Global crypto markets are facing their moment of truth these days as the broad-based slump in digital assets has intensified yet again in recent weeks. At its peak in mid-November last year, the asset class carried a total market value of nearly $3 trillion, accounting for more than 1% of global financial assets, and has since given back more than two thirds of it (as of mid-June 2022). Should investors therefore bury digital assets and remember them as a mere outgrowth of the liquidity-driven bull market? Yves Bonzon does not think so, on the contrary. The group chief investment officer at Julius Baer says, “Even though the initial days of euphoria are over, investors should not expect digital assets to fade into obscurity. Granted, as the crypto market is facing its ‘Dotcom moment,’ the narrative that digital assets will replace fiat currencies seems to have been debunked for good.”
However, digital assets will undoubtedly continue to influence our lives, probably to a far greater extent than we can imagine today. Bonzon states, “Apart from the potential to profoundly transform the legacy financial system, the proliferation of asset-encryption technologies and smart contracts also paves the way for tremendous improvement in business productivity and profitability.” The adoption of digital assets could essentially mirror the adoption of the internet in the early 2000s. In this context, the current consolidation phase triggered by deteriorating liquidity conditions is likely to have a cleansing effect—“the wheat is being separated from the chaff”—and ultimately, big winners will emerge in the space for the years to come.
What does it imply for portfolio construction? “First and foremost, digital assets offer a new asset class that expands the risk and return spectrum beyond that defined by ‘traditional’ alternatives,” Bonzon explains, “opening up the potential for an optimized risk-return relationship in portfolios. As digital assets are about to enter a phase of maturation, investors should start getting serious about them.”
As we are confronted with an asset class that is slowly coming out of its infancy, Bonzon insists that predicting how digital assets will impact portfolios is no easy task—the return and volatility history is just too short to shape a well-informed guess using traditional modelling tools. “That said, having a nominal allocation to digital assets in a multi-asset portfolio, such as a basket of leading coins, may improve risk-adjusted performance.”
A backward-looking analysis published in the January 2022 Julius Baer Research Focus Digital Assets: Balancing Risks and Returns in a Portfolio reveals that adding a 1% allocation to Bitcoin compared to a reference portfolio consisting only of equally weighted allocations to U.S. equities and U.S. Treasuries would have improved risk-adjusted performance. (The investing period starts at the beginning of 2012 and rebalancing occurs on a quarterly basis.) While the Bitcoin portfolio yields an annualized return of 10.5%—versus 8.0% for the reference portfolio—annualized volatility would only have increased to 7.7% vs. 6.3%.
"Although we obeserve an increasing usage of cryptocurrencies in the principalty of Monaco, as in many other countries, and the local regulation is being developed in this area, it is impossible to tell how big digital assets will eventually become. We do see the asset class growing over time as the market becomes more appreciative of the potentially disruptive power of blockchain technology, particulary in the area of decentralized finance. However, wed do not expect crypto coins to grow so much that they become currencies which are regularly used by private individuals."
Albert Henriques, CEO at Bank Julius Baer Monaco.
Albert Henriques, CEO at Bank Julius Baer Monaco, and Ekatherina Nossova-Croesi, Managing Director Senior Advisor at Bank Julius Baer Monaco.
“Interestingly, while small allocations to Bitcoin enhanced the return earned per unit of risk, higher allocations to Bitcoin lead to an inferior risk- adjusted performance given a disproportionate increase in incremental portfolio volatility relative to incremental portfolio return,” Bonzon reveals. “To be clear, extrapolation from the past using a relatively short time series of historical data of course has its flaws. Nevertheless, the exercise allows to identify key aspects worth bearing in mind. Above all, an investor eager to try his hand at digital assets should be able to live with the increased volatility, which is unlikely to subside in the near term. Once an investor has decided on an allocation, perhaps the most important question relates to position sizing.”
A 2021 study Cryptoassets: The Guide to Bitcoin, Blockchain, and Cryptocurrency for Investment Professionals by the CFA Institute Research Foundation suggested an allocation of 4% as an upper limit, as each additional 1% in Bitcoin proportionately increases maximum drawdown values by about 1%. Further among key decision points is the rebalancing frequency. “In unbalanced portfolios, Bitcoin would have quickly reached a dominant portfolio weight, which would have significantly harmed risk- adjusted returns, especially in recent years. This comes as no surprise, given that Bitcoin went through a significant boom-and-bust period after its initial peak in 2018. As with all volatile financial assets, investors are therefore advised to adopt a disciplined rebalancing strategy.”
To assess the merits of digital assets in a portfolio context, Bonzon believes it is critical to understand their diversification capabilities. Over the past five years, digital assets have exhibited an average correlation of about 0.2 to global equities, indicating only moderate co-movement between the two asset classes. At the margin, correlation occasionally rose as high as 0.6, typically in a risk-off market environment. Bonzon puts it differently. “Digital assets only marginally contributed to smooth portfolio returns in times of market turmoil. Observed correlation behavior relative to long duration assets—that is risk assets—as well as digital assets’ dependency on liquidity conditions limits their diversification benefits. In the long run, however, correlations could be expected to decline as digital assets mature, differentiate themselves in terms of their value proposition, and attract different kinds of investors, enhancing their role as portfolio diversifiers.”
In a nutshell, Bonzon says he can appreciate the optionality offered by a small allocation to digital assets in a portfolio context. By giving up a few percentage points of allocation, investors get exposure to potentially disruptive scenarios brought about by the blockchain technology and decentralized finance. “Prior to an investment, however, investors are strongly advised to adequately educate themselves due to the inherent risks associated with digital assets.”