By Nick Codola, CFA, CAIA
With several weeks of trading behind them, spot Ethereum (ETH) ETFs are making a significant impact, attracting over $1 billion in inflows. As I mentioned in May when the 19B-4 forms were approved, allocating to crypto doesn’t have to be an “either-or” decision between Bitcoin and Ethereum.
Bitcoin is often compared to digital gold due to its fixed supply—only 21 million coins will ever be created. This scarcity is crucial for its role as a store of value. While Bitcoin can be used for payments, its primary function is as a value store, though recent developments like “Runes” are enabling some Web 3.0 and NFT-like activities on the Bitcoin network.
In contrast, Ethereum was designed to facilitate decentralized digital financial services and is frequently likened to a “Visa” or “Mastercard” for the blockchain world. Its protocols support a higher number of transactions per second than Bitcoin, and the platform’s flexibility allows users to optimize smart contracts and payment systems through gas fees. Ethereum also supports the creation of NFTs, games, and other digital innovations. Additionally, the Ethereum network has an embedded burn-rate mechanism to manage its supply growth, with most days seeing a balance between new ETH issuance and the burn rate.
Given the differing use cases of ETH and BTC, it’s no surprise that their correlation is less than one. This lower correlation between the two assets unlocks diversification benefits when they are paired together. Although finding the ideal ratio can be challenging, research from various firms suggests a “goldilocks” allocation of around 70-30 for Bitcoin to Ethereum. For instance, VanEck recommends a 70-30 split, while Bitwise uses 75-25 ratio. Furthermore, Bitcoin and Ethereum have shown low correlations with most other asset classes, making them strong candidates for portfolio diversification.
For the sake of better reading, I reproduced the first three asset classes from the original correlation matrix, just zoomed in. Looking at a correlation matrix from the past six years, Bitcoin (represented by GBTC) and Ethereum (represented by ETH) have shown a correlation of 0.77 with each other—lower than the 0.88 correlation between domestic and international equities. Additionally, Bitcoin and Ethereum have maintained correlations below 0.5 with other major asset classes, including domestic equities (IVV), international equities (ACWX), bonds (AGG), gold (GLD), commodities (BCI), and cash.
Bitwise, VanEck, and other crypto financial institutions have conducted various studies to assess the impact of adding Bitcoin and Ethereum to a portfolio. These studies indicate that most users allocate around 3% to crypto. In recreating some of these studies, we assumed quarterly rebalancing within a conventional 60/40 portfolio, with the equity portion split 60% domestic and 40% international. The addition of crypto was funded 2/3 from equities 1/3 from bonds.
The hypothetical backtest showed that even a 1% allocation to cryptocurrency could enhance returns, though it does increase volatility. While adding crypto raised the portfolio’s max drawdown, the additional risk was justified by higher Sharpe and Sortino ratios. These ratios measure the portfolio’s excess returns relative to its volatility, with higher values indicating a more favorable risk-return profile. This is because portfolios with higher Sharpe/Sortino ratios garner more incremental return per unit of risk taken. The Sharpe Ratio divides excess returns by the volatility of the portfolio, and the Sortino ratio divides excess returns by volatility in periods where the portfolio is negative.
The introduction of spot ETH ETFs provides investors with another tool for their portfolios and is likely to improve the efficiency of the futures market, much like spot Bitcoin ETFs did for Bitcoin futures. Despite the potential benefits of cryptocurrencies in a portfolio, it is crucial that advisors and investors carefully consider their allocation size and thoroughly understand the assets and strategies they are investing in. We hope this article has provided valuable insights into the role of cryptocurrencies in a diversified portfolio.
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Orion Portfolio Solutions, LLC d/b/a Brinker Capital Investments (“OPS”) a registered investment advisor.
The views expressed herein are exclusively those of OPS, a registered Investment Advisor, and are not meant as investment advice and are subject to change. No part of this report may be reproduced in any manner without the express written permission of OPS. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. This information is prepared for general education information only. It does not have regard to the specific investment objectives, financial situation, and the particular needs of any specific person. You should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed here and should understand that statements regarding future prospects may not be realized. You should note that security values may fluctuate, and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance. Investing in any security involves certain systematic risks including, but not limited to, market risk, interest-rate risk, inflation risk, and event risk. These risks are in addition to any unsystematic risks associated with particular investment styles or strategies.
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Chartered Alternative Investment Analyst (CAIA) is a professional designation granted by the Chartered Alternative Investment Analyst Association to candidates who have completed Level I and Level II examinations. The Chartered Alternative Investment Analyst Association has established the designation of CAIA to certify that the holders have met the association’s educational standard for specialists in the area of alternative investments. The alternative investments that a Chartered Alternative Investment Analyst is trained to assess include hedge funds, venture capital, private equity, funds of funds, derivatives, and real estate investments.
1918-BCI-8/1/2024
