Current Trends Indicate Bitcoin Volatility to Decline Over Time, so Implied BTC Allocations May Increase: Report

European digital asset manager CoinShares notes that as growing numbers of investors start taking Bitcoin (BTC) “more seriously,” it raises an important question: what would be an “appropriate” or ideal amount of Bitcoin in an investment portfolio?

According to CoinShares research team, the “real answer” depends on the investor’s risk appetite or tolerance and their portfolio “investment style.” However, the team at CoinShares tries to answer this question for an institutional “multi-asset” investor with what they think is a “moderate” appetite for risk.

As noted by James Butterfiled, a CoinShares investment strategist:

  • A modest increase in an investment portfolio “risk budget of 100 basis points would suggest a portfolio weighting of 3.6%, with a 120 basis point risk budget suggesting a 4% weight.”
  • Varied back-test periods “highlight a consistency in results suggesting the subjectivity in cherry-picking specific time periods isn’t the concern many believe it to be.”
  • Bitcoin being part of “a relatively new asset class, where volatility is likely to decline as acceptance and understanding of it proliferates, implies both its future volatility and historical volatility should be taken into consideration when calculating potential portfolio weightings.”

The CoinShares team adds that there are different ways in which an investor can allocate a certain amount of their investment portfolio to Bitcoin. However, most investors tend to use “varied forms of historic volatility to determine allocation sizes,” the CoinShares team added while noting that Alpima has released “compelling analysis on understanding how much to allocate to Bitcoin based on differing portfolio styles.”

CoinShares’ report also mentioned:

“Their results highlight that a maximum diversification portfolio would have the highest allocation due to Bitcoin’s low correlation to other asset classes. We highlighted similar results in our previous work Bitcoin’s role in an investment portfolio. However, applying no constraints to a maximum diversification portfolio would lead to very large weighting in bitcoin, resulting in very high volatility.” 

The report further noted that because of BTC’s high volatility, “a minimal variance portfolio would allocate nothing.” However, there are certain challenges “in using historical volatility in that choosing different date ranges can lead to very different outcomes with the data range chosen potentially being extremely subjective.”

The report also mentioned:

“There are other approaches, such as the Black-Litterman model, which requires the investor to input their assumed growth rate and confidence in that prediction, and then apply mean-variance optimization (MVO) to maximize expected returns and suggest an allocation weight.”

According to CoinShares, the problem with this approach is that “a high confidence in your prediction is required to allocate in meaningful quantities, this is particularly difficult given how young and volatile Bitcoin is.”

But Adam Grealish of Betterment has done “some interesting work on applying the Black-Litterman model to Bitcoin,” CoinShares reveals.

As explained in the research update:

“The Black-Litterman approach highlights that high expectations of outperformance (+40% versus equities) coupled with a confidence level of 50% would suggest a 6% allocation. Unfortunately, we believe it is unreasonable to expect that level of outperformance every year, and furthermore, at lower confidence levels the suggested allocations fall rapidly. At a 5% expectation of outperformance, the suggested allocation at any confidence level is negligible.”

In order to determine just how much Bitcoin would be just right in a particular portfolio, CoinShares has  been maintaining a database of daily returns beginning from October 2015 when the leading crypto was “first financialized (available as an ETP).” The asset management firm also noted that they developed a “traditional balanced portfolio with 60% equities and 40% bonds and then added varied amounts of Bitcoin, detracting from both equities and bonds equally.”

The CoinShares team added:

“Previous analysis highlights keeping a fixed portfolio allocation and rebalancing on a quarterly basis helps mitigate Bitcoin’s volatility challenges with only moderate detriment to returns. Rebalancing has also helped improve risk-adjusted returns and have significantly reduced maximum drawdowns.”

The report also mentioned that being “acutely aware that investors have varied appetites for risk, our model portfolio can give guidance on volatility targeting.” When examining data since October 2015, “an additional 100 basis points (1%) of annualized risk suggests a portfolio weight of 3.6%,” CoinShares’ report noted.

Based on charts and available data, CoinShares points out that these numbers suggest “a fairly linear path at levels past 4% requiring an additional 120 (1.20%) of annualized risk, with a 200 basis point addition to the volatility budget suggesting a 5% allocation.”

The report continued:

“A fair critique of this analysis would be our back-test period taking a favorable period of time for Bitcoin. However, we are encouraged by how little the portfolio risk changes when the back-test periods are varied.” 

While referencing other statistical data, the report points out “how varying the back-test length from 5 years through to just 1 year for a 4% Bitcoin weighting creates a variance of just 45 basis points around the longer-term 100 basis point increase in volatility.”

The CoinShares team further noted:

“We [saw] a big decline in the additional volatility in late 2019, which we believe was due to an increase in volatility of equities and bonds rather than bitcoin. It demonstrates that if there are significant volatility spikes in equities and bonds, which is quite plausible given their high valuations, that bitcoin would look increasingly attractive from a risk perspective. Applying a fixed volatility budget of 100 basis points, instead of a weighting target of 4% bitcoin highlights how little the model portfolio’s suggested weighting varies over the varied back-test periods. The model’s suggested weightings vary from 3.2% to 5.1%.”

CoinShares concluded:

”A modest increase in an investment portfolio risk budget of 100 basis points would suggest a portfolio weighting of 3.6%, but we appreciate investors’ appetite for risk is subjective. Bitcoin being part of a relatively new asset class, where volatility and returns are both likely to decline as acceptance and understanding of it proliferates, implies both its expected future volatility and historical volatility should be taken into consideration when calculating potential portfolio weightings. Current trends suggest bitcoin’s volatility will continue to decline over time, and therefore implied allocations in bitcoin are likely to increase too.”

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