “Hodlers” have been asking. The slow bleed of Bitcoin (BTC) and other major cryptocurrencies prices has been challenging investors and their holding powers. Despite BTC still able to maintain its 112% year-to-date gains so far — thanks to the massive bull run in the second quarter and the recent China-inspired rally — the recent price correction could pressure some of the latecomers. In this article, we will study some possible diversification options for crypto portfolios from a Hodler’s perspective — i.e., diversifying investment by allocating capital into various crypto assets using long-only strategies. We will also explore how altcoins and stablecoins could balance a portfolio.
In the traditional world of finance, the performance of different assets could vary under different market conditions. For example, real estate investment trusts could outperform general equities in a turbulence market, and defensive stocks could disappoint investors when the appetite for risk is heightened. That’s when diversification comes in. The main purpose of exposure to different asset classes is to balance risk and return in a portfolio.
In the cryptocurrency space, diversification could also be one of the ways to manage risk exposure. However, some would argue that it is impossible to diversify a crypto portfolio due to the fact that major altcoins are highly correlated with Bitcoin. However, with a carefully selected basket of altcoins — in conjunction with stablecoins — investors could able to navigate the market more effectively with manageable risk.
Concentration vs. diversification
There has always been a debate about putting all your eggs in one basket. While in some cases concentrating on only one asset could maximize profitability, this also maximizes the risk exposure. On top of that, a heavy-concentration strategy gives investors no room for any errors in analysis, and it overexposes the investor to unnecessary risks.
However, over-diversification could also hurt investment returns. Some investors believe that the more assets they own, the better return they can have — and that’s not the right concept. It could increase investment cost, add unnecessary due-diligence efforts and lead to below-average risk-adjusted returns.
Market Performance Overview
Before getting into portfolio diversification, let’s have a quick recap on the performance of major cryptocurrencies. The figure below shows that OKB and BTC were among some of the YTD gainers, while XMR and XRP have been underperforming compared to their peers. Once again, this shows various crypto assets could perform very differently, highlighting the importance of balancing risk and return.
A portfolio with a balanced selection of coins and tokens could help Hodlers balance risk and returns. Here are some sample portfolios using BTC alongside other leading altcoins as well as the Fundstrat Crypto 40 Index — a weighted index tracks the top 11 to 50 cryptocurrencies by market value and liquidity. The results could make Hodlers think again about putting all their eggs in one basket.
Many BTC-based portfolios have remained solidly in the green, due in part to Bitcoin holding on to its 112% gain so far this year. As shown above, however, the portfolio containing only BTC and Ether (ETH) has been underperformed compared to portfolios that have both BTC and exposure to mid-cap altcoins. To see this, compare the 50/50 portfolio (with a yearly gain of 67%) to the one consisting of Bitcoin and the top-40 index (gaining 77% on the year).
Meanwhile, the hedging nature of stablecoins like Tether (USDT) has been reflected in the sample portfolio based on BTC and the index with a hedge (76%). In this diversification example, the exposure to altcoins is reduced, the BTC holdings are slightly increased and USDT was added. Still, the gain of this portfolio was very close to the one without USDT. In general, a portfolio that includes stablecoins can reduce the risk ratio more than one that is unhedged, but as the examples above show, it is still possible to achieve similar results.
Stablecoins are especially important in portfolios that include highly volatile coins and tokens, as can be seen in the example of the hedged basket. The group comprises XLM and OKB, which have plummeted over 46% and surged over 290% respectively. Still, this combination was able to achieve almost 80% YTD gains, and the USDT holdings were part of the reason behind that performance. In contrast, the mixture of BTC and certain altcoins without a stablecoin in the basket could underperform the other sample portfolios provided.
Additionally, experienced traders and Hodlers are able to fine-tune their portfolios by adding derivatives on top of a long-only portfolio. For example, if a Hodler is being short-term bullish on an individual coin, he can increase his leverage on that specific coin by adding futures or perpetual swap positions on top of the holdings. Structured products can also be used as a hedge in a downturning market.
Crypto asset diversification has been one of the most debated topics in the industry. Some would argue that a 100% Bitcoin allocation setup could probably still able to generate a decent return this year. However, a BTC-only portfolio will never able to capture the distinctive opportunities in the altcoin world, which could potentially generate higher returns — and, of course, putting all your eggs in one basket comes with higher risk. A carefully designed portfolio with balanced asset allocation could maximize the risk-adjusted return. As the year-end approaches, investors and Hodlers can review their risk profiles and adjust their strategies for next year.
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