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Cryptocurrency Allocations and Risk: How Much is Enough?

How much cryptocurrency "could" be added to a traditional investment portfolio?

With cryptocurrencies here to stay, more mainstream asset management firms are adding or considering adding them to their investment platforms. To date though, little consideration has been given to how well these assets fit into a traditional investment portfolio in terms of risk, diversification, and potential returns. In order to create a framework to consider this issue, we used FinMason's cloud-based calculation engine to show one way that analytics can be used to analyze a traditional investment portfolio with the addition of Cryptocurrency.

Methodology:

We used one of the largest "Moderate Allocation" ETFs as a proxy for a well-diversified traditional portfolio, and since it dominates the market capitalization of cryptocurrencies, we used Bitcoin as a proxy for cryptocurrencies, and we used a large S&P500 index ETF as a proxy for U.S. Equities.

We then asked FinMason's optimization engine to ask the following questions:

Q1: Based on historical performance, is there an optimal allocation of Bitcoin and the Moderate ETF? i.e. what portfolio of Bitcoin and the Moderate ETF gives the largest historical Sharpe Ratio. (Sharpe Ratio is a standard measure of returns relative to the risk in the portfolio)

A: A portfolio of 59% Moderate ETF and 41% Bitcoin, had the highest 10 year Sharpe Ratio of 1.06, but this is a highly risky portfolio, with an annual 10-year volatility of 32.0%, over double the amount of risk as the S&P 500 index, which had a 10-year volatility of 14.9%.

Q2. According to the definition of Sharpe Ratio, you should be able to reduce the portfolio risk by moving some of the portfolio to cash, while keeping the Sharpe Ratio the same, so we asked the engine to create the portfolio with the highest Sharpe Ratio, but no more risk than the S&P 500, and we allowed the engine to include a cash position.

A: The engine showed that a portfolio of 54% cash, 27% moderate ETF, and 19% bitcoin, had the same 1.06 Sharpe Ratio, but the same risk as the S&P 500, with a 10-year volatility of 14.9%.

Q3: The problem with this portfolio, is that most of the returns come from the Bitcoin, so choosing to invest in this portfolio would represent a choice to rely on Bitcoin for most of the investor's future returns, so the final question we asked was, if the portfolio is restricted to just the moderate ETF and Bitcoin, what portfolio gives the highest Sharpe ratio with no more risk than the S&P 500.

A: The engine showed that a portfolio of 15% Bitcoin and 85% of the moderate allocation ETF, produced a Sharp Ratio of 1.02%, with the same risk as the S&P 500. Not only does it have the same risk as the S&P 500, but it had a far smaller "drawdown" (i.e. the return from the highest point on the return chart – the "peak", to the subsequent lowest point – the "trough") of -27.3% vs -50.9% for the S&P 500. We are not suggesting that any of these portfolios are better than any others, but this analysis indicates how much cryptocurrency risk could be added within a reasonable portfolio allocation decision. The table on page 3 shows the four portfolios described above. In addition to traditional measures of risk such as volatility and drawdown, we also show the FinScore™ of each portfolio.

FinScore™ is FinMason's proprietary 1-100 risk score. It is an easy way for wealth managers and their clients to understand how risky a portfolio is. It is measured by the portfolio's sensitivity to FinMason's global 16-factor macro model. It has the benefits of representing long-term risk and is very stable over time and through changing market conditions. It is also easy for wealth managers to understand, because it is benchmarked to the five standard risk-target categories:



About FinMason

FinMason was founded by experienced industry insiders and leading technologists who have managed institutional portfolios, built and managed performance, risk, and analytics systems for large institutions, and built and sold large technology companies. FinMason solves the two largest hurdles in investment analysis – wrangling market data and calculating analytics at scale. Via FinMason’s cloud-native API the company provides a lightning-fast, customizable, calculation engine to accelerate any wealth technology build out. For more information about FinMason, visit www.finmason.com or email [email protected].