We are increasingly asked by our high net worth and family office clients whether an investment in bitcoin makes sense given its nascent stage of development and price volatility. We believe there is a compelling case to consider an allocation to this unique new asset within a diversified investment portfolio.[1] Bitcoin's predetermined and finite supply and its persistent lack of correlation to equity and fixed income securities over long periods of time make it an attractive asset in which to store wealth over the long term. We found that adding a 3-5% allocation of bitcoin to a diversified investment portfolio had a significant positive impact on historical risk adjusted returns.[2] In fact, looking back over the past 3-, 5-, and 10-year periods, a 3% position in bitcoin would have increased annualized portfolio returns by over 500 basis points on average while adding no incremental risk.[3]
Think of Bitcoin as a store of wealth
Bitcoin is a digital asset. It is software that allows for the storage and transfer of value. There are many possible applications for bitcoin, but here we are focused on bitcoin’s unique properties to store wealth. The most important of which is an unchangeable policy written into bitcoin’s code that results in a predetermined and finite supply. Only 21 million bitcoins will ever exist, with approximately 18.8 million (89.6%) outstanding as of August 2021.[4]
New bitcoins are issued in blocks during a verification process known as mining at an average rate of one block every ten minutes. The number of bitcoins issued in each block is reduced by 50% every four years. This reward will continue to halve every four years, gradually reducing bitcoin's “inflation” until the final bitcoin has been mined.[5]
Why finite money supply matters for storing wealth
In contrast to bitcoin, government-issued currency not backed by a physical commodity (“fiat money”) is subject to an unknown and infinite supply. A perceived benefit of this unlimited money supply is the ability for central banks to manage credit supply, liquidity, interest rates, and money velocity. This may be helpful in smoothing economic cycles but invites the potential for governments and central banks to debase their fiat money thereby diminishing its qualities as a store of wealth.
This becomes particularly problematic when governments spend beyond their means. Deficits require governments to borrow, which in turn requires lenders to fund the debt. Enter the central banks and a process known as debt monetization. Debt monetization is the process by which central banks increase money supply to fund government deficits.
Unfortunately, that is exactly what’s happening on an unprecedented scale. The U.S. government ended 2020 with a $3 trillion deficit. This shortfall, shown in Figure 1, equated to 15.0% of Gross Domestic Product ("GDP'), the highest deficit-to-GDP ratio since WWII. The future does not look promising either as the current administration is on course for a budget deficit of $3 trillion for the second year in a row.[6]
Figure 1: U.S. Government Deficit as a Percent of GDP as of Year-end 2020
As a result of the increasing deficit, U.S. government debt, shown in Figure 2, has been climbing for the past four decades and as of July 2021 stands at 128% of GDP.[7]
Figure 2: U.S. Government Debt as a Percent of GDP as of July 2021
So where are the central banks and money supply in all of this? In the first half of 2021, U.S. Dollar money supply (“M2”) rose to $20.5 trillion, an increase of 14.6% from the prior year.[8]
Figure 3: U.S. Dollar Money Supply as of July 2021
Even more worrisome about this increase is the inflated base from which it grew. Over the past two years, annualized growth of M2 has equaled 17.8%. Figure 4 puts this in historical perspective, with the highest previous growth of M2 on record at 13.5% in 1976.
Figure 4: U.S. Dollar Money Supply Percent Change from a Year Ago as of July 2021
Debt monetization simultaneously depreciates the currency, lowers yields on government debt, and inflates prices for assets such as stocks - - a tempting elixir of incentives for government officials subject to short-term election cycles. But, there's a hitch. Increasing government deficits funded by debt monetization inevitably lead to monetary inflation. And monetary inflation erodes the wealth of those holding fiat money. In fact, as of July 2021, even those who hold U.S. government debt are losing wealth over time.
Treasury inflation-protected securities ("TIPS") are a useful proxy for the return on government debt after adjusting for inflation. TIPS are a form of U.S. Treasury bond indexed to inflation, which means that the yield on TIPS equates to the real interest rate earned by those who own government debt. As Figure 5 illustrates, the real yield on 10-year government debt has declined into negative territory and is -1.01% as of August 2021.[9] In other words, investing $1,000 in government debt today will return $904 inflation adjusted dollars in 10 years.
Figure 5: 10-Year Treasury Inflation-Indexed Security as of August 2021
Where would you rather store your wealth?
It seems that governments are increasingly comfortable running larger and larger deficits despite the inescapable fact that they are saddling themselves with debt that can only be absorbed by inflation, higher taxes, or default.
Because debt monetization is a necessary component to fund government deficits, money supply becomes indirectly influenced by elected officials with misaligned incentives and an infinite supply of money. Bitcoin’s money supply, on the other hand, is finite and unchangeable.
U.S. Dollar supply has been growing at 18% annually for the past two years with no line-of-sight fix to the underlying problem: government deficits are increasing and higher taxes are politically intractable. Bitcoin’s inflation is equal to 1/10th that amount or 1.8% as of August 2021, a rate which is programmed to decline steadily to zero.[10]
Bitcoin’s historical returns
Bitcoin launched in January 2009 but did not price until July 2010 when it began to change hands at $0.05 per bitcoin. Since that time, bitcoin’s returns have consistently and significantly outperformed traditional asset classes such as gold and equities.
Figure 6: Compounded Annual Returns of Bitcoin, Gold and Equities as of August 2021 [11]
To avoid “cherry picking” a moment in time when bitcoin's returns appear favorable, we calculated 36-month annualized returns rolling over time. Here we also introduce a hypothetical investment portfolio comprised of 60% equity and 40% fixed income securities ("60/40 portfolio"). The 60/40 portfolio represents a traditional diversified investment portfolio against which we can compare bitcoin's performance.
As Figure 7 illustrates, the 36-month annualized return of bitcoin significantly outperformed the 60/40 portfolio over time. Bitcoin's median 36-month annualized return was 100.1% compared to 8.7% for the 60/40 portfolio. In addition, bitcoin's annualized 36-month return exceeded that of the 60/40 portfolio during 96% of the observed periods.
Figure 7: Rolling 36-Month Annualized Returns of Bitcoin vs. 60/40 Portfolio [12]
We then looked at the impact that various allocations to bitcoin would have on the historical returns of the 60/40 portfolio. We began with the 60/40 portfolio and added 10 basis point increments of bitcoin maintaining the 60/40 split between equity and fixed income securities for the balance. With each portfolio construct, we calculated 3-, 5-, and 10-year annualized returns to understand the impact that a range of bitcoin positions would have on the portfolio across the different lookback periods.
As Figure 8 illustrates, annualized 3-, 5-, and 10-year returns increased significantly even with relatively small allocations to bitcoin. In fact, the 10-year compounded annual return would have doubled by adding only a 5% bitcoin position to the 60/40 portfolio.
Figure 8: Annualized 60/40 Portfolio Returns with Allocations to Bitcoin Ranging from 0-10%
What about the volatility?
Bitcoin's positive impact on the returns of the 60/40 portfolio was not surprising given its significant outperformance relative to equity and fixed income securities. However we know that bitcoin has been a volatile asset. So the question is whether bitcoin’s contribution to the returns of a diversified portfolio more than compensate for the increased volatility.
To answer this we calculate risk adjusted returns using the Sharpe ratio, a measurement of a portfolio’s outperformance per unit of the portfolio’s volatility. The Sharpe ratio is calculated by taking the excess return of the portfolio, relative to the risk-free rate, and dividing it by the standard deviation of the portfolio’s excess returns.
All else being equal, portfolios with higher excess returns and/or lower volatility produce higher Sharpe ratios, and vice-versa. Sharpe ratios above 1.00 are generally considered “good”, as the asset or portfolio is generating excess returns relative to its volatility.
The Sharpe ratio is typically used to compare the change in risk adjusted returns when a new asset is added to a portfolio. But let's start with the Sharpe ratio of bitcoin as a standalone asset. On a trailing 36-month basis, bitcoin's Sharpe ratio is 1.48 as of August 2021. By way of comparison, the Sharpe ratio for a portfolio comprised of the S&P 500 is 0.95 while our hypothetical 60/40 portfolio is 1.05. [13]
To again avoid “cherry picking” at a time when bitcoin's Sharpe ratio might appear favorable, we calculated the 36-month historical Sharpe ratio rolling over time. As Figure 9 illustrates, bitcoin consistently produced a Sharpe ratio greater than 1.0 over time (79% of the observed periods) with a median of 1.5.
Figure 9: Bitcoin Rolling 36-Month Sharpe Ratio [14]
Observing bitcoin's Sharpe ratio over time informs us about the risk/return trade-offs of this new asset. However, to understand whether bitcoin’s contribution to the returns of a diversified portfolio compensate for the increased risk, we need to take into account the correlation between bitcoin and the other assets in the portfolio.
Adding imperfectly correlated assets to a portfolio can reduce overall volatility and therefore increase risk adjusted returns. The practical challenge for traditional investment portfolios is that there are very few assets that offer a persistent lack of correlation to equity and fixed income securities over long periods of time. Bitcoin is a unique exception.
The correlation between bitcoin’s daily returns and those of the 60/40 portfolio was 0.26, 0.19, and 0.10 for the 3-, 5-, and 10-year historical periods, respectively.[15] This indicates almost no correlation between bitcoin and the returns of a traditional diversified investment portfolio. It is not surprising then to see that a small allocation of bitcoin produced no measurable increase to the risk of the 60/40 portfolio.
A variety of measures exist to ascertain risk. For investment portfolios we use Value at Risk ("VaR"), which quantifies the extent of possible losses within a portfolio over a specified period of time. VaR is measured by assessing the amount of potential loss, the probability of occurrence for the amount of loss, and the timeframe.[16] For example, if a portfolio has a Daily VaR 1% (5 year lookback) of 2%, there is a 99% confidence that the portfolio will not have a daily loss larger than 2%, calculated using 5 years of historical data.
We calculated VaR of the 60/40 portfolio using 3-, 5-, and 10-year data to understand the impact that a range of bitcoin positions would have across different periods of time. As figure 10 shows, a 3-5% allocation to bitcoin over the past 3-, 5-, and 10 years would have resulted in no meaningful increase in the risk of a diversified investment portfolio.
Figure 10: Daily 60/40 Portfolio VaR with Allocations to Bitcoin Ranging from 0-10%
Given bitcoin's positive contribution to returns with no incremental risk, it is not surprising to see that a 3-5% allocation would have meaningfully increased historical Sharpe Ratios as well. Figure 11 illustrates this point. The 60/40 portfolio produced historical Sharpe ratios of 1.05, 1.10 and 1.22 across 3-, 5-, and 10-year periods, respectively. The addition of bitcoin to the portfolio increased Sharpe ratios meaningfully across all time periods. In fact, adding just a 3% position in bitcoin increased historical Sharpe ratios to 1.25, 1.41, and 1.46.
Figure 11: 60/40 Portfolio Sharpe Ratio with Allocations to Bitcoin Ranging from 0-10%
Conclusion
Bitcoin is a unique new asset that presents a compelling investment case when viewed through the lens of traditional portfolio analysis. Bitcoin's finite supply and persistent lack of correlation to equity and fixed income securities over long periods of time make it an attractive asset in which to store wealth over the long term. Risk adjusted returns of a diversified investment portfolio improved significantly with the addition of a small position in bitcoin. In fact, adding a 3% allocation to bitcoin increased 3-, 5-, and 10-year annualized portfolio returns by over 500 basis points on average while adding no incremental risk.[3]
About Two Ocean Trust
Two Ocean Trust was founded to serve private clients whose assets are multi-generational. We provide investment management and trust services to ultra-high net worth individuals, private family trust companies, and foundations. Based in Jackson Hole, Two Ocean Trust is uniquely positioned to provide access to Wyoming's tax advantages, modern trust laws, and enhanced privacy and asset protections.
Notes
[1] As with any asset, the value of bitcoin can go up or down and there can be a substantial risk that you lose money buying, selling, holding, or investing in bitcoin. You should carefully consider whether trading or holding bitcoin is suitable for you in light of your financial condition. Past performance is not indicative of future returns. Prospective investors are not to construe the contents of this document as a recommendation to purchase bitcoin. This information should not be relied upon as research, investment advice, or a recommendation regarding any products, strategies, or any security in particular. This material is strictly for illustrative, educational, or informational purposes and is subject to change.
[2] We began with a hypothetical portfolio comprised of 60% equities (S&P 500 Index), 40% fixed income (Barclays Aggregate Bond Index) and 0% bitcoin. We then analyzed hypothetical portfolios blending incremental 0.1% positions in bitcoin while maintaining a 60/40 ratio of equity to fixed income for the balances. A variety of measures exist to ascertain risk. We use Value at Risk (VaR), a statistic that quantifies the extent of possible financial losses within a portfolio over a specified period. To calculate risk adjusted returns we use the Sharpe Ratio which measures the profit of a portfolio in excess of the risk-free rate, per unit of standard deviation.
[3] A 3% allocation to bitcoin increased 3-, 5-, and 10-year annualized returns by 387, 507, and 619 basis points, respectively. Daily VaR (1%) decreased by 13, increased by 3, and increased by 12 basis points, respectively. Returns and VaR of each portfolio were measured across the following periods: 3-year 8/18 to 8/21, 5-year 8/16 to 8/21, and 10-year 8/11 to 8/21.
[4] Source: messari.io
[5] When bitcoin launched in 2008, the reward was 50 bitcoins. In 2012, it halved to 25 bitcoins. In 2016, it halved again to 12.5 bitcoins. Today miners earn 6.25 bitcoins for every new block mined. Because the time it takes to mine a block varies based on mining power and network difficulty, the exact time the block reward is halved varies as well. Assuming current mining power remains constant the last bitcoin will be mined in 2140.
[6] Source: Wall Street Journal
[7] Source: St. Louis Fed
[8] M2 includes cash, checking deposits, savings deposits, and money market securities. Because of its wide definition, economists tend to watch M2 supply as an indicator of the total money supply. Data as of July 2021. Source: St. Louis Fed
[9] Source: St. Louis Fed
[10] Source: messari.io
[11] Source: casebitcoin.com
[12] Based on data from August 2013 to August 2021. Source: coinmarketcap.com
[13] SPDR S&P 500 ETF as of August 2021. Source: Yahoo Finance
[14] Based on data from August 2013 to August 2021. Source: casebitcoin.com
[15] Correlations fall within the range of -1 to 1. A correlation of 1 indicates perfect positive correlation. A correlation of -1 indicates perfect negative correlation. A correlation of or near 0 indicates that there is no relationship between asset returns.
[16] VaR is calculated by taking the differences between each number in the price history and the mean, squaring the differences and dividing them by the number of values in the set.
