Beyond The Bear

The benefits of holding cryptoassets within a diversified portfolio

The dramatic surge in the crypto market at the back end of 2017 has been followed by one of the longest bear markets in its relatively short history. The pain of the ‘crypto winter’ in 2018 has been intensified by the experience of highs of the booming market in December 2017. Despite the relatively short history of cryptoassets they have provided a fascinating study of the behavior of both speculators and investors.

Undoubtedly, 2018 has left many investors and spectators scratching their heads as they contemplate the past, present and future of cryptoassets. While 2018 has been punctuated by precipitous declines, it has also seen some important leaps forward, which, unfortunately, have been overshadowed by downside volatility. It is easy to get tangled in market price gyrations, but it is important to separate what is real and not real, and, fact from opinion, when considering what has passed and what may come to pass in this nascent market.

Figure 1: ‘Year of the Bear’ has seen the market capitalization of cryptoassets shrink (source: coinmarketcap.com)

The heightened volatility of cryptocurrencies relative to more established assets and asset classes means that investor experience is about as wide and varied as it can be. We have bitcoin billionaires and individuals that have been ruined by speculative trading, perhaps through leverage trading, which is widely, but not wisely, available for the retail market. The table below shows the return for different holding periods and incorporates the dramatic rise in BTC in December 2017(BTC touched $20k briefly on the 12th of December). We have chosen bitcoin as a simplified expression of the overall market due to the high levels of market concentration and the high correlations between cryptoassets.

Timing Influences Return

Table 1: Investor experiences over different holding periods

The massive variety of investor experiences shown above suggests that the bitcoin prices in the final quarter of 2017 were hollow and should be removed from any meaningful holding period analysis. The fact that there is a more than 100% difference in return for those investors entering the market at 1/10/2017 and 1/1/2018, and exiting on 1/4/2018 highlights this perfectly. It is also worth pointing out that longer holding periods were directly proportional to greater gains, which shows the importance of having a long-term horizon when allocating capital.

Many participants have used the price peaks of bitcoin in December 2017 as a base from which to categorize the return profile of cryptoassets. Naturally, this has led to most observers and participants of the market to focus just on the recent significant decline from those lofty price levels in terms of understanding returns and the future prospects of the emerging asset class. In actual fact, cryptoassets have been on a steady growth trajectory for over ten years when one considers the historical data in the absence of significant short-term outliers of price movements.

Beware: Behavioral Biases

Volatility, both to the upside and downside, attracts attention — perhaps more than it deserves when considering a long-term investment in any asset class. This suggests that there are are many behavioral biases at play that cause and exacerbate these sharp movements in crypto markets. The run-up to the 2017 cryptoasset price peak was categorized by hype which drove a herding mentality among speculators. As is common in most assets that enter into bubble territory, this was followed by a sharp and sustained decline in the price in 2018. Looking at a wider range of price data, bitcoin currently trades near levels last seen in September 2017 — not that long ago! It is easily forgotten that from January to September 2017 the price more than tripled, meaning that even today, investors that entered in January 2017(just over two years ago) have more than tripled their investment — there are not many assets or asset classes that offer that type of performance!

Figure 2: Ignoring the hype cycle as a behavioral outlier

The focus on the most recent price movements as a means to classify returns and prospects of cryptoassets emerges from variants and interactions of known behavioral concepts including availability bias, base-rate neglect, loss aversion and confirmation bias. Essentially, investors now mostly only recall the significant fall in prices(availability bias) without considering the longer term price history(base rate neglect) of the bitcoin. One of the reasons this may be apparent is that losses have a higher value than commensurate gains for investors(loss aversion) and create emotional pain. This type of analysis that only focuses on the price declines can be used to confirm that cryptoassets have proved a bad investment(confirmation bias), when in fact it has proved very profitable over longer periods and may do so in future periods.

We believe this to be a fundamentally incorrect way to understand the market. As investors, we want to understand the long term prospects of any assets, and such ferocious appreciations and market reversals hardly make a case for any type of normalized behavior. In fact, the price movements are, in our opinion, a strong reflection of ‘Animal Spirits’ at play. Indeed, in the last year we have seen the violent impact on crypto prices from herding inspired by greed and then fear. One thing is for certain, is that these behavioral impacts may have been even more accentuated by several factors such the globally low-interest rate environment(i.e cheap money) and a lack of at least some form of a standardized and accepted method for estimating fundamental values of cryptoassets. For these reasons, the removal of this ‘hype cycle’ and the accompanying dizzying price expectations are vital in maintaining a grounded investment approach.

A Little Crypto Goes A Long Way

So how do we separate what is real and what may be driven by temporal factors? One way to do this is to extend the time period of the analysis or holding period. As with any new technology there is likely to be considerable short term volatility, however as the technology gains slow and sometimes frustrating traction, value should appreciate proportionately. We have seen this with bitcoin. Investors who cottoned on to this dynamic in 2016 and allocated only a portion of their portfolio to the emerging asset would have benefited greatly in spite of the extremes seen in the transition between 2017 and 2018. The use of longer periods effectively nullifies or normalizes the massive rise and fall in prices over this period.

For purely illustrative purposes, we have looked at returns for three multi-asset Portfolios of varying risk and in turn allocations to major global asset classes in conjunction with an allocation to cryptoassets. The major asset classes that were used were as follows:

1. Global equity(I-Shares MSCI ACWI ETF)
2. Global bonds(I-Shares Core US Aggregate Bond ETF)
3. Global property(I-Shares Global REIT ETF)
4. Global cash(JPMorgan Liquidity Funds — USD Liquidity)
5. Cryptoassets(Bitcoin USD price)

Table 2: Risk profiled asset allocation

Based on these parameters we created back-tested US dollar returns for each of the Portfolios, which were re-balanced monthly over the respective periods. The results can be seen in table 3 and 4.

Table 3: Portfolio performance and attribution over 2-year holding period(monthly re-balancing).

Table 4: Portfolio performance and attribution over 3-year holding period(monthly re-balancing).

Despite the bear market of 2017, the contribution of a small allocation to crypto is significant

over both 2 and 3-year holding periods and across all risk levels — low to high. Considering the high-risk Portfolio, the 4% crypto exposure comprises 14.1% and 18,9% of the total returns of 19.9% and 30.3% over 2 and 3-year periods respectively. The effects on lower risk Portfolios is similarly striking. It is clear from these figures that investors would have benefited significantly from minimal exposure to cryptocurrencies over these holding periods, without ‘betting the farm’ on any single asset class.

Holistic Portfolios

So the big question is should investors be allocating to cryptoassets within their Portfolios? A Portfolio should by definition have exposure to a variety of drivers in appropriate allocations that reflect the overall willingness and ability to take risk. It is our opinion that the sustained fall in cryptoasset prices over the past year have made investor entry points more palatable given the potential for long-term adoption and traction of this nascent asset class.

Of course, there are many ways to gain this exposure, and this should be carefully contemplated and executed in a way that is specifically suited to client portfolios. It is our opinion that digital assets will inevitably become ubiquitous in daily life, to the extent of the internet and therefore have a long runway of future demand. Even investors that are skeptical over these prospects should consider how allocations may improve long-term returns as well as the opportunity cost of having a zero allocation. After all, the uncertainty of the future is the exact reason why we aim to build diversified portfolios!

While we have used bitcoin as a proxy for cryptocurrency exposure, Invictus Capital offers the Meridian Fund range, which provides risk-profiled, AI-guided exposure to cryptoassets and cash. Essentially these funds offer varying and dynamically adjusted levels of exposure to cryptoassets and cash within a regulated fund structure based on risk tolerance. Allocations to cryptoassets are adjusted on a weekly basis based on the direction of prices in the cryptomarket. In this way, the funds can limit drawdown through converting crypto exposure into cash during a sustained and severe downturn.

For more information please contact the Invictus Capital Team.