Is Bitcoin Finally Settling In To Be A Useful Diversifier?

An update on Bitcoin's volatility.

I've long been intrigued with cryptocurrencies (not an early adopter by any means though) and whether the space can evolve into some sort of portfolio diversifier that I can use for clients. I had a short term trade (just a couple of weeks) in the Grayscale Bitcoin Trust (GBTC) in the middle of it's parabolic run late last year that worked out well and have just been watching since then.

In trying to assess any potential value as a diversifier, here is a two year chart comparing Bitcoin to the euro/US dollar pair and the S&P 500. I'm including EURUSD in the chart because proponents view Bitcoin as a potential currency.

Potential utility as a currency makes no sense to me with that kind of historical volatility profile. Matt Hougan wrote a research paper back in Q1 of this year showing the diversification benefit of varying percentages of Bitcoin exposure in an otherwise traditional portfolio (meaning a 60/40 portfolio). The numbers are of course compelling, otherwise why publish it? The period studied obviously includes that parabolic run up along with a decent chunk of the decline that started last December. I would not be comfortable adding an asset for diversification purposes based on data that included a run like that. Either those returns are not repeatable in which case the data has no forward looking value or those returns will repeat which I would argue would be impossible to model. To get Matt's report, click here, scroll to the bottom and click on The Case For Crypto In An Institutional Portfolio.

Looking toward the right side of the chart though, the volatility appears to be ratcheting down. A segment on Bloomberg TV noted the series of lower highs along with the fact that the $6000 level has thus far held. That TV segment noted that $6000 might be holding because that is the cost to mine Bitcoin. Here is a three month chart that isolates the relatively lower volatility.

The action of the last few months is a big step toward utility as a diversifier. I think it needs to log some time in a narrower range to then provide data to study. In regard to equities I've said before that the S&P 500 is less likely to drop 50% after it just dropped 50%. I would be less confident in saying that about Bitcoin but maybe, after dropping by 2/3rds it much less likely to drop by 2/3rds.

When I first started writing about Bitcoin I included the thought that there's nothing wrong with putting 1-2% in. If it goes to zero you would not be sent back to the drawing board and if it actually grew into a life changing piece of money that you should sell it and let it change your life.

There is still no ETF for Bitcoin. GBTC is a trust that looks more like a closed end fund. The proposed Bitcoin ETF believed to have the best shot for approval now is one from Van Eck that would price around $200,000 per share (a dollar figure relevant to the term accredited investor). The latest news appears to be that the CFTC has deemed cryptocurrencies as commodities. This could actually make it easier to launch Bitcoin ETFs.

One nagging concern I have with Bitcoin that I have not seen addressed by anyone is that there is nothing to prevent all of the positive attributes associated with Bitcoin from accruing to some yet to be created cryptocurrency. The barriers to entry appear to be very low, so why not some other crypto? A more widely discussed concern is the number of hacks or other thefts that have occurred. While I can attribute this to it being early days in the evolution of whatever is to come, nonetheless if you put $2000 into Bitcoin that then grew to $100,000 that then got stolen at Mt. Gox then you have a real problem, you've been seriously impacted and future security enhancements won't help you.

One final concern that the end user must come to grips with is that there is no oversight of Bitcoin and nothing underlying it. Critics would tell you this is essentially the definition of the greater fool theory. Proponents point to these as favorable attributes, no government involvement means that cryptos are not fiat currencies whose buying power can be eroded by inflationary government/central bank policies.

This post is simply an update on my following the space. If cryptocurrencies do become more than a curiosity it makes sense to understand what they are and what their potential utility might be.

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