Transforming Portfolios: The Beneficial Effect of Cryptocurrencies
Colin Goh, Head of Trading at Halogen Capital
October 27, 2023
In hindsight, I can safely say that, if an investor held even a small amount of Bitcoin in his portfolio over the last 10 or even 5 years, he’d have outperformed many traditional investors that didn’t.
But even without the benefit of hindsight, having a passive allocation to cryptocurrency assets is consistent with modern investment management principles, which helps us at Halogen build resilient portfolios that perform well over the long run.
There's an old investing adage: "Don't put all your eggs in one basket." While the potential returns of a concentrated bet might be great, the risk of ruin is amplified many times too. After all, the number one rule of both trading and investing is to survive. No matter how great the potential returns, the consequences of bad luck (or bad decisions) can be costly.
This wisdom underpins the concepts of asset allocation and portfolio diversification, which are fundamental principles in finance and a cornerstone of Modern Portfolio Theory (MPT). And including cryptocurrencies in this framework is no different.
But first, what is Modern Portfolio Theory?
First introduced by Harry Markowitz back in the 1950s, MPT provides a framework for strategically allocating resources across different assets and asset classes. Diversification is applied by spreading investments across various assets. This reduces the portfolio’s overall risk exposure without compromising on the optimal return.
Correlations between investment assets is the key here. Holding less correlated assets means that if one dips, another might rise, buffering against market volatility. This way, an investor can construct optimal portfolios (so called efficient market portfolios) that maximise their return for a given level of risk taken.
The poster boy of MPT today is the ubiquitous 60/40 portfolio, consisting of a 60% allocation towards equities, and 40% towards bonds. As an investment portfolio, it has generally shown to provide superior risk adjusted returns compared to investing 100% in either asset class. Its simplicity and relative performance makes it an extremely popular investment portfolio.
What happens if you add cryptocurrencies into the mix?
First, let’s examine the performance of a traditional 60/40 portfolio in its most popular implementation - a diversified portfolio for US investment products. For our equity benchmark, we’ll use the Vanguard Total Stock Market Index Fund (VTI) and for our bond portfolio benchmark, we’ll use the iShares Core U.S. Aggregate Bond ETF (AGG).
As its name implies, the 60/40 portfolio will allocate 60% of its holdings to the VTI ETF, and 40% to the AGG ETF. Because the value of our investments fluctuate with price movements, the portfolio’s target weight allocation will also fluctuate accordingly. Hence, the portfolio will be rebalanced back to these weights at the end of every month to ensure we stay with our target allocation.
Here’s how the performance stacks up (sans rebalancing costs)  from the period of 3 January 2011 to 24 October 2023.
As expected, a 100% allocation to US equities would have provided an investor with the highest total return over the period examined. Fair enough; the US stock market experienced an unprecedented boom over this time thanks to a liquidity led recovery post Global Financial Crisis 2008. Furthermore, the rise of the US tech giants in this period helped drive the broad market higher. 
However, just by eye-balling the chart, we see that the 60/40 portfolio performs decently well too, while experiencing much lower portfolio volatility over that same period. This is evidenced by the table of performance metrics, where the Sharpe ratio of the 60/40 portfolio is higher than either of the two benchmark ETFs.
The Sharpe ratio is a common measure of risk-adjusted returns - the higher, the better. It measures how much return your portfolio achieved for each unit of risk taken. From an investor’s perspective, risk-adjusted returns matter because not everyone has the same amount of risk tolerance. Higher volatility is accompanied by larger negative drawdowns from time to time, and some investors would rather not be exposed to that. In theory, you would feel more comfortable allocating a larger sum of your networth to portfolios with higher risk adjusted returns.
The 60/40 portfolio’s Sharpe is higher than the benchmarks despite having nearly equal weights between the two allocations. This is the principle of MPT at work, where (at least in the last 40 years), US equities have been loosely correlated with bonds. Balanced allocations to the two assets resulted in superior risk-adjusted returns precisely because of that.
As is commonly advised in investment literature though, past performance is not always indicative of future performance. The loose correlation between US stocks and bonds have been taken for granted in the low inflation QE era. But this was not always the case.
Going back even further in time, there were several periods where the correlation between the two asset classes were relatively high. For a more recent example, look no further than the last two years, where US interest rate volatility has weighed on the traditional 60/40 portfolio’s performance. Given that, there’s certainly value in looking for other diversifying measures in one’s portfolio.
So, what happens if you take the typical 60/40 portfolio, and modify it to include some cryptocurrency exposure?
We’ll use the same benchmarks and methodology as our naive 60/40 construction above, and include an allocation to Bitcoin in it. Given the recency of the asset class, we choose Bitcoin over other cryptocurrency assets as it has the most longevity and longest history. The period under observation has also been restricted to that in which we could reliably obtain data for (which was also the reason for the period chosen in the traditional 60/40 experiment above).
Despite the shorter data history, we should be able to adequately demonstrate how adding Bitcoin to an investment portfolio is consistent with modern investing principles. To appeal to the most conservative of sceptics, allocate 2% from the equity allocation to invest in Bitcoin (i.e. a 58/40/2 portfolio). We’ll also examine a slightly more aggressive allocation at 5% of Bitcoin instead (i.e. a 55/40/5 portfolio).
Here’s how the performance stacks up:
Amazingly, just allocating 2% of your portfolio towards Bitcoin, rebalanced monthly, produces a total return that mirrors a pure equity portfolio over the period, for much less risk. On a risk adjusted basis, the 58/40/2 portfolio vastly outperformed the traditional 60/40 portfolio, i.e. you would have gotten similar returns to a pure equity allocation by taking much less risk over the period. As a diversifier, Bitcoin’s addition has clearly had a positive effect despite the small allocation.
Meanwhile, the 5% allocation to BTC, despite being only 3% more than our previous portfolio, vastly outperformed even the equity benchmark, contributing higher total returns and producing a much higher Sharpe ratio.
Could it have been timing luck? Given Bitcoin’s exponential price growth in its early years, any investment in that part of the period examined would have helped the portfolio outperform tremendously. Let’s narrow the period under investigation to the start of 2018, in the midst of a cryptocurrency winter.
A pure equity portfolio outperformed all blended portfolios over this period on a total return basis, mainly due to the extreme outperformance of US tech stocks. On a risk adjusted basis though, while pure equity actually outperformed the traditional 60/40 portfolio, portfolios with Bitcoin allocations still came out on top. In fact, portfolios with Bitcoin allocations outperformed the traditional 60/40 portfolio as well on a total return basis.
How does this apply to us as Malaysian investors, the majority of whom earn in MYR?
Diversified portfolios are not unique to US based assets. Let’s perform this exercise in the Malaysian context. For our equity benchmark, we’ll use our local FTSE Bursa Malaysia KLCI ETF (0820EA)  and for our bond portfolio benchmark, we’ll use the ABF Malaysia Bond Index ETF (0800EA). We’ll examine the performance of the diversified portfolios over the same 5 year period.
Here’s how things stand:
It’s unfortunate that our local equity benchmark has not performed as well over the past 5, or even 10 years. While local bonds still show a net positive gain, they are far from the returns one can hope for. In fact, from this simple study we could actually conclude that the optimal mix for a diversified portfolio of Malaysian securities isn’t a 60/40 ratio of benchmark equities and bonds.
However, we can clearly see the positive effect of diversification with the inclusion of cryptocurrencies in our portfolio construction. As a whole, just a small allocation away from local equities towards Bitcoin has helped the portfolio improve significantly. It just wasn’t enough to offset the continued underperformance in local equities over this period.
Why does including an allocation to cryptocurrencies, even one as small as 2% of an investment portfolio, have such a magnified effect on both total returns and risk adjusted returns? Here are three main reasons.
The first is a historically low correlation to traditional financial markets. As a new asset class which hasn’t quite become mainstream yet, Bitcoin has generally enjoyed a low correlation with traditional risk assets like equities. In the context of MPT, adding Bitcoin to an investment portfolio has a great diversification effect. While this correlation has increased in recent years, both due to increasing adoption and the recent highly inflationary environment, Bitcoin still continues to see lower correlations to equity assets in general.
The second is due to a phenomenon called convexity. Like financial options or venture capital investments, the price of Bitcoin, especially in its early years, appreciated exponentially. Let’s say an investor invested 2% of his portfolio into Bitcoin at the start of 2011. If the price of Bitcoin went to zero the very next day, the investor would have been down 2% on his total portfolio. Unfortunate, but not the end of the world for our investor. However, Bitcoin’s price in USD terms is now nearly 100,000 times higher than it was at the start of 2011. Without doing anything, that 2% allocation alone would have increased the value of the entire portfolio nearly by nearly 2000%. That’s convexity at work, where the downside is capped, but the upside can be exponential. Hence, even though Bitcoin was such a small part of the portfolio, its contribution to the portfolio’s growth was significant.
The third is due to rebalancing. While it would have been great to not do anything and be up 100,000 times on an early Bitcoin investment, the future is unknown to all. There were times when Bitcoin saw significant drawdowns uncorrelated to the broad market, such as in 2017 to 2018, at which point an investor would likely question his investment logic. We manage this risk by rebalancing our portfolios, ensuring that our risk exposure to riskier assets is controlled. If a 2% allocation to Bitcoin ended up becoming a 10% allocation due to price appreciation of Bitcoin, rebalancing helps us take profit on that position, by selling the allocation down until it is back to 2% of the portfolio. Simultaneously, it then allocates those profits to the other, traditionally less risky instruments. That way, the portfolio enjoys some of the gains in BTC price, while also protecting it from the associated price volatility. The blended portfolio’s risk-adjusted returns are also preserved.
What This Means
The effect of cryptocurrencies in an investment portfolio, as a diversifying force and a convex return kicker, has been a positive one so far. Whether you believe in the potential of Bitcoin and cryptocurrencies or not, there should be no question that, over the past 12 years, a passive allocation towards cryptocurrencies as an asset class helped diversified long term portfolios outperform their more traditional counterparts. This is especially true if you are a Malaysian investor. Cryptocurrencies are diversifiers in terms of asset class, geographical exposure, and currency exposure to local risk assets.
Is cryptocurrency investing risky? Yes, we don’t deny that. Will Bitcoin and other major cryptocurrencies continue to act like convex instruments? Probably, though not to the extent that they did at inception. Will they continue to be good diversifiers to your portfolio? We do think so, though that also might change in the future.
Indeed, there’s a lot of uncertainty when investing in a new asset class. Ultimately though, we’ve shown that through prudent diversification via asset allocation, coupled with disciplined risk management, we can enjoy the upsides of investing in cryptocurrencies while mitigating the downsides.
If you are a local investor focused on Malaysian risk assets, here’s some final food for thought. This graph is the same model portfolio study using our local Malaysian benchmarks, starting from the 2011 period. Can we really afford not to look for alternatives?
Regardless, we hope you found this discourse insightful. If you wish to start your journey into cryptocurrency investing, and are interested in any of the asset allocation strategies discussed above, we here at Halogen are happy to help you get started.
 Rebalancing is done on a low frequency basis and only for the differences in asset weights, so excluding those costs should not inflate total performance materially. This is also a cross sectional study, so any ‘error’ is relatively consistent across portfolios.
 We note that the US equity market performance is disproportionately dominated by tech companies, though using VTI helps mitigate some of that effect as opposed to using an ETF like SPY.
 Admittedly, the FBMKLCI Index is less inclusive than the VTI ETF in terms of sector coverage, but it’s the most accessible vehicle to the average local investor.
Disclaimer : The information, analysis, and viewpoints presented here are intended solely for general informational purposes and should not be construed as personalised advice or recommendations for any specific individual or entity. For personalised investment decisions, investors are advised to consult their licensed financial professional advisor. The opinions expressed by the author are based on certain assumptions or prevailing market conditions, and they are subject to change without prior notice. This material is being distributed for informational purposes only and should not be regarded as investment advice or an endorsement of any particular security, strategy, or investment product. While the information provided herein may include data or opinions from sources believed to be reliable, its accuracy and completeness are not guaranteed. Reproduction of any part of this material in any form or reference to it in other publications is strictly prohibited without the express written permission from Halogen Capital Sdn Bhd. Halogen Capital Sdn Bhd and its employees assume no liability regarding the use of this material or its contents.