By Martin Howard, senior research analyst
As digital assets such as Bitcoin have become more accessible to investors, their adoption in institutional portfolios has been on the rise. And while it’s true they can be more volatile than traditional assets, few have considered how to approach mitigating the risk of a digital asset portfolio allocation. In reality, the answer isn’t as complex as one might think—it can in fact be possible to mitigate digital asset risk with relatively straightforward portfolio construction techniques.
Bitcoin: Upswings and downswings
Since Bitcoin was introduced to the marketplace in 2009, the digital asset has been associated with the potential for tremendous upside—but also deep drawdowns. This volatility is evident in recent data, where since the beginning of 2015 the average rolling 12-month historical volatility of Bitcoin has been approximately 71% with a maximum drawdown of 83%.
However, with these risks come potential benefits. As shown below, Bitcoin has exhibited low correlation to traditional assets such as large cap equities, and despite significant drawdowns has delivered an annualized return of over 100% since 2015.
Bitcoin v Russell 1000
Nonetheless, when thinking about a Bitcoin allocation in the context of a broader portfolio, it’s important to consider how to manage the digital asset’s inherent risks. And while there are many sophisticated techniques to help control volatility, here we examine three simple approaches to mitigating Bitcoin risks:
1: Bitcoin + Cash
The first approach is as simple as combining Bitcoin with a low volatility asset such as cash. When rebalanced daily, a 50% equal weighting of Bitcoin and cash cuts volatility in nearly half over the 2015-2020 period—from 71% to 36%. This in turn helped reduce the maximum drawdown from 80% to 55%.
It’s also possible to adjust the weight of the cash component to achieve a target level of volatility. If we apply the FTSE Target Volatility methodology to target a 25% volatility, the portfolio on average allocates around 45% to Bitcoin and 55% to cash. As shown, this approach reduced both portfolio volatility and return.
2: Bitcoin + Large Cap Equities
While combining Bitcoin with cash can effectively mitigate risk, it can also dampen performance and essentially represents an all or nothing exposure to the digital asset. An alternative approach is to seek risk reduction through greater diversification—by choosing assets with low correlation to Bitcoin, such as large cap equities.
For example, an allocation of 2.5% in Bitcoin in the Russell 1000 portfolio, rebalanced quarterly resulted in volatility and maximum drawdowns comparable to those of the Russell 1000 Index—but with an excess annualized return of 3.2% since 2015. And increasing the Bitcoin allocation to 5% enhanced the performance further giving an excess return of 6.4%, with volatility and drawdowns remaining virtually identical to those of the Russell 1000 Index.
3: A combined approach
The final approach combines these two ideas. In this example, we allocate 5% of the portfolio to the 25% target volatility Bitcoin strategy to create the hypothetical Russell 1000 Bitcoin Boost 25%/5% Index. As shown, the result was a performance comparable to the 2.5% allocation, but one which came with the controlled risk of the Bitcoin allocation.
All three of these approaches demonstrate that mitigating some of Bitcoin’s perceived risks doesn’t necessarily require complex portfolio construction techniques. In the context of a broader portfolio, digital assets’ historically low correlation to traditional asset classes can potentially make them a powerful diversification tool. And in these examples, a risk-controlled Bitcoin portfolio was integrated into an asset allocation as a natural extension of the portfolio construction process.
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