Crypto winter 2.0?

The bears are in the ascendant this year. Stocks and bonds aren’t the only asset categories currently in a bear market. Cryptocurrencies also have lost a massive amount of value over the last 12 months. Institutional investors, however, are not turning their backs on Bitcoin and the like, but are instead increasingly viewing “cryptos” as a distinct asset class of their own. The slump on the financial markets (including a second crypto winter) gives crypto optimists an opportunity to rethink their investment strategy and broaden their portfolios’ diversification.

No place to hide

The wrenching turnaround in monetary policy by central banks, coupled with mounting downside risks to economic activity and ongoing geopolitical tensions, has taken a heavy toll on financial markets since the start of this year. Stocks and bonds have simultaneously lost a massive amount of value. A 60/40 portfolio (60% stocks, 40% bonds) is currently down more than 20% year-to-date. The commodities complex is the only relevant liquid asset class that is up for 2022 thus far, but commodities are unlikely to make up a position worth speaking of in the asset portfolios of most investors. So, in this sense, Bitcoin, which has plummeted by almost 60% year-to-date, is in good company. While the synchronous selloff on equity and fixed-income markets marks uncharted territory for “classical” investors and is thus especially painful for them, crypto enthusiasts are already accustomed to digital currencies’ wild volatility. In contrast to traditional asset classes, Bitcoin’s actual volatility has not increased this year. As for the length of the crypto correction, though, the current episode, as measured by Bitcoin’s price performance, is the longest one in the young history of cryptocurrencies. Its duration by now has already exceeded the length of the “crypto winter” of 2017/2018.

Losses across a broad front | Bitcoin is no exception

Year-to-date performance

Sources: Bloomberg, Kaiser Partner Privatbank

Down in the abyss | Just an ordinary drawdown?

Bear markets in Bitcoin

Sources: Bloomberg, Kaiser Partner Privatbank

Constantly high volatility | But the volatility differential versus stocks and bonds is narrowing

Annualized volatility (6-month rolling average)

Sources: Bloomberg, Kaiser Partner Privatbank

Beloved, loathed and (in)dispensable

But those declared dead live longer… A lot has happened in the crypto world since we published our blog post titled “Bitcoin – beloved, loathed and (in)dispensable(?)”, in which we examined the benefits and drawbacks of digital currencies. For example, Ethereum, the second-largest cryptocurrency by market cap, successfully completed “the Merge” in September, shifting from a proof-of-work to a proof-of-stake architecture. The Ethereum blockchain should now become not just faster and more secure, but most notably also more sustainable. The Ethereum Foundation calculates that the update will reduce the blockchain’s energy consumption by 99.95%. That may take some wind out of the sails of crypto critics from a sustainability standpoint at least, particularly if Ethereum’s example catches on and prompts even the Bitcoin community to undertake efforts to switch to a more environmentally friendly tack. Meanwhile, the institutionalization of cryptocurrencies continues apace in spite of the deep bear market as they further entrench themselves as a distinct asset class of their own. The flood of news about cryptocurrencies thus hasn’t let up lately: the Nasdaq exchange in the USA plans to set up its own crypto unit, asset management colossus BlackRock intends to launch a Bitcoin trust, and Fidelity announced that it will soon be bringing access to Bitcoin trading to its 34 million brokerage clients. Wall Street banks like Citibank and Morgan Stanley are also (aggressively) rolling out a variety of projects in the crypto and blockchain space. So, against this backdrop, there really is no burst cryptocurrency bubble to speak of at the moment. It’s more like a “crypto winter 2.0” that will flush weak crypto projects out of the market, but will also lay fertile ground for further innovations and new applications, technological advancements, and new business models – all thanks in large part to continued vibrant investor interest and an unrelenting flow of risk capital.

Buy the dip? | A buying opportunity for optimists

Bull and bear markets in Bitcoin

Sources: Bloomberg, Kaiser Partner Privatbank

A good entry point, but enter crypto in a diversified way

So, it would be inappropriate to sound the death knell for digital coins. Early members of the ardent cryptocurrency fan base (who may still be sitting on sizable price gains) are unlikely to be particularly perturbed by the poor performance this year anyway. Nevertheless, such crypto optimists should use the current broad market correction and the resulting cheaper valuations and increased return expectations in nearly every asset class as an occasion to carefully review their portfolios and to reduce or entirely eliminate any clustered risks there that may exist. In recent years, blending a 5% or 10% allocation to cryptocurrencies into a 60/40 portfolio would already have been enough to substantially enhance its performance. According to our model calculations, such an “enrichment” with crypto exposure is likely to notably improve the risk/return profile of a portfolio also in the future.

An (objective) retrospection | Bitcoin as a performance booster

60/40 portfolio with (and without) Bitcoin

Sources: Bloomberg, Kaiser Partner Privatbank

In our model calculations, we derive our five-year return expectation of 25% p.a. for Bitcoin (which seems optimistic at first blush) from the adoption trajectory of previous pathbreaking, disruptive technologies like the internet or mobile phones. Although this expected return is still very high compared to that for other asset classes, it is significantly lower than the historical return since 2014. Our estimate of expected volatility is also conservative; despite the substantially lower performance expectation, we estimate expected volatility to be “only” around one-third lower than actual past volatility (68%). This puts the future expected Sharpe ratio at 0.58, which is much lower (and less attractive) than the Sharpe ratio for the period since 2014 (0.84), presenting another good reason for investors with current elevated exposure to cryptocurrencies to strive to better diversify their portfolios.

An increasing performance correlation between Bitcoin and stocks… | …makes broader diversification all the more imperative

Correlation between Bitcoin and S&P 500 index

 Sources: Bloomberg, Kaiser Partner Privatbank

An optimal portfolio with Bitcoin

But to obtain a model optimal portfolio, our way of constructing it goes well beyond blending Bitcoin into a “simple” 60/40 portfolio because the performance correlation between Bitcoin and the equity market has further increased in recent months and may stay elevated, and because there are various complementary asset classes with similarly attractive risk/return profiles and comparatively low performance correlations. We accordingly enlarge the field of asset classes to include corporate bonds (investment-grade and high-yield), emerging-market bonds, microfinance bonds and insurance-linked bonds (cat bonds), as well as convertible bonds and market-neutral strategies. A portfolio optimized by including these ingredients (let’s call it an “optimal balanced” portfolio) gives grounds to anticipate an excess return (alpha) of 1.9 percentage points (with a 5% allocation to Bitcoin blended in) or 2.7 percentage points (with 10% Bitcoin) over the expected return on a 60/40 portfolio (5.9% p.a.) over the next five years at the same level of risk. With an expected Sharpe ratio of 0.81, the optimized portfolio with a 10% allocation to Bitcoin blended in is particularly likely to still be attractive to longstanding crypto investors (who are used to being pampered with high Sharpe ratios). At the same time, its much lower volatility (expectation: 10.6%) should allow them to sleep easier at night.

An (optimistic) outlook | More efficient portfolios with crypto

Risk/return profiles of different portfolios

Sources: Bloomberg, Kaiser Partner Privatbank

Practical implementation – more than just Bitcoin

However, when implementing our model portfolio in actual real-world practice, exposure to cryptocurrencies should be built up with more than just the help of Bitcoin because broader diversification has added value also in the crypto space. Only time will tell whether Bitcoin will retain its status as the leading digital currency by market cap or will lose relevance to competitors named Ethereum, Solana, Polkadot and others due to sustainability concerns and their more future-proof technologies. That’s why it makes sense to invest the 10% allocation earmarked for crypto assets in a broadly diversified basket of the most promising crypto projects. But diversification doesn’t have to end there. Whoever believes in the future of the crypto sector has a wide array of other investment possibilities (and risk profiles) to choose from by now besides simply participating in the price performance of individual cryptocurrencies. The spectrum stretches from income-generating yield strategies to factor and hedge-fund strategies and all the way to venture capital investments. Crypto optimists who additionally would like to help themselves to these asset buckets can build out the crypto share of their portfolios to even more than 10% with a clear conscience.