Imagine coming home and opening your refrigerator to find a jar full of your favorite juice. After taking a sip, you realize that the kind soul who made the juice added too much water, and there's not much you can do to fix it – removing water from juice is a messy process. However, if the juicer is too stingy with the water, you can simply dilute the juice with additional water and enjoy the perfect refreshing drink.
A similar phenomenon occurs with the risk of financial assets. If an asset has very little risk, it's difficult to "take water" from it and make it riskier, usually through leverage. Conversely, if the asset is too risky, it is easy to dilute it with cash equivalents, such as short-term T-bills or T-bills.
Crypto assets have emerged as a new asset class in the last 14 years. As they gained popularity, debates arose about their role in a portfolio of traditional assets. The controversy largely stems from concerns about the level of risk associated with these assets, which is significantly higher than even the riskiest traditional assets.
Related: What Paul Krugman is wrong about cryptocurrencies
Well, instead of complaining about high risk, one can add some water (eg T-Bills) and then check how well diluted crypto assets fit into a portfolio of traditional assets. This is precisely what we did. We took three years of post-pandemic data, from Q2 2020 to Q1 2023, for indices representing (global) stocks (the MSCI World Index), (global) bonds (the total return index value USD-Hedged Bloomberg Aggregate Global Credit), Short-Term T-Bills (Bloomberg 1-3 Month US Treasury Bill Index), and Cryptocurrencies. The next step was to dilute the cryptocurrencies with T-Bills. We chose two parts crypto to three parts T-Bills, which led to volatility levels that were less than double what is typical for stocks.
The grand finale is threefold: we took all portfolios ranging from 1% to 99% stocks and the rest were allocated to bonds (quarterly rebalancing was used in all simulations), which we call original portfolios; determined how much of the equity portion could be replaced by diluted crypto while maintaining the same level of volatility, leading us to the final portfolios; and looked at what happens to other relevant portfolio metrics. The following graph summarizes the results.
The red line (left axis) shows how many cryptocurrencies (both diluted and pure) are in the final portfolios. Unsurprisingly, the more capital there is in the original portfolio, the more room for cryptocurrencies. The straight line indicates that there is a linear relationship (technically, an affine relationship once it does not cross the origin) between these two variables, which can be found by simple regression. The regression reveals that the amount of pure cryptocurrency in any given final portfolio is determined by this formula: 0.17% plus 6.40% multiplied by the fraction of shares in their respective original portfolio. Although this relationship is based on these specific indices, there is no reason to expect significantly different behaviors for portfolios with different allocations in stocks and bonds, or even for those that also include other asset classes. Therefore, this formula can be seen as a general rule of thumb for improving a portfolio by replacing stocks with crypto.
But what is the impact of trading stocks for diluted crypto? We can get some clues from the blue line on the graph above (right axis). Despite the small proportion of cryptocurrencies in the portfolio, there are substantial gains in risk-adjusted returns (as measured by the Sharpe ratio), which range from 0.05 to 0.25. This indicates that the final portfolios generated significantly higher returns than their original counterparts while maintaining the same level of volatility. Furthermore, the graph shows that the more crypto is added to the portfolio, the greater the observed increase in the Sharpe ratio.
Related: The Crypto Recession Is More Than The Macro Environment
Just to give these numbers more color, we can take the example of the traditional allocation of 60% stocks and 40% bonds. This portfolio returned 7.6% per year in our analysis period with an annualized volatility of 11.4%, resulting in a Sharpe ratio of 0.59. Using the formula, the final portfolio has 4% in crypto (0.17% + 6.40 x 60% = 4%), 6% in T-bills (4% x 1.5 = 6%), 50% in stocks (60% - 4% - 6% = 50%) and 40% in bonds. As expected, volatility is the same as the original portfolio, but returns grew to 10.2%, leading to a Sharpe ratio of 0.82, 1.4 times higher.
As these simulations indicate, the discussion should not focus on whether there is room for cryptocurrencies in a portfolio of traditional assets. Instead, we should be talking about the best way to allocate to this asset class. The above formula summarizes a simple approach that gives good results. If you are still skeptical about investing in cryptocurrency, have a glass of your favorite juice with the right concentration of water and think about it while you drink.
Joao Marco Braga da Cunha is the Hashdex portfolio manager. He earned a master's degree in economics from the Fundação Getulio Vargas before earning a doctorate in electrical and electronic engineering from the Pontifical Catholic University of Rio de Janeiro.
This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts and opinions expressed herein are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
