Bitcoin… you either love it or hate it. You hate it because it keeps going higher. And you don’t know why. You love it also because it keeps going higher. And you either think you know why or you don’t really give a damn why.
It Is A Crazy World Today
Bitcoin took the world by storm in 2017 with its astounding 20-fold surge from around $900 to near $20,000. If you invested $100,000 during this period, you could have walked away with $2 million in your pocket. All that in just a year. Mighty impressive. But it shook the world again when it plunged more than 80% from that high in less than a year. It was largely a retail game then. Some thought that was the end of it. But in 2020, it roared back with institutional interest. And at the point of writing, it already broke past $50,000.
Crazy? Well, we are in crazy times. Bitcoin is not the only monster. There is Tesla (TSLA) which defied all odds rising to trade at a mind-blowing PE ratio of more than 1600 at one point. Then more recently, there is GameStop Corp (GME). A story of common folks banding up to take on the institutional Goliaths. They won. Their efforts sent the stock flying from 17 bucks at the start of the year to well over $400 in less than a month. Many attributes that to the power of social media, technology, cheap access to the financial markets, and an increasing wealth divide fueling resentment against the rich and powerful.
You can’t blame such behaviors. When US Fed bailed out the rich time and again with their money printing, they prevented wealth from redistributing. With that much money in the system today, it is not hard to see where the bulk of it went. It is definitely not to the average man to put food on the table. Much ends up in the markets. And if you want a share of that, you got to be in it.
Can We Fit Bitcoin Somewhere?
Alright, I digressed. Let’s go back to bitcoin. In particular, I want to address this question. Can we fit bitcoin somewhere? Possibly, but don’t put every single dime and bet big on it. I know you saw news of people becoming millionaires after betting big on bitcoin. Success stories are everywhere. But, I believe the casualties are no less. They just aren’t publicized. This is how the media always works. So if you want to invest in bitcoin through a more conservative approach, we can try fitting it in the context of a larger portfolio comprising other assets.
Now before I proceed, let me put in some disclaimers. First, I am not an expert in bitcoin or any other cryptos. And neither am I personally invested. I am a quantitative investing practitioner. So for me, this is purely an analytical exercise to see how bitcoin affects the performance of a traditional portfolio.
Risk Parity Portfolio With BitCoin
To fit bitcoin among traditional assets, we need to tackle one key question: How much should we allocate to bitcoin? A simple solution is to adopt a balanced approach such as risk parity. In a nutshell, risk parity allocates capital to each asset such that each of them holds an equal amount of risk. So no single asset dominates. It makes your portfolio more robust and less susceptible to black swan events from a single asset. To understand more, you can read about it in my previous posts:
If you are interested, I also teach a series of investing courses. And one of those focuses on Risk Parity. It is called All-Weather Investing Via Quantitative Modelling In Excel. It covers everything from its concepts to model development and deployment.
1 — The SPY/IEF/BTC Risk Parity Portfolio
Let’s use a typical portfolio construct using stocks and bonds. For stocks, we use SPY (S&P 500 ETF). And for bonds, we use IEF (US 5–10Yr Treasury). Of course, then there is BTC (bitcoin). We then build a risk parity portfolio with these 3 assets and compare it against one built using only SPY and IEF. The portfolios are rebalanced at the end of every month to bring their risk levels back in line. No leverage is used. For your information, I used a transaction cost of 1.52% for BTC trades in the model (referencing the bid-ask spreads and trading fee in Coinbase). The backtest starts in Oct 2014 as that is the earliest date for BTC data I can lay my hands on. It ends on 16 Feb 2021.
I must say the results looked really promising. Well, I do expect the returns to be better. Bitcoin has a spectacular run. So when you add it to any portfolio, this is pretty much a given. What is however worth mentioning is it almost doubles the CAGR from 5.6% to 10.1% with only a minimal increase in risk. That results in a markedly higher Sharpe Ratio of 1.85. And despite Bitcoin being dramatically more volatile and having an immensely turbulent period in 2018, the maximum drawdown experienced is only -4.4%. All these are achieved with an allocation ranging from 1% to 14% to bitcoins each month with the average allocation hovering around a modest 5%.
2 — The SPY/TLT/BTC Risk Parity Portfolio
Let’s try using TLT which is a longer duration, and more aggressive Treasury bond ETF, instead of IEF. Other than that, everything else stays the same i.e. 1.52% transaction costs for BTC, no leverage, etc.
Again, the results are pretty impressive. The CAGR increases to 16.2% beating even SPY’s 13.5% which is high by historical standards. Volatility remains low at 10% with a drawdown around half that of SPY. If we look at the Sharpe, the risk parity portfolio with bitcoin outdoes all the rest once again. The higher return and volatility are the result of using a more volatile bond ETF and an increased allocation to BTC. The monthly allocations to BTC ranged from 3% to 16% with an average of around 8%. While this is higher than our previous portfolio, it wasn’t drastically different.
3 — The SPY/TLT/GLD/BTC Risk Parity Portfolio
Now, let’s fit in both the Real Gold and our “Digital Gold” (BTC) to construct the risk parity portfolio this time.
The results also improved by a good amount. This is both in terms of absolute returns and risk-adjusted returns. CAGR rose to 14.1% which is higher than both SPY as well as the risk parity portfolio without BTC. Both volatility and drawdown are also still much lower compared to SPY. The monthly allocations to BTC range from 1% to 17% with an average of around 6%.
Ending Note — Bear These In Mind
The backtests showed that adding bitcoin did improve the performance of the portfolios. These are encouraging outcomes. But there are still a couple of things to take note of here.
1. The history is short
While bitcoin started way earlier, the backtests began only in 2014 when the data becomes available on Yahoo Finance. In any case, earlier data may not be of as much relevance today. So all in, we have about 6+ years of data. That is a relatively short period. Aside from the volatility fallout in 2018 and the Covid-19 pandemic in 2020, the market has not yet undergone any serious downturns since 2008. These are periods that will put the portfolio through a real stress test. So how bitcoin will behave when a catastrophe of that magnitude hits is anybody’s guess.
2. Bitcoin and stocks both head south together
The correlation between bitcoin and the rest of the assets during this 6 year period is on the low side. That is great. In fact, bitcoin has been touted as a good diversifier for stocks. But this is just a macro picture. We need to dive deeper by narrowing in on the relevant periods. What would be ideal is for bitcoin to move up during a stock crisis or at the very least stay flat. While we don’t have anything of the same magnitude as the great financial crisis in 2008, there are short episodes here and there that might provide us some clues of how bitcoin might perform.
Let’s look specifically at how the different assets perform during months or periods where SPY pullbacks or drop more than 2%.
From the chart, Bitcoin’s behavior seems to run counter to what people expect. Because the results suggest that SPY and Bitcoin go down together more often than not in critical times. This includes periods such as Volmageddon from Feb 2018 to Mar 2018), the big stock market selloff in the last quarter of 2018, and the recent pandemic crisis from Feb 2020 to Mar 2020. So I wouldn’t depend on bitcoin to save my ass if the stock market enters a serious correction or bear market. To weather different conditions, you will still need other assets in your portfolio.
3. Where is Bitcoin headed?
I don’t think there is a good answer to this question. Ardent supporters think bitcoin is the future of currency and the next digital gold with the sky being the limit. Those who dislike bitcoin think they are fundamentally worth next to nothing. So the range is anywhere from zero to infinity. Not very helpful indeed. But for some people, the value of anything is based on what people are willing to transact it for. And if there are enough people willing to cough up $50,000 for a bitcoin then that is what it is worth right now. That is what mark to market is about.
Personally, I don’t think bitcoin will become something that entirely replaces fiat currency. If it does, its value won’t be wildly swinging around like what it did and it would lose its appeal. It would also be inconceivable for central banks to sit around and let it come to the extent that it replaces the dollar without any intervention. Because the central bankers would then have to pack their bags and go home. One of their core jobs is to monitor and control the money supply. And when that happens, they can’t do either.
Bitcoin has grown significantly enough to warrant a place as a key asset in the market. But it is still small when it comes to mainstream usage. And of course, its acceptance hinges on the fact that it can be readily converted into the dollar. So the chances of an outright ban on it are slim as many market participants are involved now. And it may be some time away before we see it being put to any test. As to how the scenario will play out when that happens, I have no idea.
See you in my next post.
Originally published at https://investmentcache.com on February 19, 2021.