How Much Crypto Should You Have in Your Portfolio?

On this episode of The Long View, Bitwise Asset Management’s CIO and one of the world’s leading experts on crypto, exchange-traded funds, and financial technology, Matt Hougan, talks the role of cryptocurrency in a diversified portfolio, cryptocurrency funds and ETFs, and the volatile crypto market.

Here are a few excerpts from Hougan’s conversation with Morningstar’s Christine Benz and Amy Arnott.

How Much Investors Should Allocate to Crypto in Their Portfolio

Amy Arnott: You mentioned some of the performance characteristics making bitcoin and other cryptocurrencies really valuable from a portfolio perspective. And, if you look historically, it seems like if you test different allocations, the more crypto you’d had, the better your portfolio would have done, even on a risk-adjusted basis, because the returns have been so high and skewed to the upside. So how should investors think about the appropriate size for a cryptocurrency allocation within a portfolio?

Matt Hougan: Yeah, that’s right. Well, I think the answer is unless you have extraordinary conviction. And I would put myself in the camp of extraordinary conviction. So, my personal portfolio has a much higher weight than this. But for investors who don’t have extraordinary conviction, I think there’s a magic dividing line around 5% of the portfolio. As you mentioned, if you put it into a portfolio optimizer, it will want more and more crypto, because the historical returns are just so high that it boosts the risk-adjusted returns all the way up. But something funny happens at around 5% on a historical basis, which is that crypto becomes the primary driver of the maximum drawdown of the portfolio. The maximum drawdown, of course, is the biggest fall from a peak to a trough in what your total portfolio value is. And to me, that’s a really important statistic, because that’s the statistic that investors feel in their gut. And that’s the statistics that makes investors panic. And actually, the single biggest risk in crypto is not technological or regulatory or anything like that. It’s behavioral. It’s investors panicking when the inevitable volatility comes. And 5% puts you into the risky camp, where all of a sudden bitcoin is dictating the volatility of your overall portfolio. You don’t want to do that. I think of it a little bit like hot sauce. Hot sauce is great when you’re eating and makes food taste better. But if you put too much in it, it can be painful for people. So, I think if people keep that sort of framework in mind, they’ll end up in a relatively good place.

Arnott: So, it’s a condiment, not a main dish.

Hougan: That’s right.

Is the Sharpe Ratio a Good Metric for Bitcoin?

Christine Benz: You mentioned risk-adjusted returns. And I’m wondering if you can talk about whether you think the Sharpe ratio makes sense as a metric for bitcoin?

Hougan: I think you could look more at the Sortino if you were being specific to exclude upside volatility. And bitcoin has a great deal of upside volatility. But I think it’s reasonable, particularly when you look at the overall portfolio context. The challenge with just looking at bitcoin idiosyncratically is it has a relatively short track record. So, you don’t want to be tempted into putting too much into it. But I think if you look at it within a portfolio context, I think looking at its impact on the Sharpe ratio of the overall portfolio or the Sortino ratio, if you want to be more specific, I think that’s a relatively good way of understanding its impact.

Arnott: So, if I’m an investor who holds cryptocurrency, should I be viewing it in the context of my regular portfolio alongside traditional asset classes like stocks and bonds? Or given the volatility and the potential upside, do you think people should hold it off to the side as a separate portfolio or more speculative asset?

Hougan: Well, I think the answer comes down to whether you think it has a risk of going to zero. So, if you think it has a risk of going to zero, it’s a good idea to side pocket it and just consider it a speculative bet that may have a great long-term impact on your portfolio. But if you can gain conviction that it’s not going to zero, then adding it to your traditional portfolio transforms it into this incredible asset. And the reason that’s the case is because if you add it to your traditional portfolio alongside stocks and bonds, then you can rebalance your portfolio and that’s what lets you capture the noncorrelated benefits of bitcoin. Of course, as you guys know, if you add noncorrelated assets to a portfolio, but don’t rebalance, it doesn’t actually influence your long-term return pattern very much.

It just smudges it out into gray. It’s only when you add noncorrelated assets and then rebalance that you’re really able to harvest the volatility. That’s where you get what you see when you do historical analysis of bitcoin, which is if you add it to a portfolio, you dramatically increase the returns historically without significantly increasing the volatility of the overall portfolio. I think if investors can get their head around the idea that crypto is not going away—it may go up and down, but it’s not going away—and therefore add it to a traditional portfolio and rebalance that portfolio. It’s arguably, at least on a historical basis, one of the best sorts of portfolio enhancement assets that has ever existed. So, I like it within the traditional portfolio context, but I understand some people like to side-pocket and just let it ride, and I think that’s fine, too.

When Crypto Investors Should Look at Rebalancing

Benz: To follow up on the rebalancing question, what kinds of threshold should people use? How should they determine when to rebalance?

Hougan: We looked at this and the net result of our study was it didn’t really matter. We looked at monthly rebalancing. We looked at quarterly rebalancing. We looked at annual rebalancing. We looked at tolerance-based rebalancing, where let’s say you decided you want a 1% allocation, and you rebalance if it gets to 2%. Broadly speaking, it doesn’t matter. What I would say is the data suggests just do what you were already doing. Bitcoin, if you strip away all the baggage that surrounds this asset class and Silk Road and BlackRock and this and that, all the psychological baggage, it’s just another asset. And if you put it into a portfolio context and treat it as another asset and rebalance just like you did with other assets, historically, that’s led to great results. That’s not a guarantee it will in the future, but historically, it’s led to great results.