UK based stock market indices peddler, FTSE Russell – 2 months ago – published a research paper in which the firm analysed portfolio diversification strategies that institutional investors could consider. The strategies are targeted at helping investors who – as of yet – abstain from adding Bitcoin to their portfolios, due to their aversion to the downside risk associated with the digital asset’s volatility.
With cryptocurrency investment becoming more, and more accessible, more classic financial institutions have, in recent months – perhaps due to the current trend of global economic uncertainty – begun to add digital currencies to their portfolios. FTSE Russell cautions investors to take digital asset volatility risk mitigation into account when dabbling with crypto, and suggests three simple portfolio construction methods.
Nature of The Beast
Anyone who knows anything about Bitcoin should be aware of the asset’s volatility. Bitcoin’s volatility results in wild price swings that offer a lot of upside opportunity, however it is also responsible for some potentially painful downswings as well. Since 2015, Russell’s data reveals, Bitcoin’s average rolling 12 month volatility has averaged about 71% with drawdowns that are as deep as 83%.
In spite of the risks the assets present, the profit potential is also quite significant. With Bitcoin showing low correlation to traditional – large market capitalization – assets, and has been responsible for gains upwards of 100% since 2015.
When adding Bitcoin to a broader portfolio, one should think about managing the benchmark crypto asset’s downside risk. While there are a lot of sophisticated volatility mitigation mechanisms one could employ, FTSE offers three simple, easy-to-apply, asset mixing approaches to the question.
Bitcoin & Cash
The first approach entails mitigating Bitcoin’s volatility risk by simply mixing cash into the portfolio. Since cash is a relatively low volatility asset, an equally weighted Bitcoin/Cash portfolio reduces volatility from 71%, to 36%, about half. With the most that drawdown the rudimentary portfolio could muster, falling from 83% to 55% – so volatility was cut, roughly, in half.
FTSE Russell says one can target a lower level of volatility by adjusting the Bitcoin/Cash allocation ratios. To achieve volatility levels of about 25%, one would have to weight the portfolio 45% to Bitcoin, and allocate the 55% remainder to fiat currency.
Bitcoin & Stocks
Sure, a Cash/Bitcoin portfolio can lower some of the risk of loss – acknowledges FTSE Russell, however this strategy really hurts index performance and is pretty much an all-in approach to digital asset investing. The LSEG Group subsidiary recommends diversifying into high market capitalization equities.
They go on to offer the example of a 2.5% Bitcoin weighting against their in-house equities index, the Russell 1000, rebalanced on a quarterly basis. This led to volatility levels that were similar to the Russell 1000 portfolio’s performance – on it’s own. The returns however, were negligible, by digital asset standards – 3.2% in a sample period spanning from 2015, to 2021. A 5% Bitcoin weighting against the same index, for the same sample period, yielded 6.4% returns…great!
A Mixed Strategy
FTSE had a go at combined portfolio strategy, mixing Bitcoin, equities, and cash in one portfolio. Employing the 25% target volatility strategy, 5% of the index was allotted to Bitcoin. Yields were as low as the 2.5% Bitcoin allocation approach, when weighting the digital currency against equities.
Bitcoin volatility has been identified by a number of research papers, as one of the key reasons – aside from regulatory uncertainty – why the bulk of institutional investors remain on the sidelines of digital asset investment activity. FTSE Russell’s portfolio construction methods, with Bitcoin included, indicate that volatility risk mitigation needn’t be a nightmarishly convoluted affair.
Though returns were lower than any avid crypto investor would be used to, they probably would be satisfactory to an institutional investment strategy, which prioritizes the mitigation of risk. What is more, the target goal of lowering volatility risk was achieved. Perhaps, institutions who have already taken the plunge into digital asset markets have adopted similar strategies. We may – on the back of FTSE’s findings – see more institutional firms allotting some of their capital to Bitcoin, in future.