Crypto Assets and Financial Portfolios: Volatility, Drawdowns, Strategic Allocations
Crypto assets are becoming increasingly interesting as an asset class. Bitcoin and Ethereum are a useful addition to most portfolios. However, potential investors face a number of challenges that need to be addressed before investing.
Authors: Maximilian Bruckner, Felix Fernandez, Prof. Dr. Philipp Sandner
Crypto assets are highly volatile and comparisons with traditional asset classes are challenging
When comparing price movements of Bitcoin and the MSCI World or a similar stock index, we immediately notice a strong visual difference, see Figure 1. Bitcoin dominates the chart, while fluctuations in stock and gold prices are barely noticeable next to the high volatility of Bitcoin. There are various reasons for this volatility, which can be discussed at length. For now, our focus is on how to deal with this property.
The data confirms our initial observation: In the analyzed period (see Figure 1), Bitcoin shows an annualized volatility of 87%. Gold and stocks are at 15% and 16%, respectively. However, Bitcoin’s annualized return is also in a different order of magnitude, at just under 107%. The challenge for investors is to somehow place Bitcoin in the same “dimension” as stocks and gold, to be able to make a meaningful comparison. We can achieve this through “downscaling” or “deleveraging”.
Many investors should already be familiar with leverage. Typical leverage products are derivatives that amplify price fluctuations of the underlying products. Example: If the DAX moves by 1%, the value of a 5 x leverage product on the DAX changes by 5%. Yet, many often overlook the fact that the opposite of leverage can also be created. Through strategic allocation/hedging, we can scale down price fluctuations. For example, to deleverage Bitcoin to 10%, all we need to do is invest only one tenth in Bitcoin and hold the rest as a “cash hedge”. For example, if we have €1000 available, this means we would invest €100 in Bitcoin and hold €900 in cash. Figure 2 shows the effect of a deleveraging of Bitcoin down to 10%.
Scaling Bitcoin down to 10% as described above (and simply holding the remaining 90% in cash) statistically “moves” the new asset class into the same dimension as more familiar asset classes like stocks, bonds, and gold. Scaled down, Bitcoin still shows better returns than other asset classes, even with a now comparable volatility. Accordingly, the Sharpe ratio, i.e., the risk-adjusted return, is also better: 10% Bitcoin has a Sharpe ratio of 1.25, while stocks are at 0.65.
A strategic allocation with regular rebalancing helps manage drawdowns
Drawdowns correlate quite strongly with high volatility. This is also true for crypto assets: drawdowns of over 80% have been observed in the past. Such losses are usually difficult to integrate into a portfolio. At first glance, this makes crypto assets unattractive for many investors.
Diversification across different crypto assets typically provides no relief here. Although a diversified basket of crypto assets does show a better Sharpe ratio than Bitcoin, the systemic risk cannot be reduced this way and high drawdowns remain. This is due to a high correlation within the universe, i.e., between the different crypto assets. Better results and a more effective drawdown reduction can be achieved with strategic allocations and regular rebalancing.
Figure 3 shows the effect such an allocation can have on a reference portfolio. The reference portfolio we use consists of 70% equities and 30% bonds, while the portfolio with crypto exposure invests 4% of the portfolio in crypto assets and regularly rebalances this allocation. Especially the lower third of the figure, the drawdowns, are relevant for our analysis.
Both portfolios — one consisting of stocks and bonds; the second with small crypto exposure — show a very similar risk profile. In fact, the difference in drawdowns between the reference and crypto portfolio is quite small: 25.5% and 26.3%, respectively. Furthermore, the crypto portfolio scores with a higher return and correspondingly better Sharpe ratio.
It is important to note that this positive effect only holds for small to moderate crypto exposure in the portfolio. If one exceeds the 10% mark, the characteristics of crypto assets start to dominate the rest of the portfolio. Therefore, it is better to keep small exposure and adjust it regularly (monthly). Otherwise, with bull and bear markets, which are very pronounced in crypto assets, the actual allocation changes — this should be avoided to keep the risk profile of the portfolio as constant as possible
Active management can create significant value
A wide range of actively managed crypto funds that employ various strategies are available to professional investors. These crypto funds can be broadly divided into two groups: directional beta funds and market-neutral funds. Directional beta funds usually seek to either provide a higher return relative to the benchmark (i.e. Bitcoin) or offer lower risk through long/short strategies, quantitative strategies, or multi-strategy approaches. Market-neutral funds generate returns largely independent of market movements, for example through arbitrage or market-making. Individual funds can be beneficial in the portfolio depending on the investor profile, but there is significantly more potential in combinations of both types of funds and appropriate diversification across different manager styles. This tactic offers an alternative to the previously mentioned lack of diversification effects in pure crypto investments and opens up a broader solution space for portfolio construction (see Figure 4).
In Figure 4, the beta fund universe is shown in the upper right corner — the first group of crypto funds. While these managers can achieve impressive returns, this comes with very high risks. At the bottom left, in stark contrast, are the market-neutral funds with a more positive risk-return profile. However, these funds generate significantly lower returns than a pure long position in Bitcoin.
If we combine a selection of beta funds and market-neutral funds, the solution space between the two poles opens up. Although one loses some return compared to the beta funds, the risks (and drawdowns) are reduced many times over.
With the use of deleveraging and the selection of manager styles, investors have good tools at hand to effectively manage risks of crypto investments.
In most cases, a moderate admixture of crypto assets generates significant added value in the form of higher risk-adjusted returns for almost any investor portfolio. In addition, the absolute risks remain in an entirely non-critical range with moderate admixtures. A vital prerequisite for this is careful modeling and, above all, periodic tracking (i.e. rebalancing) of the strategic allocations.
About 21e6 Capital
Maximilian Bruckner is Head of Marketing & Sales bei 21e6 Capital AG. Previsouly, he was engaged as Executive Director of the International Token Standardization Association (ITSA) and was instrumental in creating the world’s largest token database for classification and identification data on tokens. In addition, Maximilian has conducted research at the Frankfurt School Blockchain Center.
Felix Fernandez is on the Board of Directors of 21e6 Capital AG and continuous his role as co-founder of OpenMetrics Solutions in Zurich. He has more than 20 years of experience in the financial industry and previously held leading positions at Deutsche Börse.
Prof. Dr. Philipp Sandner has founded the Frankfurt School Blockchain Center. From 2018 to 2021, he was ranked among the “top 30” economists by the FAZ. He is also on the Board of Directors of FiveT Fintech Fund, 21e6 Capital and Blockchain Founders Group.