Commentary: Finding the right crypto allocation in a traditional portfolio

Stock market volatility, inflation, the merits of diversification and other factors continue to push investors to reevaluate the benefits of a traditional 60/40 portfolio.

New allocation models over the last decade have included alternatives like real estate, private credit and commodity strategies, and these trends have only accelerated as pension funds, endowments and other allocators search for the optimal allocation balance that enhances returns while managing risk.

Recently, cryptocurrency has entered the institutional conversation surrounding alternatives and, despite the industry's challenges last year, many allocators have renewed interest given this year's strong recovery in prices and growing confidence that the asset class is here to stay. Yet, questions remain about how to best allocate to bitcoin and this broader emerging industry in a diversified portfolio.

Investors are right to ask questions about the level of risk associated with these assets since bitcoin and other crypto assets have higher levels of voltaility even when compared to other risk assets like stocks, REITs and private equity. The rapid development of the crypto ecosystem and rise in prices has led to a lot of "just buy more bitcoin" portfolio advice and punditry without appreciation for volatility considerations, risk tolerance or regulatory and legal factors.

Previous studies on crypto allocations have mostly concluded that larger allocations to bitcoin result in higher returns and higher volatility, which can be appropriate for many portfolios, but this guidance isn't particularly helpful given that volatility tolerance is different for different investors.

Luckily, the industry has evolved significantly and there is now enough data to help answer this important question that remains top of mind for investors: Is there a quantifiable method for determining the right amount of crypto to allocate within any given portfolio?

This is something our team has worked on for some time. As bitcoin and the crypto ecosystem continues to develop, more data has become available to inform decisions about portfolio allocations. Recently, we developed a formula that is instructive, regardless of an investor's exposure to equities and other risk assets.

To arrive at a formula for considering a crypto allocation within a specific portfolio, we focused on measuring the impact of adding "risk-free" assets like Treasury bills alongside crypto assets within a traditional portfolio in order to impact the Sharpe ratio.

For our analysis, we compiled three years of data, from the second quarter of 2020 to the first quarter of 2023, using the MSCI World index, Bloomberg Global Aggregate Credit Total Return index, Bloomberg 1-3 Month U.S. Treasury Bill index and the Nasdaq Crypto index (as of April 30, bitcoin was the largest constiuent in the crypto index with a 66.1% weighting). To dilute the crypto with a risk-free asset, we used a crypto-to-T-bill ratio of 2:3, which led to volatility levels far less than typical for equities. We then included this diluted crypto allocation within a set of portfolios that had anywhere from a 1% to 99% equity allocation, with the remaining allocation to bonds. This allowed us to determine how much of the equity portion could be replaced by our T-bills/crypto allocation while maintaining the same level of volatility.

As expected, there was a linear relationship between the level of equity in the original portfolios and the amount of crypto that can be added — the more equity in the portfolio, the more room for crypto. Running a simple regression revealed that the amount of crypto that can be held in any of the new portfolios (i.e., those with crypto) while maintaining the same level of volatility is determined by the formula: 0.17% + 6.40 x the percentage of equities in the portfolio.

Despite crypto's small proportion in the new portfolios, we found substantial gains in risk-adjusted returns when replacing equities for crypto, ranging from a 0.05 to 0.25 Sharpe ratio increase.

But what would this mean when specifically applied to a 60/40 portfolio?

Before adding the crypto allocation, the 60/40 portfolio returned 7.6% each year with annualized volatility of 11.4%, resulting in a Sharpe ratio of 0.59. Using our formula, the new portfolio has 4% in crypto (0.17% + 6.40 x 60% = 4%), 6% in T-Bills (4% x 1.5 = 6%), 50% in equities (60% - 4% - 6% = 50%) and 40% in bonds. As expected, volatility in this portfolio was the same as the 60/40 portfolio without crypto. However, the new portfolio with crypto returned 10.2%, leading to a higher Sharpe ratio of 0.82.

Looking beyond this three-year analysis period, we have also found similar results that suggest a modest crypto allocation may improve risk-adjusted returns, as Sharpe ratios increase as an allocation rises from zero to 5%.

The investment thesis for bitcoin and other crypto assets will play out over years and decades, not weeks and months. But if bitcoin continues to demonstrate its resilience and its long-term thesis as "digital gold," and other crypto assets continue to offer the incentives needed in a global economy shifting to a digital paradigm, then our formula may serve as a good guideline for measuring the amount of exposure institutions may be comfortable having. There is no silver bullet when it comes to determining the right allocation for any asset, and crypto is no different. These simulations indicate that conversations around crypto allocations shouldn't just be about whether or not to allocate to crypto, rather, they should be about how to allocate to crypto based on risk tolerance and exposure to other risk assets.

The macro environment this year, defined by an ongoing banking crisis, monetary policy uncertainty and continued geopolitical stress, has led to an unfriendly landscape for risk assets.

But bitcoin and the broader crypto universe have performed well despite this and despite a lack of regulatory clarity in the U.S.

We think this is a clear sign that investors are beginning to better appreciate crypto's long-term investment thesis. For investors able to look beyond the short term, bitcoin and other crypto assets will become increasingly important as adoption accelerates and the world becomes increasingly digital.

As the implosion of FTX in 2022 reminded us, there are many wrong ways to invest in this technology (e.g., unregulated offshore exchanges).

This will change over time as bad actors are removed, the understanding of crypto grows and more investment vehicles are made available to investors. In the meantime, understanding how crypto investments fit within an institution's investment guidelines, risk tolerance and long-term objectives is an important and necessary step to getting exposure to this transformative asset class.

Marcelo Sampaio is CEO and co-founder of Hashdex Asset Management, a digital asset-focused investment firm with offerings in the U.S., Europe and Latin America. He is based in Rio de Janeiro, Brazil. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.