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Interest in crypto as a new asset class is growing, even (or should I say especially) amongst professional and institutional investors. Investment conferences worldwide can no longer afford to omit crypto from their keynotes; one would be hard-pressed to find such a conference without at least one sponsor from the crypto space. Asset managers and family offices are all flirting with the idea of including crypto in their portfolios, often their clients have started demanding the option to do so. In fact, an EY study found that more than a fifth of institutional investors and a quarter of traditional hedge funds are planning to further increase their exposure to crypto assets. The capital inflow expected here will be massive. However, many first-time crypto investors are unsure about the effects a crypto allocation may have on their portfolio. 21e6 Capital, a Swiss crypto investment advisor, has recreated the typical portfolio allocation of a European family office and analyzed what impact different levels of crypto exposure have on the performance of such a portfolio.
Author: Maximilian Bruckner
The first step of our analysis is the construction of a reference portfolio investing in stocks, bonds, and some alternatives. We will focus on a typical German or Swiss portfolio, since this is the region we are currently most active in. Essentially, asset managers here often split their portfolio to roughly 60% stocks and 30% bonds. The remaining 10% are distributed amongst real estate, commodities, venture capital, and private equity. To simulate the standard performance of such a portfolio, we use indices to represent the various asset classes mentioned. Figure 1 gives an overview of the different assets and indices used, as well as their performance over the last years.
Figure 1: Creating a reference portfolio to use for our analysis
In this figure, we have split up the different components of our reference portfolio. The allocation in the actual portfolio then is as follows:
● 20% DAX (German stock index)
● 30% MSCI ACWI (Global equities)
● 10% SDAX (German small-cap stock index)
● 10% BONDSDE (German bonds)
● 15% BONDS (Global bonds)
● 3% COMMODITIES
● 5% REITSDE (German real estate)
● 3% PREQUITY (Private Equity funds)
● 2% VNCAPITAL (Venture Capital funds)
● 2% CASH
Figure 1 also includes a cryptobasket and crypto fund concept, which we will introduce later. For now, this should be sufficient to model the performance of a typical portfolio constructed by a professional investor.
The attentive reader may have noticed that we are using a logarithmic scale in this figure and may ask themselves why. Actually, all the other figures in this article will also use a logarithmic scale. A log scale ensures that a movement in the index will always have the same magnitude in relative terms, regardless of the time at which it happened. For example: If the index grows from 1 to 1200 over a long period of time, then on a linear scale a movement of 10% at the beginning of the index (e.g., from 10 to 11) would be much smaller than a movement of 10% at the end of the index (e.g., from 1000 to 1100). Relatively speaking, however, this movement is the same. So, the logarithmic scale ensures that both movements are visually the same size in the illustration.
Figure 2a: Bitcoin on a linear scale. Note how it seems as if volatility is increasing as we move toward the right side of the graph.
Especially when analyzing cryptocurrency, a linear scale makes little sense for this exact reason. When looking at Bitcoin on a linear scale, it seems as if Bitcoin is more volatile now than six years ago. However, this is not the case, as the logarithmic scale nicely shows. Volatility and drawdowns have remained fairly consistent. Figure 2a shows Bitcoin on a linear scale, whereas figure 2b applies a logarithmic scale. Here, the problem described is illustrated very clearly. The very popular Bitcoin Stock to Flow Model also uses a log-scale, for this exact reason.
Figure 2b: Bitcoin on a logarithmic scale. A much clearer, more consistent picture.
Next, to simulate the impact of a crypto admixture on our reference portfolio, we create a “cryptobasket” by discretionally selecting ten cryptocurrencies. The weighting of the different currencies in our cryptobasket is strictly according to market capitalization. Therefore, Bitcoin and Ethereum are the two largest positions. Together, they account for about 84% of the cryotobasket. In addition, there are positions in Binance Coin, Cardano, Solana, as well as Polkadot to cover the biggest altcoins. For decentralized finance, we added Uniswap. Bringing up the rear are the “original” cryptocurrencies besides Bitcoin and Ether, namely Ripple, Litecoin, and Bitcoin Cash. A detailed illustration of the weightings can be seen in the waterfall chart in the lower third of figure 3.
The goal of this cryptobasket is to represent a typical crypto portfolio investing in different cryptocurrencies over a long period of time. Accordingly, our rather simply composed cryptobasket generates a performance which can be described as very characteristic for crypto. The returns are stellar. However, volatility and drawdowns are far above the pain threshold of most professional investors at 101% and 80%, respectively.
Figure 3: Returns and drawdowns of our cryptobasket. The waterfall diagram also shows the allocation in the basket.
Before we turn to the various admixtures of this cryptobasket into our previously established portfolio, let us first compare performances directly. For this purpose, figure 4 gives a good overview. The blue line represents the cryptobasket, as already seen in figure 3. The green line reflects the reference portfolio, the return is in the expected range for the period since 2016, the Sharpe ratio of 0.80 is also normal. Since drawdowns are one of the major showstoppers preventing professional investments in crypto, we should take a detailed look at them here. 2018 to 2020 was a stable period for our reference portfolio, but the cryptobasket showed massive drawdowns during this time. In crypto circles, this period is known as “crypto winter”. 2018 was a particularly bloody affair, as Bitcoin lost about 70%.
Figure 4: Comparing our reference portfolio with the naive cryptobasket, as well as a more sophisticated crypto fund concept.
You may hace noticed that figure 4 includes another purple line. This one represents a crypto fund concept that uses strategic asset allocation and institutional risk management to aim for equity-like drawdowns and mostly preserve crypto-like returns. While 2018 would not have been a great year for this concept either, the drawdowns are actually in the same range as those of our reference portfolio. Specifically, the reference portfolio has had a maximum drawdown of 18.9% since 2016, while the cryptobasket is at 79.5%. With a maximum drawdown of 19.5%, the fund concept is only slightly above the reference portfolio. Such vehicles show: it is possible to invest in crypto without full exposure to the notorious volatility, and we expect more of these highly sophisticated approaches to emerge in coming years.
Now we can finally get down to the nitty-gritty: What happens to the performance of our reference portfolio when we start adding crypto exposure? And how does the risk-return profile of the portfolio change when we gradually increase this exposure? We start by allocating 2% to our cryptobasket. We do this by reallocating from the existing positions into our cryptobasket, so that the weightings in the various traditional assets do not change. It is important to keep the portfolio in the same balance as before, so the results are an accurate representation of the real world. With a rather small crypto allocation of 2%, we already observe a significant improvement of the Sharpe ratio (i.e., the measure of risk-adjusted return) from 0.89 to 1.11. This means that the return increases more than the additional volatility and drawdowns of the portfolio.
If we increase the crypto allocation to 4%, the Sharpe ratio improves further, but by a smaller margin, to 1.23. From figure 5, we can also observe that the improvement in the Sharpe ratio becomes smaller with each increase in crypto exposure, as the volatility of the cryptobasket slowly takes over. Consequently, the maximum drawdowns also increase. Adding a 6% exposure to our cryptobasket will already result in an increase in drawdowns unattractive for many professional and institutional investors.
Figure 5: Adding crypto to our reference portfolio.
It’s worth noting that, especially with lesser exposure, the volatility, and maximum drawdowns, of the portfolio hardly change — less than 100 base points each, despite the sometimes very volatile periods (the crypto winter) that are included in the observed time period. Returns increase by 3%. From a purely rational, portfolio optimization-oriented point of view, there is hardly any reason why investors should not add a small crypto allocation to their portfolio. One should also consider that our cryptobasket reflects a rather naive strategy — nevertheless, this primitive cryptobasket has a positive effect on the portfolio. Meanwhile, there are much more sophisticated products, such as the previously mentioned fund concept, which can further minimize volatility and drawdowns.
Another interesting observation can be made by closely inspecting the bottom half of figure 5, which shows only the drawdowns. During some periods, more crypto exposure results in bigger drawdowns than the zero crypto portfolio (for example, toward the end of 2018). But in recent history, there are barely any instances where it is only the crypto-heavy portfolio going through the wringer. In fact, in 2020 there are some instances where adding 10% crypto exposure resulted in less volatility than the normal reference portfolio.
Yes, there can be a fundamental debate about crypto. Typically, the naysayer will yell something about Ponzi schemes and energy consumption. But with rising adoption, and the world’s largest financial institutions beginning to offer cryptoasset products, there is a consensus in the market that crypto is here to stay. Also, a recent study by the Frankfurt School Blockchain Center shows that it’s quite simple to calculate the carbon footprint of a Bitcoin investment, and hence offset said footprint. You can find it here. In any case, there is plenty of literature and material discussing cryptocurrencies on a fundamental level. In this brief article, we simply wanted to show that adding diversified crypto exposure to your portfolio, even in small quantities, has a positive impact that should put a smile on your face. Returns increase by around 3%, and volatility and drawdowns barely move by 1%. It should be noted again that for this analysis we used quite a naive cryptobasket; more sophisticated tools are available. Crypto funds can offer a great entry point to investing in crypto assets, many of them consistently outperform Bitcoin. There are also several interesting market-neutral crypto funds engaging in arbitrage and market making. People say “there’s no free lunch in finance”, but this sure seems like one.
21e6 Capital is a Swiss investment advisor, connecting professional investors with optimal crypto investment products. 21e6 Capital has analyzed over 1,000 crypto funds across the world and condensed them into a selection that can yield crypto-exposure with minimized downside risk. Backed by a highly experienced team of crypto and finance experts with in-depth knowledge in digital assets and DLT, 21e6 Capital created a unique quantamental strategy that is aimed at achieving crypto-like returns while minimizing risk and volatility to global equity levels. The 21e6 Capital team builds upon strong academic roots with a track record of leading crypto asset and decentralized finance publications and research, ensuring state-of-the-art crypto investment solutions for financial industry professionals.
Maximilian Bruckner is Head of Marketing & Sales at 21e6 Capital AG. Prior to this, he was engaged as Executive Director of the International Token Standardization Association (ITSA) where he focused on research and classification of crypto assets according to the International Token Classification (ITC) framework. He was heavily involved in the creation of the world’s biggest token database for classification and identification data on tokens (TOKENBASE). Maximilian graduated from the Frankfurt School of Finance and Management and did academic research in close consultation with Prof. Dr. Philipp Sandner. You can contact Maximilian via e-mail at firstname.lastname@example.org to request more information on 21e6 Capital AG or ask any questions regarding this article. You can also follow him on LinkedIn to stay updated.
This article is an informational document and does not constitute an investment recommendation, investment advice, legal, tax or accounting advice or an offer to sell or a solicitation to purchase any securities and therefore may not be relied upon in connection with any offer or sale of securities. The views expressed in this letter are the subjective views of 21e6 Capital personnel, based on information which is believed to be reliable. Any expression of opinion (which may be subject to change without notice) is personal to the author and the author makes no guarantee of any sort regarding accuracy or completeness of any information or analysis supplied.