Does Crypto Deserve a Place in Portfolio Construction?
JPMorgan
2024-12-05Crypto’s appeal has largely been its alpha generation potential, but even here challenges persist. While Bitcoin’s returns have been impressive, they’ve come with extraordinary volatility, four times that of the S&P 500.
Bitcoin has staged a remarkable rally this year, doubling in price to nearly $100,000. As of today, it is near an all-time high. The drivers behind this rally have changed over the course of 2024: at the start of the year, momentum was fueled by the SEC’s approval of spot Bitcoin ETFs, allowing investors to gain exposure to Bitcoin without having to purchase or store it directly, a milestone in the institutionalization of the industry. More recently, Bitcoin has surged in the aftermath of the U.S. elections, up 40% in roughly a month. Excitement has been fueled by hopes of more favorable policy toward cryptocurrencies: the current SEC Chair, a long-time critic of crypto, announced that he would step down when the President-elect takes office, paving the way for Congress to establish a legal framework for crypto and further increase the industry’s legitimacy.
With Bitcoin and other cryptocurrencies now as close to “mainstream” as ever, many investors are asking: does crypto deserve a place in portfolio construction? Unfortunately, while the remarkable returns this year are hard to ignore, determining how or where crypto fits into strategic asset allocation is far from straightforward. To evaluate crypto’s potential role, it is helpful to first assess its success as currency. Here it falls short: it is neither an effective store of value (as evidenced by the incredible price appreciation) nor an effective medium of exchange (it is rarely accepted in retail transactions and while a legal framework might help to ameliorate this, the volatility of most crypto tokens will still keep merchants wary). It is therefore better to think of crypto as an asset.
As an asset, crypto is best thought of as an “alternative”, and therefore it is helpful to determine its ability to fulfill the typical roles of alternatives in portfolios: income (e.g., infrastructure), diversification (e.g., hedge funds) or alpha generation (e.g., private equity). Against the first two criteria cryptocurrencies again fall short. Most crypto assets, including Bitcoin, generate no income and Bitcoin in particular has been a poor diversifier: its three-year rolling correlations with stocks and bonds are both positive, as most cryptocurrencies have behaved like risk assets with hyper-sensitivity to interest rates since 2020. Crypto’s appeal has largely been its alpha generation potential, but even here challenges persist. While Bitcoin’s returns have been impressive, they’ve come with extraordinary volatility, four times that of the S&P 500. Moreover, unlike Bitcoin, equities are driven by predictable fundamentals, such as revenue and earnings growth, which analysts can forecast to estimate future performance. This makes them more reliable for long-term investment goals.
That said, one area where cryptocurrency does potentially have value is in the foundational innovation that underpins the asset: blockchain technology. At its core, a blockchain is a database, but one that makes significant improvements to the existing “rows and columns” method of storing information: it does not require intermediaries to function (which, for example, allows individuals to transfer assets digitally without the use of a third-party, like a bank) and it is extremely secure (the “crypto” in “cryptocurrency” refers to the cryptography that is used to secure transactions and verify the identities of users). For more promising blockchains, tokens can therefore be thought of as ownership stakes, since utilizing a blockchain requires transacting in its token.
Given these realities, the role of crypto in portfolio construction is mostly a function of risk tolerance. Cryptocurrencies are inherently unpredictable: there is little visibility into future price movements and blockchain technology, while exciting, also has few barriers to entry, meaning tokens can become obsolete (and therefore worthless) as new ones enter the market with improved functionality. As a result, for most investors, any allocation to crypto in a portfolio should be kept both small enough to ensure that even in the event of a significant sell-off it does not derail overall portfolio objectives and well diversified.
Crypto has failed to act as a portfolio diversifier
Source: J.P. Morgan Asset Management.
