Portfolio Insights – Cryptocurrency

This is the second article in a series where I go through components of the model portfolio constructed targeting a 16% annual return. Here, I discuss the role of cryptocurrencies in my portfolio. Other articles featuring the other components of this model portfolio comprising a bond/fixed income, equities, a global macro-quant fund, and venture capital will be released in time to come. Read the first article on an FX Fund I invested in here.

TL;DR – There is an increasing validation by major institutions that cryptocurrency (or at the very least, bitcoin) plays a part in an investment portfolio. Research based on actual figures and bitcoin’s historical returns and volatility show that you can optimize and increase the efficiency of a portfolio by adding a 3-5% allocation into bitcoin. Accessibility has improved tremendously in the last 5 years, and initial risks of security are alleviated with more and more custodianship solutions. As part of asset allocation, exposing a 3-5% of your portfolio to cryptocurrency is a balanced way to capture the potential (unknown) upside, yet controlling your downside risk. I am personally invested.

The rise of bitcoin in the later part of 2020 has generated some healthy conversation of whether one should (and if so, how to) invest in cryptocurrency. I’ve been vested in cryptocurrency for a while now, and for those who have followed my personal updates, would have known that I made calls to add to your cryptocurrency positions sometime in Q4 2019, after some price movements suggested that interest in the market was regaining.

Pat on the back: anyone who had invested then would have made an easy 1.5-2.5x return now.

In fact, I’ve been articulating a wider adoption of this since early 2017 for those who have a higher risk appetite, although admittedly, times were a bit different then.

This article is set out in two parts. The first part is for the theoretical investor, and is intended to aid understanding as to how adding cryptocurrency in a portfolio actually improves the efficiency and returns of a portfolio. If you want to be responsible, you need to know exactly how and why cryptocurrency is increasingly becoming a more and more investible asset.

If that isn’t your thing, you can skip to the second part of this article which is for the practical investor, where I’ve set out my preferred platforms and strategies in managing my cryptocurrency portfolio.

Part 1 – Cryptocurrency in a portfolio

As previously stressed, investments really only make sense if you can evaluate them against the over-arching context of modern portfolio theory (“MPT”). As I set out in the first article of this series, the key thing about MPT, or plainly put, portfolio management, is the decision to invest across a stream of financial tools, in order to reduce your risks yet still maintain the ability to achieve the targeted return. The principle can be simplified as this:

It is better to invest in 2 instruments (assuming equally), 1 with a return of 10% and another with a return of 20%, then to invest in a single instrument potentially returning 15%.

Of course, this is a gross simplification and it is a lot more complicated than that, but once you apply at least a framework of this, you realize that you have a lot more freedom to allocate your resources in each investment class.  

The case for cryptocurrency in a portfolio can be summarized in this sentence: Adding a small allocation (3-5%) of cryptocurrency into your portfolio increases the potential return at a greater factor than the risk added.

There are multiple studies and research papers on the numbers at play in relation to a generic portfolio, and studies from 2016-2020 have all yielded a similar conclusion:

You can refer to the source articles above for a bit more deep-dive on the numbers so I won’t be doing that here, but there are 2 key points I want to highlight to support this position:

1. First, note that the sharpe ratio of a portfolio actually increases when you add a small allocation into cryptocurrency. What this means, to put it very simply, is that every “unit” of risk is giving you more return. You can read more about what the sharpe ratio is all about here.
2. Second, note that the portfolio’s US market correlation actually falls. What this means is that by adding cryptocurrency, your portfolio becomes less subject to the US Market’s performance.

This is really the starting point of the justification to add cryptocurrency in your investment portfolio – because cryptocurrency has historically been uncorrelated with traditional assets, you can include them to build a portfolio with a higher risk-adjusted return.

To be frank, all this tells you is that from a numerical statistical and portfolio asset management perspective, there is a defensible case to add cryptocurrency into your portfolio. The next step in this analysis would then be to investigate the possible investment themes behind this instrument, as well as its sustainability.

To really understand the investment theme behind cryptocurrency, I would strongly suggest reading this article by Lyn Alden. It’s one of the better articles I’ve come across because it takes a very reasonable outlook with some objective observations. Together with this article, here are four broad developing trends as to why I think cryptocurrency has going for it as an asset class:

1. History – 10 years is not long, but after 10 years, bitcoin still exists
2. Institutional adoption – most recent in 2020, but increasingly, you see more and more institutions adopting cryptocurrency as part of their investment portfolios. More importantly, you see an ecosystem of institutions (eg. custodianships) slowly developing
3. Law – more and more regulatory bodies and governments are coming out and taking a position on the existence (and hence regulation) of cryptocurrency
4. Government recognition – more countries are developing their own versions of “cryptocurrency”

This is a trend which cannot be ignored. The case that cryptocurrency is going to have some legs in our economy is getting clearer and clearer. From a risk-reward analysis and management of my portfolio, it only makes sense to me to expose my portfolio to this (while at the same time controlling my risk exposure).

Part 2 – how to invest

In order to access the world of cryptocurrency in what I think is the most convenient and safe way, it would be good to have the following:

1. A USD based account (holding fiat currency)
2. A crypto-fiat platform account, where you can acquire cryptocurrency with your USD (and which accepts transfers from your USD-based account)
3. A crypto-crypto platform account, to trade between cryptocurrencies
4. A “cold” (offline) wallet
5. (Optional) A derivative-crypto platform account

The above could be all offered by a single platform, but I’ve generally used separate platforms because of lower fees (for example, my crypto-crypto platform account allows me to purchase crypto with fiat but only with credit cards, and I don’t like paying the extra fees on using my credit card).

Here are my preferred service providers:

1. I use Gemini to acquire cryptocurrency. I generally like it because it offers me the lowest fees by allowing me to transfer USD straight from my fiat bank account.
2. I use Binance for my crypto to crypto trading. I like binance because of the large number of currency pairs it offers, and it’s been one of the most reliable exchanges in terms of protecting against hacking events and addressing these problems.
3. I use the S nano ledger for my cold wallet. To quickly summarize, any cryptocurrency you don’t plan on actively trading should be stored on a cold wallet, as this greatly minimize any chance of hacking. Read more about cold wallets here.
4. Lastly, for more interesting derivative dealing (including what I think is really one of the easiest ways to get exposed to Defi investment), I use Matrixport.

PS. The links above are all my affiliate links – you get a little something and I get a little something when you do sign-up, so if it’s not too much trouble and this has been helpful so far, it’ll be great if you can sign-up through those links.

Now that you are all set up and ready to jump into the world of cryptocurrency, I want to cover three ways you can get exposure and operate your cryptocurrency portfolio. This will depend on your familiarity, understanding, investment theme/outlook on cryptocurrency and ultimately, your preferred style of managing your money. I personally use a combination of all three in managing my own portfolio.

First, you can simply be a hodler; buy some bitcoin and generally be a less active investor. This is perfect for more beginner investors, and all you have to do is to rebalance your portfolio occasionally, as you would have done for every asset class. I started off being a hodler, holding some of my bitcoin inactively from 2011 till maybe about 2017.

Second, once you get a bit more comfortable in understanding the market, you can then trade the range. Bitcoin is as the highest market cap cryptocurrency often trades in a 1500 bound, and this pattern has repeated for a while. If you look at the year 2020 for example, the May to September period (before the explosive rise) saw bitcoin ranging within two 1500 channels, from about 8200 – 9700, and then from 10,500 – 12,000.

Third, once you get even more comfortable in knowing how to place your trades and your trading style, consider using derivative instruments to automate your buying and selling strategy. I use Matrixport’s (effectively) put and call options to automate my buying, and earn additional interest in the event it doesn’t hit the option’s strike price:

In the example below, you could for example, set an automated buy for $17,000 within 5 days, and earn an AY of 23.36% in the event the strike price is not met.

A fourth way, which I also use Matrixport for, is to take part in decentralised finance (“Defi”) yield farming. I won’t go into the details here, but in short, this is another way to “juice” your returns if you want to earn extra yield on your cryptocurrency holdings. I commonly use this when largely for my stable coin holdings, while waiting for suitable moves to take in the interim.

See for example – an easy 8-10% AY on a portion of my USDC holdings

So that’s a beginner’s introduction to the introducing cryptocurrency into your portfolio.

Some final and concluding thoughts.

There is a lot of speculation as to what the price of bitcoin/cryptocurrency can reach. If you look through the internet, you will see calls for bitcoin reaching $100,000 (or even more).

To me, this is ultimately still speculation. The potential for cryptocurrency to bring about a difference in how we think about money as concept is true. However, whether or not this eventually reaches the stage of mass adoption is a bigger question with world-changing implications. Any overly zealous believer preaching that cryptocurrency is going to moon is, at the end of the day…overly zealous.

A responsible investor would continue to keep exposed to cryptocurrency, and continue to revisit the investment theme behind adding cryptocurrency in one’s portfolio. Maybe, one day, it will reach those prices. But until then, there’s nothing wrong in taking a more cautious, prudent, calculated view based on actual hard numbers in dealing with cryptocurrency.