Does Cryptocurrency Belong in Your Portfolio?

PETER MLADINA, Executive Director of Portfolio Research, Wealth Management
CHARLES GRANT, CFA, Director of Asset Allocation Research, Wealth Management

At the beginning of 2024, the Securities and Exchange Commission approved the first exchange-traded funds that own bitcoin. While this removes some of the stigma around bitcoin — particularly in the wake of recent high-profile cryptocurrency frauds and bankruptcies — does it justify a role for cryptocurrency in your investment portfolio?

Cryptocurrencies are based on the novel blockchain technology, which uses the encryption from cryptography to validate transactions and securely transfer and store assets. The blockchain technology can be used as a public ledger to record any transaction, but its first and best-known use was with cryptocurrency.

Cryptocurrencies are a type of money that differ from traditional currencies as they are digital in form and not issued by a government. They use the blockchain coding system to store, transfer and validate transactions. As of December 2023, there were more than 20,000 cryptocurrencies accounting for an estimated market value of $1.8 trillion, according to CoinMarketCap, a U.S. cryptocurrency data provider. However, the true market value is uncertain, as price manipulation through self-dealing transactions is not uncommon across many cryptocurrencies. Bitcoin is the dominant cryptocurrency representing approximately half of that estimated market value. It was launched in 2009 as the first implementation of blockchain technology. The estimated market value of cryptocurrencies is equal to about 1% of the market value of publicly-traded stocks and bonds, which constitute the majority of investment portfolio holdings.

Stocks and bonds are capital assets, deriving intrinsic value from the present value of their future cash flows. Because these future cash flows are uncertain, competitive financial markets price capital assets to have a positive expected return above a risk-free return. Commodities derive intrinsic value as fundamental inputs into the economy. The value of a diversified basket of commodities will appreciate at close to the rate of inflation over the long run. Currency is legal tender by government decree (i.e., fiat), legally requiring vendors and creditors to accept payment in dollars (or euros, yen, etc.). The values of major fiat currencies are managed to baskets of goods and services by central banks — connecting their value to the real economy. This legal privilege, when accompanied by sound central-bank policy, is the source of their intrinsic value. Art and collectibles offer rare beauty and historical significance. Bitcoin and other cryptocurrencies have none of these qualities. Their value is highly speculative. The absence of a clear source of intrinsic value likely explains their high volatility: Nobody really knows what they should be worth.

At Northern Trust, portfolios are composed of capital assets to generate a positive expected return. We divide capital assets into risk-control or risk-asset subportfolios based on their primary risk-factor exposures. The return of risk-control assets, such as cash and high-grade bonds, is driven by maturity-related interest rate risk (term risk). Their role is to control total portfolio risk with uncorrelated and more stable periodic returns, and to secure high-priority goals. The return of equities and equity-like return-seeking risk assets is driven by market risk. Their role is to maximize diversified return, and to fund long-term and aspirational goals. When combined, these building blocks also provide robust diversification. Using this analytical framework, we can now explore whether cryptocurrency has a role as either a risk-control or risk asset in a diversified portfolio.

CRYPTOCURRENCY IS NOT A RISK-CONTROL ASSET

VOLATILITY RISK

Money has three functions: It serves as a store of value, unit of account, and medium of exchange. While cash plays an important role in a portfolio’s risk-control allocation, bitcoin and other cryptocurrencies are an unsuitable replacement.

Cash is currency and it makes up part of the risk-control allocation. The most common use for cash is as a convenient and legally binding way to settle a financial obligation. Individuals and institutions in the United States are legally required to accept dollars, but not bitcoin or other cryptocurrencies. As a result, only a small percentage of online vendors and brick and mortar businesses accept payment in bitcoin.

Investor interest in bitcoin has been driven in part by its significant price movements, including a 156% increase in 2023, recovering some of its -76% drawdown from November 2021 to November 2022.

Bitcoin Price and Returns on Bitfinex (as of 12/31/2023)

(Source: Bitcoinity)

Bitcoin Annualized Return and Standard Deviation

While the price increase has attracted investors, its dramatic price swings violate the store-of-value function for a currency as measured by the annual variation in exchange rates of a currency. Bitcoin’s price has had a volatility risk (standard deviation) of 68% from 2013, when it began trading on the largest cryptocurrency exchange, Bitfinex, to December 2023. Over the same period, the volatility of the Federal Reserve’s trade-weighted U.S. dollar index was just 5%. Although bitcoin’s volatility has come down more recently, it is still very high and similar in magnitude to the risk of venture capital. The SEC noted this contradiction between the return and its role as currency when it stated to the U.S. Senate that cryptocurrencies are primarily “being promoted as investment opportunities,” with their use as a medium of exchange “a distinct secondary characteristic.” High volatility disqualifies cryptocurrency as a risk-control asset. Additionally, goods and services are rarely priced in bitcoin, so it is not used as a unit of account. And goods and services are rarely purchased directly with bitcoin, so it is not used as a medium of exchange. In short, it does not have the attributes of a functional currency.

STRUCTURAL RISKS

Despite the encryption provided by blockchain technology, massive cryptocurrency frauds have occurred. More than a quarter of all 2023 cryptocurrency thefts occurred on exchanges, according to blockchain data platform Chainalysis. Digital wallets, especially those maintained by exchanges, have been the source for the largest attacks. The first and largest bitcoin exchange, Mt. Gox, collapsed in 2014 after losing $500 million of customer money to hackers.

Exchanges themselves also continue to be centers of illicit activity. In 2022, exchange customers lost more than $9 billion in the collapse of FTX. And in 2023, Binance, the largest global exchange, paid $4 billion in a settlement with the U.S. government surrounding violations including money laundering and other crimes. Although the instant and irreversible nature of the blockchain protects transactions, it is also the reason criminals target and keep much of their fraudulently gained bitcoins.

The structure of a cryptocurrency can also put investor capital at risk. While stablecoins are structured to maintain a constant $1 value, in 2022 the stablecoin Terra became worthless, losing $18 billion in investor capital when its stable algorithm failed. The loss of Terra led to a run on interest-earning cryptocurrency deposits at New Jersey-based cryptocurrency platform Celsius Network Ltd. The company filed for bankruptcy when it could not repay $4 billion in deposits it had misappropriated. The elevated risk of fraud and other catastrophic loss also disqualifies cryptocurrency as a risk-control asset.

CRYPTOCURRENCY IS NOT A RISK ASSET

The role of risk assets is to maximize diversified return. But cryptocurrencies are not capital assets, so they have no economic source of positive expected return. As previously noted, bitcoin has had a standard deviation of 68% since 2013, and it has not been meaningfully correlated to any of the risk-asset classes such as global public equities, high-yield bonds or alternative investments. Based on portfolio optimization tests of bitcoin with other risk-asset classes, we find that bitcoin’s uncorrelated returns do not sufficiently compensate for a speculative expected return with high volatility to achieve a weight within the risk-asset subportfolio. Cryptocurrencies do not qualify as a discrete asset class within the risk-asset allocation, though they might be held within the alternative investments allocation along with other exotic assets and trading strategies.

Investors can now purchase exchange-traded products that directly own bitcoin and are regulated by the SEC. Bitcoin futures are available to investors who don’t want direct bitcoin ownership or want to hedge their bitcoin exposure. The futures are financially settled requiring no physical ownership and are regulated by the Commodity Futures Trading Commission.

While there is no doubt that historical bitcoin returns have been phenomenal, investors should be cautious. In addition to lacking a clear source of intrinsic value, investors who aim to speculate in bitcoin should consider the risk that accompanies various forms of ownership.