Will Bitcoin Ever Be a Fiduciary Asset?

Gold in fact has a somewhat negative correlation to equity, but even gold massively sells off whenever there is a real financial crisis (remember what happened in 2008).

According to anecdotal evidence, Bitcoin should be a diversifier. Our representation of BTC is the Bitcoin Investment Trust (GBTC), which is the main vehicle to invest in BTC for institutional investors (buying BTC directly is hindered by regulatory and technical difficulties).

Thus looking at correlations we conclude that BTC can serve as a moderately diversifying asset for the equity market, but the diversification is quite modest. Investing in gold seems like it should produce a better diversification effect as its correlation with the market is -.07.

However, BTC is also incredibly volatile. Indeed, the volatility of BTC is 8 times higher than the volatility of gold and the volatility of the market, which are roughly comparable. Thus investing in BTC carries significant risks of market losses compared to the risk that is involved investing in gold as a diversifying asset.

Interestingly, looking at the Sharpe ratio of BTC, it appears off-the-charts strong. The Sharpe ratio for BTC is 1.25 (Average return annualized return is 104%), and gold has a Sharpe ratio of 0.2. (This for the historical period of our time series from 2015-2017.)  

However, this is where we clearly hit a limit of usefulness for measures based on Modern Portfolio Theory, because BTC returns are very abnormal, while Sharpe ratio assumes an approximate normal distribution of returns and thus might significantly understate the risk of losses in BTC.

A recent event underscored the massive volatility inherent in Bitcoin investing. In July and August, we had multiple news about an emerging civil war in Bitcoin that was connected to a technical issue called the hard fork. Probably because of that, BTC had returns of +30% to -30% on a weekly basis between May 24 and June 14. Even with the volatility of 82%, these are a weekly 3-sigma event with normal distribution probability of less than 1%.

Diversifying assets should hedge the portfolio against possible market fluctuations. However, for institutional investors diversifying assets should also have a limited downside, otherwise the losses incurred may exceed any possible risk reduction.

For now, Bitcoin (like other cryptocurrencies) is a purely speculative investment into a fascinating technology.

There are other ways of diversifying assets without the nauseating volatility, such as gold and other alternative investments. Bitcoin is not a good fiduciary recommendation at the moment. However, with increasingly probable acceptance of Bitcoin as a financial asset for institutional investing, it could become a much more stable asset and its moderate correlation with equities would be a bonus. We are still some time away from that point in time.

— Yaacov Kapeliovich is currently a faculty member at the University of Connecticut. The above is his personal opinion and not a UConn position on the issue.