With the recent approval of spot Bitcoin ETFs by the SEC, money is rapidly flowing into these new products. Wealth advisors are being asked to consider if these should be added to traditional investment portfolios. Long before the approval, mainstream asset management firms have been 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.

With professional advisors looking for guidance on this new topic, it may be helpful to use a data-driven approach to develop a framework for considering the potential diversification benefits of Bitcoin ETFs in a traditional investment portfolio.

In order to create a framework to consider this issue, an optimization engine can be used to show one way to analyze a traditional investment portfolio with the addition of cryptocurrency. This approach could then be used to answer questions that a wealth advisor may have:

Advisor: “Based on historical performance, is there an optimal allocation of Bitcoin and the Moderate ETF?” 

Put another way, 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)

The engine finds that a portfolio of 47% Moderate ETF and 53% Bitcoin, had the highest 10-year Sharpe Ratio of 1.05.

Advisor: “Hmmm. This is a highly risky portfolio, with an annual 10-year volatility of 40.8%, more than double the amount of risk in the S&P 500 index, which had a 10-year volatility of 15.2%. How can we use Bitcoin in a lower risk portfolio?”

Well, 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, what happens if we ask the engine to create the portfolio with the highest Sharpe Ratio, but no more risk than the S&P 500, and allow the engine to include a cash position.

The engine showed that a portfolio of 64% cash, 17% moderate ETF, and 19% Bitcoin, had the same 1.05 Sharpe Ratio, but the same risk as the S&P 500, with a 10-year volatility of 15.2%. 

Advisor: “Now the problem with this portfolio, is that most of the historical returns come from Bitcoin. Choosing to invest in this portfolio would represent a choice to rely on Bitcoin for the bulk of the investor's future returns. What if, instead, the portfolio is restricted to just the moderate ETF and Bitcoin (with no cash position), then what portfolio gives the highest Sharpe ratio with no more risk than the S&P 500?”

The engine showed that a portfolio of 15% Bitcoin and 85% of the moderate allocation ETF, produced a Sharp Ratio of 1.01, 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 -27.1% vs. -50.9% for the S&P 500. 

This is not to suggest that any of these portfolios are better than any others – this should be left to the research and views of professional advisors, but this analysis indicates how much cryptocurrency risk could potentially be added within a reasonable portfolio allocation decision.

The table below shows the four portfolios described above.

Methodology: One of the largest "Moderate Allocation" ETFs was used as a proxy for a well-diversified traditional portfolio, and a large S&P500 index ETF was used as a proxy for U.S. Equities. For the spot Bitcoin ETFs, Bitcoin daily prices were used, as the new ETFs have insufficient history to be used directly.

Phil Taylor, CFA is the President and Chief Analytics Officer at FinMason, Inc. and past Chair of the Board of CFA Society New York.