Interest in cryptocurrencies continues to grow. Last year, Fidelity conducted a survey of institutional investors and found that nearly 80% of respondents found digital assets appealing.1 This past summer, a survey of 100 hedge fund chief financial officers revealed expectations that over 7% of their assets will be invested in cryptocurrencies within the next five years.2 More recently, Bakkt, a well-known custodian and exchange of digital assets, conducted a similar survey of more than 2,000 consumers across the U.S. and found that nearly half of all respondents had invested in cryptocurrencies in 2021.3 Survey data can certainly be interpreted in various ways, but we believe that cryptocurrency adoption is increasing. Therefore, understanding the potential risks and opportunities of adding cryptocurrencies to a broader portfolio is becoming more important.
In our May 12, 2021 report titled “The investment rationale for cryptocurrencies”, we noted that we consider cryptocurrencies to be alternative investments, specifically within the Macro hedge fund strategy. To quantify the impact of adding cryptocurrencies to a hedge fund portfolio, we compare some portfolio characteristics (below) of allocating between hedge funds and cryptocurrencies in different proportions over a four-year horizon. The analysis proxies hedge fund exposure using the HFRI Fund Weighted Composite Index, while cryptocurrencies are represented with the Bloomberg Galaxy Crypto Index.4 Rather than focusing on a single cryptocurrency or hedge fund, we used broader indices in an effort to diversify the exposures.
Incorporating crypto into a hedge fund allocation has historically produced a higher Sharpe ratio
Sources: MPI Stylus, Bloomberg, Wells Fargo Investment Institute. Analysis from September 2017 through July 2021. This table is hypothetical and for illustrative purposes only. It is not intended to represent an actual investment. Investments fluctuate with changes in market and economic conditions due to numerous factors some of which may be unpredictable. There can be no assurance any investment will increase in value. The index information is included to show general return data and is not intended to imply that an investment portfolio will be similar to the indices either in composition or element of risk. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and do not reflect deduction for fees, expenses or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Past performance is not a guarantee of future results.
See end of the report for index definition. Standard Deviation is a statistical measure of the volatility of a portfolio’s returns. The higher the standard deviation, the greater volatility has been. Sharpe ratio measures the additional return that an investor could expect to receive for accepting additional risk.
We believe that the results of this analysis are compelling. This hypothetical hedge fund portfolio produced an annualized return of 7.5%, an annualized standard deviation of 8.1%, and a Sharpe ratio of 0.75 from September 2017 through July 2021.7 This portfolio also experienced a maximum drawdown of -11.6% and had a high correlation (0.93) with the Russell 2000 Index.8
However, reducing the allocation to hedge funds by 5% and shifting that to cryptocurrencies (represented by the Bloomberg Galaxy Crypto Index) resulted in an annualized return that was nearly five percentage points higher per year, with only modestly higher volatility and roughly the same maximum drawdown compared to the Russell 2000 Index. Significantly higher returns with only slightly higher volatility resulted in a more efficient portfolio (compared to Russell 2000 Index), evident by the 22-point improvement in the Sharpe ratio, and implies that much of the volatility added was “good/up” volatility – in other words, there were swings higher in the cryptocurrency prices. Interestingly, the correlation to the Russell 2000 decreased by 20 points, which indicates that adding cryptocurrencies improved overall portfolio diversification as well. Of course past performance is not a guarantee of future results.
A 90% allocation to hedge funds combined with a 10% allocation to cryptocurrencies again resulted in a further decline in the correlation to the Russell 2000, a higher annualized return, as well as a higher annualized standard deviation. However, the maximum drawdown decreased more materially, and the improvement in Sharpe ratio was marginal. Above a 10% cryptocurrency allocation – again within the context of an overall hedge fund portfolio – witnessed a deterioration in Sharpe ratio, especially in that larger cryptocurrency allocations would have exposed the portfolio to comparatively higher cryptocurrency volatility and larger drawdowns over that period.
As of September 7, the Bloomberg Galaxy Crypto Index was up nearly 166% year-to-date, despite a nearly 60% drawdown over the summer. Simply put, though cryptocurrencies continue to mature as a new asset, they remain highly volatile. We favor modest position sizing for qualified investors. A 5% to 10% allocation to cryptocurrencies within the broader hedge fund allocation offered efficiency in recent history. This finding aligns with our preferences for cryptocurrency exposure, as described in our cryptocurrency investment rationale.
Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.