For a few years after its launch, Bitcoin was an outlier asset. Portfolio managers kept away from it because they didn’t know how exactly it worked, and in particular, the risks involved. Also, being an entirely new asset class, it was not clear how they needed to treat it without getting into legal trouble. That is no longer the case.
Today, institutional investors hold close to 4% of Bitcoin in circulation long term returns. The accumulation keeps growing over time. Some of the investment firms have made a name for themselves as experts at leveraging the cryptocurrency’s potential on behalf of investors.
The list of major players includes MicroStrategy, Galaxy Digital Holdings, Square Inc (set up by Twitter founder Jack Dorsey), and Grayscale Investments. In total,13 investment firms are holding close to 600,000 bitcoins (BTC)—worth approximately £7.6 billion by today’s (November 2020) exchange rate.
With major investment firms adding Bitcoin to their portfolios, and a significant interest coming from individual investors, it can be argued that the cryptocurrency is slowly becoming a mainstream asset.
Meanwhile, regulators in many countries around the world, including the United Kingdom, have eased up a bit about the cryptocurrency after understanding what it is and how it works. They are also figuring out how to regulate crypto investments.
But why exactly are portfolio managers and investment firms getting interested in cryptocurrency?
The contribution of Bitcoin to a portfolio
It turns out that Bitcoin brings to portfolios a value or contribution that cannot be found in other investment assets. That contribution is primarily its negative correlation with the traditional assets.
Indeed, if you analyze the price of Bitcoin since its launch in 2009, and compare it with the performance of the others, the cryptocurrency seems to have always avoided having a positive correlation with traditional assets such as fiat currencies, stocks, and commodities.
In this case, a negative correlation means that as the price of traditional assets like stocks drop, that of Bitcoin is often likely to go in the opposite direction, and vice versa. That means having the cryptocurrency in the portfolio helps to smoothen the extreme price swings and realize positive returns.
The negative correlation comes from the fact that the factors that affect Bitcoin’s price are not the same as those that affect the price of gold, stocks, or any other of the traditional investment assets. And even when the same factor affects Bitcoin and traditional assets, the impact is hardly the same. It is often the opposite impact on the two sides.
For example, during a financial crisis, and, in particular, the plummeting of the stock value, the price of Bitcoin is likely to go up as investors treat it as a haven. Indeed, Satoshi Nakamoto created Bitcoin largely as a response to the 2007 global financial crisis.
Meanwhile, when faith in the cryptocurrency is shaken by, for example, a major exchange hack, like what happened with Mt Gox in 2014, the stocks and precious metals markets are always so far removed from that reality.
Also, the supply nature of Bitcoin is quite different from that of the other assets. It is a deflationary asset with a supply limit capped at 21 million and an emission rate that halves every four years. Except for gold, the supply of the other assets can easily be controlled by relevant authorities.
How Bitcoin benefits from a portfolio
Thanks to its deflationary nature and high price volatility, Bitcoin has been the asset with the highest amount of gains in the last decade. That means the potential of one making huge returns by investing in Bitcoin is higher than with any of the traditional assets.
However, the huge returns realized from investing in Bitcoin comes at significant risk. Many times higher risk than what exists in the traditional markets. It turns out Bitcoin also benefits by being in a portfolio with other assets.
In a mixed portfolio, Bitcoin contributes to the potential of high returns. That comes from its high volatility and the growing value resulting from the reducing emission rate and an expanding adoption. In particular, it cancels out losses that might occur from traditional assets.
In return, Bitcoin gets some mitigation to its own low price swings through the traditional assets’ performance and stabilizing force.
One investment firm, Iconic Funds, has reported that a portfolio having as low as one percent in cryptocurrency can increase returns by as much as 100%.
There are repercussions with this development, though, especially on the identity and the role that Bitcoin might take going forward. In particular, Bitcoin could be finding its core function to be more of a store of value and less of a medium of exchange and unit of account. It could be well on its way to being indeed a digital gold.