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The Role of Cryptos in a Diversified Portfolio

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Stockholm (HedgeNordic) – Institutional investors are increasingly pondering about the addition of cryptocurrencies to a diversified portfolio. Back in October of 2021, hedge fund manager Paul Tudor Jones said that Bitcoin, just like gold, is a great way to protect wealth over the long run. “I like Bitcoin as a portfolio diversifier,” Jones said on CNBC’s Squawk Box. “Over time it’s a great diversifier. Again, I look at Bitcoin as a store of wealth.”

Martin Estlander, the founder of Finnish systematic manager Estlander & Partners has been closely studying the crypto asset space in recent years. He also views cryptocurrencies as a store of value. “The supply of cryptocurrencies is rule-based, hence the supply is transparent and in many cases limited, which makes them a good store of value,” he argues. “This is in contrast to fiat currencies, which are being printed at a discretionary basis and are currently printed a lot, thus devaluing the value of these currencies,” he adds. “Being a true store of value is one of the prime qualities of a currency.”

“The supply of cryptocurrencies is rule-based, hence the supply is transparent and in many cases limited, which makes them a good store of value.”

Uncorrelated Asset

The essence of modern portfolio theory involves moving beyond simple diversification and reducing overall risk by building a portfolio of assets that exhibit low correlation of returns. “Crypto assets offer proven advantages in that regard due to their exotic nature and a unique set of drivers,” explains Mikkel Morch, Executive Director and Risk Management at digital assets-focused hedge fund ARK36. “Thanks to these characteristics, they can act as a diversifier in normal market conditions.”

“Crypto assets offer proven advantages in that regard due to their exotic nature and a unique set of drivers.”

“The crypto market has a market cap of nearly $2.5 trillion and has long surpassed being just a “fly,” says Anna Svahn, the founder and CEO of Antiloop Hedge. “Although the asset class is still young, it is clear that digital assets work and will continue to work as a diversifier in portfolios due to  their low correlation to traditional markets.” Niclas Sandstrom, CEO digital assets-focused firm Hilbert Group, and Mikkel Morch agree that the lack of correlation to other asset classes warrants the inclusion of cryptocurrencies in a portfolio. “Digital assets definitely provide a very sensible diversification option as data suggest low – or at times even negative – correlation with traditional assets,” according to Morch.

“Although the asset class is still young, it is clear that digital assets work and will continue to work as a diversifier in portfolios due to  their low correlation to traditional markets.”

“Historically, if you look at longer-term correlation, either based on daily returns, or monthly and quarterly returns, cryptos still have a very low correlation to traditional assets,” adds Sandstrom. “That is a good thing for portfolio diversification.” Sandstrom goes on to argue that cryptocurrencies can serve as both a diversification tool and a growth engine for a portfolio. “Cryptocurrencies also serve as return drivers for a portfolio,” says the CEO of Hilbert Group, which went public on Nasdaq First North Growth Market in late October.

“You are looking at an asset class that has generated an annualized return of more than one hundred percent in the past four years,” Sandstrom tells HedgeNordic. “Having low correlation and a high expected return is ideal for inclusion in a traditional portfolio,” he continues. Calculations computed by the Hilbert team on market data spanning over the last four years show that a ten percent allocation to Bitcoin to an all-equity portfolio would have doubled the portfolio’s return without dramatically increasing its volatility profile. “A portfolio with a crypto allocation could generate a much higher return without changing the risk level,” says Sandstrom. “That is going to be the case for the next decade as this area grows and until it matures to become similar to traditional assets in terms of volatility and expected return.”

“Having low correlation and a high expected return is ideal for inclusion in a traditional portfolio.”

“Digital assets, which include but are not limited to cryptocurrencies, can serve both purposes depending on the specifics of a given portfolio, including asset selection and position sizing,” argues Morch, one of the four Danish co-founders of ARK36. “These specifics would vary according to the investor’s objectives, profile risk, and a number of other factors,” he continues. “It could be both or either depending on the portfolio strategy,” agrees Svahn. “One could argue that Bitcoin as a “digital gold” or Ether (or another platform token) could be considered a diversifier, while single projects built on one of the platforms rather would be seen as a growth engine with higher risk.”

“A small allocation to a basket of carefully selected digital assets could serve as a good diversifier,” considers Morch. Digital assets could also serve as a growth engine for a portfolio, argues Morch. “Digital assets can still be reasonably expected to grow as an asset class. In comparison with other traditional assets, they still have a relatively small market cap,” he explains. “If Bitcoin does eventually displace gold as the institutionally preferred inflation hedge, its price could still rise multiple folds. So there is definitely a case for seeing BTC as a growth asset as well.”

“A small allocation to a basket of carefully selected digital assets could serve as a good diversifier.”

“The same is true for the market cap of digital assets as a whole,” continues Morch. “The growing adoption rates of these assets as well as their integration into traditional finance, the exceptional rate of innovation seen within this space, and the highly disruptive potential of crypto as technology all suggest there is plenty of room for growth that translates well into significant upside potential.”

“Any asset which has a strong bull case can be both a diversifier and a growth engine,” concurs Martin Estlander. “The correlation between stocks and cryptocurrencies is low (often below 0.3), which would qualify cryptocurrencies as a good diversifier.” However, cryptocurrencies do not always serve as a hedge against broader market sell-offs. “Following the market turbulences caused by the initial Covid shock, cryptocurrencies took a beating in the same way as equities did, so it is not necessarily a hedge against sell-offs,” acknowledges Estlander.

“Again, the main case as I see it is that cryptocurrencies are a store of value, while fiat currencies are being devalued,” argues the founder of the first hedge fund in the Nordics. “In the US, the balance sheet of the FED has increased around 100 percent since the start of the year 2020. Equities have risen about 50 percent. How much wealthier has the equity investor become?” ponders Estlander. “Bitcoin has increased 750 percent. What if the investor values his equity position in a non-devaluing currency such as Bitcoin instead of in US Dollars?”

The Survival of the Fittest

With more than 10,000 different cryptocurrencies in circulation at the moment, the survival of the fittest remains the indisputable truth and the jungle law of the cryptocurrency universe. “We are still early in the era of digital assets, meaning many projects existing today won’t be here in the future,” argues Anna Svahn. “There are so many cryptocurrencies at the moment, so not all are going to be valuable,” agrees Sandstrom. “The majority of these are actually going to zero.”

“There are so many cryptocurrencies at the moment, so not all are going to be valuable. The majority of these are actually going to zero.”

Sandstrom believes the survival of the fittest in the cryptocurrency space is an analog to the tech boom and bust in the 2000s. “There were lots of internet companies at the time, but maybe only ten percent of them are around today,” says Sandstrom. “We see the same development for crypto.” For that reason, Sandstrom opts for building a well-diversified portfolio of carefully selected cryptocurrencies to gain exposure to the space. “The total market cap is what one should be focused on. That will go up,” emphasizes Sandstrom. “One could identify some winners or some high probability cases. We certainly think Bitcoin as digital gold is among those winners, and Ethereum is there as one of the biggest operating systems on which other cryptocurrencies run. But beyond that, it is very hard to predict the future winners. The main thing is to have a broad-based exposure.”

The Role of Cryptos

Although Bitcoin and other cryptocurrencies may indeed have a home in a diversified portfolio, investors are also increasingly asking about the role of cryptocurrencies in our daily lives, societies, and monetary systems. “I believe that the whole banking and financial industry will see huge change as a result of not just the increased adoption of digital currencies, but from the introduction of smart contracts and decentralized finance, which, in the long run, will dismantle the huge cost of financial infrastructure,” argues Martin Estlander. “Several corners of the industry will be disrupted. I think banks are beginning to see the threat concretely.”

“Cryptocurrencies are going to completely revolutionize the monetary system, but it depends on which way the regulation will go.”

“Cryptocurrencies are going to completely revolutionize the monetary system, but it depends on which way the regulation will go,” argues Niclas Sandstrom. “There will be huge disintermediation, which is really enabled by the smart contract. A lot of the cumbersome administrative processes are going to be largely eliminated and reshaped,” he continues. “Retail banks will find it harder to make fees. But everything where you keep track, such as in the insurance industry, logistics, supply chain management, medical records, land registry, you name it, everything is going to be governed by blockchains. We think smart contracts and blockchains will change industries, including the banking industry.”

“We are seeing a strong trend towards greater mainstream adoption of Bitcoin and cryptocurrencies, which is already resulting in their integration into the traditional financial systems.”

“We are seeing a strong trend towards greater mainstream adoption of Bitcoin and cryptocurrencies, which is already resulting in their integration into the traditional financial systems,” says Mikkel Morch of ARK36. “Crypto transactions are fast and convenient to execute both locally and globally and are often cheaper than bank transfers because no intermediary entities are involved. Additionally, highly decentralized cryptocurrencies such as Bitcoin are censorship-resistant. No governmental authority can feasibly manipulate or control the design features of Bitcoin such as its supply cap,” continues Morch.

“While these features make cryptocurrencies attractive to both individuals and businesses, they have also given rise to a new set of challenges for governments and financial regulators,” points out Morch. “The approach they have taken so far has varied considerably around the world with some governments going as far as to declare Bitcoin the legal tender and others banning it or strictly limiting its use.” According to Morch, “the mainstream adoption of cryptocurrencies will certainly hasten the advent of government-issued cryptocurrencies known as Central Bank Digital Currencies of CBDCs.”

“The mainstream adoption of cryptocurrencies will certainly hasten the advent of government-issued cryptocurrencies known as Central Bank Digital Currencies of CBDCs.”

“Supposedly, these are to offer the best of both worlds, combining the speed and other benefits of cryptocurrencies without the associated risks,” adds Morch. “Whether that scenario will materialize remains to be seen. However, with many other countries moving ahead with their own CBDC programs, it is nearly certain that CBDCs will become an important part of the future of money, supplementing physical cash and bank reserves. Monetary policy could benefit remarkably from this technology.”

 

This article featured in HedgeNordic’s “Diversification” publication.

 

Picture by grafvision – Envato Elements

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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