Just as the investment landscape has evolved since the mid-century, so too should our concept of a diversified portfolio. While this shouldn’t be a controversial statement, it doesn’t fail to ruffle the feathers of change-resistant investors clinging to the same portfolio allocations established seventy-two years ago following the introduction of diversification.
With the publication of his groundbreaking essay titled ‘Portfolio Selection’, Nobel prize-winning economist Harry Markowitz first introduced diversification as an investment strategy in 1952. The strategy was the core of his Modern Portfolio Theory and has since become a guiding principle for savvy investing. But while a portfolio composed of traditional assets – stocks, bonds and cash (and cash equivalents) with varying return correlations – may have equated to a diversified portfolio back then, can we say the same in today’s economic landscape? Look at the list of assets and you may notice one glaring omission: digital assets. With the undeniable diversification benefits and widespread adoption of this modern asset class, we must ask ourselves: Can an investment portfolio today be considered truly diversified if it does not include digital assets?
At Blockstone Capital, our answer is no. Thanks to its unique return profile, its integration into mainstream markets, substantial institutional support and the growing appetite for decentralized finance, digital assets – most notably cryptocurrencies – have evolved from a niche asset class to one that offers unique benefits that must be leveraged in a diversified portfolio. The benefits of digital assets are so substantial that we believe a necessary component of any diversified and future-friendly portfolio is the active and expert management of a 5% allocation to cryptocurrencies.
First, consider the uncorrelated return profile. While diversification may be the key to risk adjustment, uncorrelated returns are the key to diversification. Cryptocurrencies benefit from uniquely low and sometimes entirely uncorrelated return profiles and unlike traditional assets, move independently of public equities. BTC, for example, has 90-day rolling correlations with NASDAQ and the S&P500 between ± .5. The potential diversification value of cryptocurrencies is therefore substantial. It is a value that does not only play out in theory but is also upheld in practice. We have seen that portfolios incorporating digital assets and cryptocurrencies have demonstrated higher risk-adjusted returns with annual returns of 17.5% at a lower annualized volatility of 6.25% compared to those excluding them, which exhibit an annualized volatility of 7.46%.
Through the strategic allocation of digital assets within a portfolio, investors can leverage diversifying effects to construct optimized portfolios that lie on the higher end of the Efficient Frontier and more closely align with their risk tolerance and return expectations. Even a modest allocation of 5% can allow investors access to portfolios with both higher absolute returns and higher risk-adjusted returns. The recent decoupling of cryptocurrencies from traditional assets – demonstrated by rolling correlation shifts from .86 to -.85 with S&P500 and .45 to -.43 with Gold – will only serve to increase the benefits of further diversification.
The value – both potential and realized – of cryptocurrencies is not going unnoticed. Growing awareness has resulted in substantial institutional investment thereby maturing the asset class beyond its experimental status into a widely traded and trusted liquid asset. The approval of spot Bitcoin ETFs by the Securities and Exchange Commission (SEC) in January this year was a significant demonstration of institutional support for cryptocurrencies and a milestone step towards their legitimization and integration into traditional financial markets. As of June, these ETFs have accumulated nearly 875,000 BTC.
The relationship between cryptocurrencies and today’s changing financial environment operates as a positive feedback loop. The economic landscape, with its new paradigms of transparency, liquidity and infrastructure combined with a growing appetite for decentralized finance offers a fertile environment for digital assets and cryptocurrencies to thrive. At the same time, the growing adoption of cryptocurrencies is bolstering these new paradigms and further stimulating the appetite for a financial market that rewards innovation, improves accessibility and challenges traditional financial systems.
Given the potential diversification value and the optimal financial landscape, why the continued hesitation surrounding the integration of cryptocurrencies? The answer is simple: risk. Despite the increased stability of several cryptocurrencies over recent years, there is no denying that the asset class carries a unique volatility and risk profile that necessitates expert and robust risk management. It’s unfortunate however, that this consideration, which would apply to any relatively ‘new’ and disruptive asset class, results in many investors turning their backs on digital assets entirely instead of facing the challenges and reaping the rewards.
As well as continually educating themselves about the nuances of digital assets and market movements, financial advisors and investors should engage digital-asset native institutions that can provide the necessary knowledge and risk mitigation processes to successfully navigate the complexities. The high liquidity of cryptocurrencies, for example, is one unique characteristic of the asset class that experts can leverage, using their experience to dynamically manage portfolios by adjusting positions in response to market conditions.
With the volatile nature of the digital asset space, staying abreast of shifts and changes, such as regulatory decisions (e.g. the SEC approvals at the beginning of the year), is crucial and in-depth expertise and experience empowers these institutions to make informed decisions that not only optimize the benefits but also manage the risks.
Just as important as their strategic know-how is these institution’s appreciation of the importance of transparency and risk mitigation. As with anything considered ‘new’ and not yet ‘tried and tested’, cryptocurrencies are often met with doubt and distrust. Transparency and communication are therefore necessary in all transactions and holdings to foster trust and ensure security, as are safeguards. Utilizing safeguarding services such as insurance and reputable custodians to protect investments are just some of the safety measures that these institutions put into place. Proof of Reserves verification, in particular, has been pivotal in enhancing transparency and safeguarding customer assets on centralized exchanges.
As we approach late July, Blockstone Capital’s outlook on cryptocurrency and Bitcoin specifically remains cautiously optimistic. The strong spot ETF inflows, coupled with favourable macroeconomic indicators including a lower-than-expected CPI print, have bolstered Bitcoin's resilience. Despite potential headwinds from large-scale sell-offs, such as those from Genesis, the market has demonstrated a robust capacity to absorb these shocks. The ongoing decoupling of Bitcoin from traditional financial assets further underscores its unique position in the market. Investors should be prepared for potential volatility but can remain optimistic about the possibility of a breakout from the recent trading range, driven by continued positive sentiment and institutional interest.
Seventy-two years have passed since Markowitz’s Modern Portfolio Theory was first introduced. While its principle of diversification remains just as valuable, it’s time for us to reapply it to today’s economic context and reconsider what constitutes a ‘diversified’ portfolio. Digital assets and their benefits of uncorrelated return profiles, enhanced risk-adjusted returns, extended Efficient Frontiers and high market liquidity cannot be ignored. Neither can their risks. Combined with active management and the implementation of robust risk mitigation, investors must allocate a small percentage (5%) to cryptocurrencies if their portfolio is to be truly diversified. Then, and only then, will they fully leverage the benefits of Modern Portfolio Theory in today’s changed economy.
By Carl Szantyr, Founder and Managing Partner, Blockstone Capital
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