Compared with traditional assets such as equities and fixed income, digital assets are often prone to high volatility and deep drawdowns. However, they typically have a low return correlation with other assets.
For example, since the beginning of 2015, the average rolling 12-month historical volatility of Bitcoin has been approximately 73% with a maximum drawdown of 83%. In contrast, the Russell 1000 Index (comprising mid- and large-cap US Equities) had a volatility of 18.5% and a maximum drawdown of nearly 35% over the same period. The 12-month rolling return correlation of Bitcoin to the Russell 1000 over this period has been, on average, 0.06.
Since the start 2020, correlation has been higher (~0.26) due to market conditions stemming from Covid-19. Nevertheless, despite the drawdown, Bitcoin has returned ~80% per annum since 2015, significantly greater than the ~11% per annum return of the Russell 1000 Index.
How, then, can the risks associated with Bitcoin and other digital assets be managed to justify a larger portfolio allocation?
The key is to utilise diversification and control volatility in the portfolio construction process – with three simple and accessible potential approaches:
- Volatility control
- Cash weighting
It is possible to apply a volatility control mechanism to reduce the volatility of Bitcoin to a level comparable with stocks.
A simple way to do this is combine Bitcoin with a low volatility asset such as cash. Rebalanced daily, a scenario involving a 50% equal weighting of Bitcoin and cash would have almost halved volatility over the 2015-2020 period, from 72% to 36%. In turn, the maximum drawdown would have fallen from 80% to 55%.
A more sophisticated method is to adjust the weighting of the cash component based on the current level of Bitcoin volatility, thereby controlling volatility to achieve a target level on average, for example 25%.
One of the ways to achieve this is via the FTSE Russell Target Volatility methodology, which on average allocates around 45% to Bitcoin and the rest to cash when targeting 25% volatility. But while this helps to mitigate a lot of the risk in the cash and Bitcoin portfolio, it also dampens performance; it essentially represents an ‘all or nothing’ exposure to the digital asset.
Greater diversification comes from increasing the number of holdings in a portfolio and/or by choosing assets with low correlation to Bitcoin, such as equities.
This aids diversification since equity returns and Bitcoin returns are more asynchronous, meaning drawdowns are therefore more likely to occur in different periods. This provides the second mechanism to mitigate the risks associated with Bitcoin.
For example, allocating 2.5% to Bitcoin and the remaining 97.5% to the Russell 1000 Index, and rebalancing the allocations on a quarterly basis, ensures exposure to Bitcoin is limited and overall portfolio risk is mitigated through diversification across the large number of stocks in the Index. Back-testing has shown the volatility and maximum drawdown to be comparable with those of the Russell 1000 Index, however an excess return of 2.6% per annum was realised. An increased allocation of 5% to Bitcoin enhanced the performance, whilst volatility and drawdowns were virtually identical to those of the Index.
Taking this a step further, the benefit of combining these two ideas can be seen in the chart below, illustrating the rolling 12-month volatility of the portfolios discussed.
A 5% allocation of a 25% target volatility Bitcoin portfolio – with the remainder being allocated to the Russell 1000 Index – is used to create the Russell 1000 Bitcoin Boost 25%/5% Index. This results in marginally lower realised volatility during the high volatility periods of late 2017 and during 2020.
Through relatively straightforward portfolio construction techniques, it is feasible to mitigate some of the perceived risks of Bitcoin and other digital assets by reducing volatility and taking advantage of their low correlation to traditional asset classes, along with diversification through portfolio weighting.
In doing so, a risk-controlled Bitcoin portfolio can be integrated into equity (or other asset class) portfolios, to gain exposure to digital assets.
Author from FTSE Russell: Martin Howard, senior research analyst.