In a recent interview on CNBC, famed Ark Investment Management CEO Cathie Wood said, “The move by institutional investors into Bitcoin could add $500,000 to its price, if they ultimately give it a 5 percent allocation.” While we’re unsure of that math, we do believe that the key to a higher Bitcoin price is greater adoption by institutions and advisers, and the key to greater adoption is increased regulation.
“Institutional managers have to look at new asset classes that are evolving and that have low correlations,” Wood argued. “That’s the . . . Holy Grail in terms of asset allocation.” We agree, and we believe that it will be low stock and bond yields that force investors into other asset classes. But we would also argue that investors will not make the full Bitcoin allocation move until there is a certain level of safety or regulation. At the same time, Bitcoin in the future will likely not be the low-correlation asset it has been.
What’s brewing for cyrpto regulation
We need to draw the distinction between cryptocurrencies, like Bitcoin, and crypto tokens. Bitcoin is considered a commodity and has futures contracts in the U.S. because there is no single issuer — Bitcoins are “released” to miners who encrypt Bitcoin transactions, receiving Bitcoins as a reward. Crypto tokens, often used to raise money, are issued on an existing blockchain, most often Ethereum, but may not be registered with the Securities and Exchange Commission.
SEC chair Gary Gensler has made his position on tokens clear. First, if tokens meet the definition of an investment contract — and he believes many do — then they are a security and need to be registered with the SEC. Second, any exchange or lending platform that deals with investment contracts also falls under the jurisdiction of the SEC.
There is bipartisan support for crypto regulation, and we think it is a matter of time before all investable digital assets are under SEC jurisdiction, which will build crypto confidence. Unfortunately, it may not happen until crypto has “a spill on Aisle 3,” as Gensler likes to say.
Bitcoin adds volatility but also higher risk-adjusted returns
Thanks to its high returns and low correlation to other assets, Bitcoin has been heralded as a great addition to any diversified portfolio. Indeed, as we show in the chart, reducing U.S. stocks by 5 percent and allocating those funds to Bitcoin has generated significantly higher risk-adjusted returns.
Annualized returns since July 2010 are much higher for the Bitcoin portfolio (20.73 percent versus 9.59 percent). While the standard deviation of the Bitcoin portfolio is meaningfully higher (14.08 percent versus 9.06 percent), risk-adjusted returns/Sharpe ratio ([percent return - percent risk-free rate] / percent standard deviation) is still meaningfully higher for the Bitcoin portfolio.
Beware the volatility
The Bitcoin portfolio has a higher standard deviation because Bitcoin is so much more volatile than any other asset. The average daily price change (up or down) over the past 100 days for Bitcoin is 3.2 percent. That’s 5.5 times higher than the S&P 500 100-day average daily price move of 0.57 percent.
Bitcoin has had three periods of devastating declines, ranging from -83.1 percent to -93.1 percent: June 2011 to November 2011, November 2013 to January 2015, and December 2017 to December 2018. These declines had a couple of things in common. First, they came after massive gains, and second, they occurred roughly two years before a halving date (Bitcoin miner rewards are cut in half every four years). With the next halving date slated for mid-2024, we believe a period of weakness may be upon us, which should present a good buying opportunity.
Low correlation, but . . .
Bitcoin is attractive due to its low correlation to other assets. This is desirable because it can, in theory, hold its value even if other assets decline. But it’s important to make two points here. First, when the market rallies hard or tanks, correlations rise. Ned Davis Research’s chief global investment strategist, Tim Hayes, likes to say that during a waterfall market decline, the correlation of all assets is 1. In a steep market sell-off, we do not believe that Bitcoin would be spared. Second, the more Bitcoin is included in institutional portfolios and traded like other allocation assets, the more we expect correlations to rise.
Bitcoin’s correlation to equities began to rise in March 2020. We have noticed the highest correlation between Bitcoin and the Russell 2000 Value Index. Over the past ten years, the Bitcoin–Russell 2000 Value correlation largely oscillated between -0.1 and 0.1. However, post-COVID recession, the 52-week correlation has been oscillating between 0.35 and 0.45, a meaningfully higher level.
We’re bullish . . . but investors need to know what they own
We think the prospects for Bitcoin are bright. Asset managers looking for alternatives to low-yielding stocks and bonds should eventually look to crypto for returns, and Bitcoin stands to benefit. Bitcoin adoption as an asset class should get a boost from increased regulation, which would help give an “all clear” signal to asset allocators. While we don’t believe that Bitcoin’s correlation to other assets is as low as touted, we do feel that a 5 percent allocation to a portfolio should lift risk-adjusted returns over the next ten years. In our opinion, managing volatility with diversification and buying after a significant correction are the keys to successful ownership.
Pat Tschosik, CMT, CFA, is the senior portfolio strategist at Ned Davis Research. NDR is a global independent investment research, solutions, and tools provider owned by Euromoney Institutional Investor.