Modern Portfolio Theory and the Crypto Portfolio

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August 31, 2022

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Must Read

Today’s most important story for crypto investors.

The Peculiar Challenges of Crypto Regulation (Wall Street Journal): Jay Clayton, former head of the SEC, penned this useful commentary on crypto regulation where he drops five key insights:

Startup investing is mostly limited to rich folks, while "going public" is difficult and expensive for small companies. This means ordinary investors are locked out of most pre-IPO opportunities, which has fueled the market for funding companies through token offerings.

The "Uber strategy" (build a disruptive product, worry about regulation later) won't work for crypto. Companies need to worry about regulation now since investor money is at stake.

Crypto crosses regulatory agencies. There's no single regulatory body in the U.S. that can handle all the different use cases for crypto, so they've got to work together.

Crypto emerged globally at the ordinary investor level. This is the thing that has taken regulators most by surprise. Crypto didn't happen with banks or large institutions, but with investors like us all over the world.

Pro-crypto and pro-regulation peeps need to work together. We've got to find compromise. It's not all or nothing, but rather somewhere in between.

Investor takeaway: Clayton suggests the U.S. should regulate stablecoins first (which we've predicted will happen). What he does not recommend is sitting on our butts since China is already serious about crypto.

Modern Portfolio Theory and the Crypto Portfolio

by Preetam Kaushik

What is Modern Portfolio Theory?

Modern Portfolio Theory (MPT) was formulated in 1952 by noted economist and Nobel Prize winner Harry Markowitz. The theory focuses on risk-averse investors and the optimal strategies for them in a marketplace inherently filled with risk.

Markowitz created a framework for investors to maximize returns while simultaneously minimizing risk. This entailed the utilization of diverse portfolios where none of the assets are closely connected or related.

This diversification is at the core of MPT. However, it relies on two key assumptions:

Rational investors are generally risk-averse
Investments are either high risk/high reward or low risk/low reward

With an MPT framework, the focus is on choosing an optimal mix of assets to increase returns while keeping risk levels low (note MPT doesn't prohibit any investor from making high-risk investments; it seeks to balance out the risk).

MPT relies on the correlation between risk and return. If you want a higher rate of return, you should be willing to shoulder more risk in your portfolio. It is all a matter of adjusting the portfolio per your risk appetite/aversion.

MPT is less concerned with the performance of individual assets. Instead, the focus is on the expected performance of the entire portfolio, which is calculated on all the assets in the portfolio and proportionally weighted.

Sharpe Ratio (courtesy Wikipedia)

What is the Sharpe Ratio?

Like the MPT, the Sharpe Ratio was also developed by a Nobel Laureate in Economics. From the mind of William F. Sharpe, this tool is very important for portfolio managers seeking a balance between risk and returns using the MPT framework.

Created in 1966, the Sharpe Ratio is still extremely popular in financial circles due to its relative simplicity. It's designed to indicate how much extra return you stand to gain by exposing yourself to additional risk from the marketplace.

In the investment market, the closest thing you have to a risk-free asset is US government-issued treasury bonds and bills. If you invest all your money into these bills, you may have close to zero risk, but also low returns.

However, if you invest in more volatile assets with higher returns (i.e., stocks or crypto), you stand a chance to earn higher returns at the cost of increased risk. The Sharpe Ratio will indicate how well such an equity investment will perform compared to a similar allocation of funds in a risk-free investment.

The formula for the Sharpe Ratio looks like this:

Sharpe Ratio = (Rp – Rf)/σp

Rp is the return from the equity portfolio.

Rf is the return from a risk-free investment.

σp is the standard deviation of the excess return assets.

The Sharpe Ratio is displayed in decimal form like 0.87, 1.15, or 2.35. Here is what different Sharpe Ratios mean for your investment:

Below 1.0 is considered sub-optimal.
Between 1.0 and 2.0 is considered good or acceptable.
Above 2.0 is considered a very good investment.
Above 3.0 is considered exceptionally good.

The Sharpe Ratio is widely used to calculate the risk-return ratio by investors and portfolio managers. It can be used for:

Comparing different portfolios or funds
Analyzing the past performance of a fund/portfolio
Deciding if adding a new asset to the portfolio is worth the risk

MPT, Sharpe Ratio, and Cryptocurrencies

Cryptocurrencies, as investors well know, are characterized by high volatility and an often even higher rate of returns. Given the quantum of risk involved, the Modern Portfolio approach is critical in crypto investment decisions.

The Sharpe Ratio is extremely useful in this context since it measures the changes in risk vs. return balance whenever a new asset is added to a portfolio. Whether you are planning to optimize your crypto portfolio or add a crypto asset to your stock portfolio, the Sharpe Ratio could prove quite useful.

However, there are major caveats when using traditional analytics and tools in the relatively young sphere of crypto.

Tools like the Sharpe Ratio work best when you have abundant (and accurate) historical data. Ideally, you need data across at least one bull/bear cycle, more if possible. With the average length of a bull market being around 2.7 years and a bear market at 9.6 months, a cycle is roughly 3.6 years. Many cryptocurrencies have not even been around that long!

This leaves us with relatively older tokens like bitcoin (2009), Litecoin (2011), Ripple (2012), and Ethereum (2015) as the best options for Sharpe Ratio analysis. Of these, two cryptos stand out due to their excellent Sharpe Ratios: BTC and ETH.

Sharpe Ratio of Bitcoin and Ethereum

These two crypto assets are the highest-ranked based on market capitalization. In terms of risk vs. return, they are the assets that routinely go above 2.0 and even across 3.0 on occasion.

According to this table, the Sharpe Ratio of bitcoin has consistently stayed between 1.50 and a peak of 4.32 since 2013. The chart shows it performs better than any other asset including US stocks, US real estate, bonds, and even gold.

Here is a chart to represent the delta between bitcoin and these assets. It's based on data from November 2021, when BTC last hit a peak in a bull market:

Remember: higher = better.

Despite being a newer token, Ethereum has been outperforming bitcoin in recent years. While the former remains the top dog in the crypto market, some experts predict Ethereum will dethrone bitcoin as the most valuable crypto in the coming years due to its superior feature set, which includes faster transactions, a more diverse ecosystem, and smart contract support.

Ethereum routinely scored well above both the S&P 500 stocks and bitcoin several times in 2021:

Courtesy PortfoliosLab BTC and ETH reports

Crypto Portfolio Risk and Modern Portfolio Theory

The chart above also shows how volatile Ethereum can be when compared to the other two assets. Though it often brings the benefit of increased returns, the loss risk is also quite high across a bull-bear cycle.

Here is a quick look at the comparison of Sharpe Ratio and volatility across different percentages of bitcoin and Ethereum in portfolios:

Source: https://www.youtube.com/watch?v=TBkYlkGzOro

Based on these values, we can create three different portfolios under the Modern Portfolio Theory:

Low-Risk Portfolio: 65% BTC/35% ETH

According to the table, volatility is lowest when you have a higher proportion of bitcoin to Ethereum (roughly 65:35). Altcoins don't have a place in this portfolio due to the lack of data and hence higher risk exposure. Older cryptos like Litecoin are not worth considering because they either perform worse than bitcoin/Ethereum or bring additional risk.

Medium-Risk Portfolio: 70% ETH/30% BTC

There is quite a bit of headway in this space for tinkering depending on your stomach for risk exposure. Splitting the money evenly between bitcoin and Ethereum is a good starting point. Here, you can see the Sharpe Ratio pull ahead to 1.1 albeit at the cost of increasing volatility.

Investors interested in pushing for greater returns can consider flipping the allocation to 70% Ethereum, around 30% bitcoin, and maybe even a tiny 1% allocation to promising altcoins like Cardano or Solana. At this point, the SR reaches 1.2, with volatility climbing to 0.85.

High-Risk Portfolio: 95% ETH/5% BTC

It is for good reason that many investors use bitcoin as a crypto analog to gold. Historically, it is the safest bet in the blockchain market for long-term holdings. However, if you have a high tolerance for risk and an appetite for greater returns, you can consider allocating most of your investments to Ethereum.

At this point, bitcoin is relegated to a 5% stake, with altcoins given further attention in the hope of catching any positive runs in the future. Solana and Cardano are the best options right now, with high market capitalization and recent Sharpe Ratios in the high 2.0s and even exceeding 3.0 in some instances.

Limitations in MPT and Sharpe Ratio

Modern Portfolio Theory focuses heavily on variance, which measures the dispersion of volatility over time. However, two portfolios with the same variance levels can experience different types of losses:

One may see frequent, but smaller losses.
One may have rare losses of much greater magnitudes.

Rational investors would ideally pick the portfolio with smaller losses, but this aspect is not adequately represented in MPT. It requires a deeper study of downside risk, something MPT does not take into account.

Another huge weakness of MPT in the crypto market is the focus on historical data. This is a new market where data is still limited. We don’t have enough information to build forecasts with reasonable accuracy.

Similarly, Sharpe Ratio assumes a normal distribution of returns under standard deviation. However, in real-world financial markets and especially crypto markets, returns can be heavily skewed by high volatility and frequent drops and spikes in prices.

The ratio is also vulnerable to manipulation based on the selected datasets. Cherry-picking historical data can distort projections of risk-adjusted returns. A balanced dataset that represents multiple highs and lows in an asset’s performance history can help prevent this.

Investor Takeaway

The cryptocurrency market is still in its infancy, and there is plenty of time for it to evolve and mature. Theories and tools of portfolio management from traditional financial markets can apply to the novel world of crypto.

However, there are still significant limitations and hurdles, many of which are related to the unavailability of historical data. It will take at least a few years, if not a decade, for this situation to improve.

In the meantime, you can make judicious use of approaches like Modern Portfolio Management in crypto investing so long as you use high-quality data.

ICYMI