Originally conceived as a digital, encrypted alternative to traditional currencies controlled by central banks, bitcoin has also been attracting more interest from mainstream investors.
Amy Arnott, portfolio strategist for Morningstar, looks at the arguments in favour of bitcoin as an investment, and shares the reasons she continues to be skeptical.
The case for Bitcoin
Bitcoin proponents often argue that because only 21 million bitcoins can ever be mined, a permanently limited supply should support its value.
It’s often viewed as an alternative to gold, which also has a limited supply but has a more definable intrinsic worth because it’s used for jewellery, industrial applications, and as a tangible store of value.
Cryptocurrencies like bitcoin could potentially benefit from increased demand for secure international transactions, low-cost banking, and anonymous micropayments or general-purpose payments. The network effect also comes into play with bitcoin, as growth in usage should (theoretically) increase its value at an exponential rate.
Bitcoin’s limited supply also makes it a potential hedge against long-term inflationary pressures. With the Federal Reserve printing money at an unprecedented rate, the market is currently pricing in a 5-year breakeven inflation rate of 2.18%, which would be higher than the unusually benign inflation we’ve seen in recent years. Bitcoin has often (though not always) historically had a negative correlation with the U.S. dollar, which started losing ground in March 2020 after a generally strong upward trend over the previous decade.
Bitcoin’s future value partly depends on widespread acceptance and usage as an alternative currency. Unlike traditional currencies, it’s not controlled by central governments. In that sense, it’s the ultimate insurance policy against weakness in the U.S. dollar or a collapse in mainstream financial systems.
The case against Bitcoin
As a virtual asset that doesn’t generate cash flows, bitcoin has no intrinsic value. Its value depends largely on what people are willing to pay. When Guggenheim’s Scott Minerd was quoted in December 2020 claiming bitcoin could be worth as much as $400,000, bitcoin prices quickly escalated. But without a strong foundation to support an underlying value, asset prices can rapidly drop.
That’s exactly what happened in 2018, when the CMBI Bitcoin TR index dropped 74%. More recently, bitcoin’s price shed nearly 30% from its peak on January 8 until briefly dropping below $30,000 on January 27, 2021. Even intra-day pricing tends toward the extreme, with prices often swinging by double-digit percentages within the same trading day. These sharp price moves mean bitcoin owners must be prepared to “HODL”--hold on for dear life.
Bitcoin is often described as digital gold, but it hasn't held up particularly well during periods of market crisis. In the fourth quarter of 2018, for example, bitcoin lost about 44% of its value, compared with about 14% for the broader market. When the novel coronavirus roiled the market from Feb. 19 through March 23, 2020, bitcoin lost about 38%, compared with 34.5% for Morningstar's U.S. Market index. During weeks when the overall equity market posted negative total returns (over the period from August 2010 through the end of 2020), bitcoin notched positive results only about half of the time.
As mentioned above, bitcoin proponents often argue that limited supply should create a floor for bitcoin’s value. But while the supply of bitcoin itself is limited, there’s nothing preventing competing cryptocurrencies from emerging. There are already numerous bitcoin alternatives available, including Ethereum, Litecoin, Cardano, Bitcoin Cash, and Lumens, to name a few.
Role in a portfolio
I looked at the impact of adding different percentages of bitcoin to an all-equity portfolio.
- 3-year period ended December 31, 2020: Higher returns more than offset the added volatility.
Over this trailing 3-year period, bitcoin’s meteoric rise could lead to a simple conclusion: The more, the better.
Bitcoin showed more than four times as much volatility (as measured by standard deviation) as equity market indexes over the period. But because of its low correlation with the equity market, adding bitcoin didn’t increase volatility all that much. Even a 10% bitcoin weighting would have increased the portfolio’s standard deviation by a fairly moderate amount.
Sharpe ratios increased in tandem with higher weightings in bitcoin.
- 10-year period ended December 31, 2020: One of the most volatile assets.
Bitcoin’s standard deviation was more than 15 times that of the equity market, making it among the most-volatile assets in Morningstar’s database of 35,000-plus market indexes. Both risk and returns increased with larger bitcoin weightings. Even a 1% weighting would have led to a sharp increase in standard deviation compared with an all-equity portfolio, as well as significantly worse drawdowns.
As mainstream investors increasingly embrace bitcoin, its value as a diversification tool is diminishing; as a result, there’s no guarantee that adding bitcoin will improve a portfolio’s risk-adjusted returns, especially to the same extent it did in the past.
Our research over the past 36 months has shown that bitcoin has had fairly low correlations with most major asset classes over the past three years. Correlations have been trending up, though. In 2020, for example, bitcoin had a correlation coefficient of 0.68 versus the S&P 500, compared with 0.32 for the trailing three-year period.
However, its negative correlation with the U.S. dollar has grown even more pronounced, making it a potentially valuable hedge against continued softness in the greenback.
I am skeptical about the case for bitcoin as an investment asset.
While it is nearly impossible to pin down what its underlying value should be, its popularity with momentum investors and speculative buyers makes it prone to pricing bubbles that will eventually burst.
Much of bitcoin’s eye-popping 10-year record owes to an off-the-charts runup from 2011 through 2013, when the CMBI Bitcoin TR index posted annualized returns of more than 1,000% per year, including a gain of more than 5,300% in 2013 alone. These gains may not be repeatable, partly because trading volumes in bitcoin have increased nearly 3,000-fold since 2014.
On the positive side, volatility has significantly decreased, although bitcoin’s standard deviation remains more than four times higher than that of the broader equity market.
However, there are some compelling arguments in favour of bitcoin as an alternative currency and as a commodity that can help support new technologies, such as smart contracts and more-efficient financial transactions with built-in encryption. For that reason, bitcoin is probably best used in (very) small doses as a hedge against weakness in the dollar and major disruptions in the global financial system.
