Can Cryptos Add Value to Traditional Portfolios?

With the increasing exposure to crypto in the investment space, many investors with traditional portfolios are showing interest in adding crypto.

But before investors take this route for either immediate returns or retirement planning, it’s essential to realize that crypto comes with a lot of volatility despite the potential for its high return.

What is Crypto Portfolio Allocation?

Portfolio allocation in crypto is the percentage of your portfolio dedicated to crypto. For instance, crypto investments could make up 20% of your portfolio.

Can Crypto Be Added to Traditional Portfolios?

To answer this question, you need to look at traditional portfolio allocation first.

  • Medium Risk: 60% equity / 40% bonds
  • Low Risk: 25% equity / 75% bonds

Risk allocation is the process by which an investor chooses how much risk they’re willing to tolerate, and then allocates their funds to different asset classes based on their respective risks. Low risk portfolios are more stable, but are unlikely to yield massive profits. Higher risk portfolios are more volatile but, with active management, can yield massive returns.

Most experts agree that crypto is a high-risk asset. However, someone who wants to invest in volatile asset classes can combine them with bonds (fixed income assets) to mitigate the volatility of crypto.

Suppose we modify the above medium risk portfolio by allocating  3% of the portfolio to crypto, taken from equity. The portfolio would then look like this:

  • Bonds – 40%
  • Crypto – 3%
  • Equity – 57%

The portfolio is rebalanced every three months so that it maintains these percentage splits as the market fluctuates. Rebalancing is a powerful tool used to stabilize portfolios that include high-risk assets.

How Can Crypto Benefit Traditional Portfolios?

Many traditional investors are curious about introducing crypto to their portfolios. Here are some of the benefits traditional investors can reap by introducing crypto to their portfolios:

Cryptos Diversify Portfolios

The major reason for investing in crypto is that it diversifies portfolios, which, counterintuitively, helps reduce risk, even though crypto itself is a high-risk asset.

Volatility of Crypto Doesn’t Affect Other Asset Classes

When you invest in crypto, there is always a risk that the value will drop suddenly, and you could lose money. However, this volatility doesn’t necessarily affect other asset classes in the portfolio.

For example, if you have a mix of stocks and crypto and the stock prices go down, the crypto prices could still go up. This is because the two asset classes are not linked.

Helps Recover from Draw Downs After a Crash

If there’s a dip in the stock market, the crypto prices may still be high, allowing investors to recover faster from market fluctuations, and vice-versa; if there’s a dip in the crypto market, stock prices may still be high.

Can Cryptos Add to Returns Without Dramatically Increasing the Risk?

Cryptocurrency can be added to a portfolio but with a warning that comes with high levels of volatility. For an investor who is comfortable with a medium level of risk, adding a small percentage (say, 5-10%) of their total portfolio to cryptocurrency could lead to good returns without overly compromising the stability of the portfolio as a whole.

Data shows that by moving a small portion of your total portfolio, usually a single-digit percentage, from equity to crypto, the performance of the portfolio can improve significantly.

It’s important to compare investments in crypto with similar risk profiles. For example, for investors who want a profile with lower than  5% annual risk or volatility, it’s best not to include crypto in your portfolio.

But for investors who can accept annual volatility of 10%, investing in crypto can yield terrific benefits.

Basic crypto investing revolves around buying Bitcoin and Ethereum since they’re the two largest and most well-known currencies.

If you’re looking to add a broader mix of cryptos to your portfolio, there are a few other things to consider:

  • Research which coins have the potential for growth and invest in those.
  • Consider investing in ICOs (initial coin offerings) as these offer opportunities to invest in new and innovative cryptos.
  • Be prepared to lose some money — with any investment, there’s always a potential for losses.

Risks to Consider for Adding Crypto to Traditional Portfolios

When attempting to create a crypto based traditional portfolio, you must keep two investment risks in mind.

Systematic risk refers to the risk in the market as a whole. For instance, if the economy takes a downturn and people stop spending money, it could affect how your investments perform. Since the crypto market is highly volatile, they are very susceptible to systematic risk.

Unsystematic risks refer to risks specific to a certain company or security. For example, a specific company might have financial troubles that could affect their stock price.

If you’re invested in a cryptocurrency, your investment could be affected by issues in the blockchain’s security or problems in the management of the coin or token. Blockchain-wide problems are an example of systematic risk, whereas issues with an individual coin or token are an example of unsystematic risk.

Conclusion

For investors who are willing to stomach the risks involved, adding a small percentage of crypto holdings may help to stabilize a portfolio’s overall performance and improve returns.

Qdeck is a cloud-based wealth management platform that uses machine learning and artificial intelligence to construct automatically-rebalancing portfolios for wealth advisors, RIAs, and wealth allocators. If you need an extra hand adding crypto to your traditional portfolio, the Qdeck platform can help.

DISCALIMERS:

Rotella Capital Management, Inc. (d/b/a Qdeck) (“RCM”) is a registered Commodity Trading Advisor with the Commodity Futures Trading Commission (“CFTC”) and a Member of the National Futures Association (“NFA”).

Investment in any RCM program is speculative and involves significant risk of loss. There can be no assurance that the programs will be able to realize its objectives. Programs may not be available in all jurisdictions, and investments may not be suitable for all investors. Information is subject to change without notice. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

RCM IS A MEMBER OF NFA AND IS SUBJECT TO NFA’S REGULATORY OVERSIGHT AND EXAMINATIONS. ROTELLA HAS ENGAGED OR MAY ENGAGE IN UNDERLYING OR SPOT VIRTUAL CURRENCY TRANSACTIONS IN A MANAGED ACCOUNT PROGRAM. ALTHOUGH NFA HAS JURISDICTION OVER RCM AND ITS MANAGED ACCOUNT PROGRAM, YOU SHOULD BE AWARE THAT NFA DOES NOT HAVE REGULATORY OVERSIGHT AUTHORITY FOR UNDERLYING OR SPOT MARKET VIRTUAL CURRENCY PRODUCTS OR TRANSACTIONS OR VIRTUAL CURRENCY EXCHANGES, CUSTODIANS OR MARKETS. YOU SHOULD ALSO BE AWARE THAT GIVEN CERTAIN MATERIAL CHARACTERISTICS OF THESE PRODUCTS, INCLUDING LACK OF A CENTRALIZED PRICING SOURCE AND THE OPAQUE NATURE OF THE VIRTUAL CURRENCY MARKET, THERE CURRENTLY IS NO SOUND OR ACCEPTABLE PRACTICE FOR NFA TO ADEQUATELY VERIFY THE OWNERSHIP AND CONTROL OF A VIRTUAL CURRENCY OR THE VALUATION ATTRIBUTED TO A VIRTUAL CURRENCY BY RCM.

Unique Features of Virtual Currencies. Virtual currencies are not legal tender in the United States and many question whether they have intrinsic value. The price of many virtual currencies is based on the agreement of the parties to a transaction. There are various risks associated with the unique features of virtual currencies, only some of which are explained herein. For instance, cryptocurrency exchanges have in the past been closed due to fraud, failure or security breaches. In many of these instances, the customers of such cryptocurrency exchanges were not compensated or made whole for the partial or complete losses of their account balances. Any of the assets that reside on a cryptocurrency exchange that shuts down may be lost.

Price Volatility. The price of a virtual currency is based on the perceived value of the virtual currency and subject to changes in sentiment, which make these products highly volatile. Certain virtual currencies have experienced daily price volatility of more than 50%. There are various risks associated with the extreme price volatility of virtual currencies and the possibility of rapid and substantial price movements, which could result in significant losses. For instance, the value of the Account relates directly to the value of the cryptocurrencies held directly or indirectly by the Account, and fluctuations in the price of cryptocurrencies could materially and adversely affect an investment in the Account. Several factors may affect the price of cryptocurrencies. Momentum pricing of cryptocurrencies may continue to result in speculation regarding future appreciation in the value of cryptocurrencies, inflating and making the market price of cryptocurrencies more volatile. As a result, cryptocurrencies may be more likely to fluctuate in value due to changing investor confidence in future appreciation or depreciation in the market price of cryptocurrencies.

Valuation and Liquidity. Virtual currencies can be traded through privately negotiated transactions and through numerous virtual currency exchanges and intermediaries around the world. The lack of a centralized pricing source poses a variety of valuation challenges. In addition, the dispersed liquidity may pose challenges for market participants trying to exit a position, particularly during periods of stress. In valuing virtual currency products, the Investment Manager will seek to take into account access to liquidity and the volatility of these markets. Liquidity risks are also major concern, as it may become difficult or impossible to retrieve funds that have been invested in cryptocurrencies. Client should be aware that there is no assurance that cryptocurrencies will maintain their long-term value in terms of future purchasing power or that the acceptance of cryptocurrency payments by mainstream retail merchants and commercial businesses will continue to grow. In the event that the price of cryptocurrencies declines, the Investment Manager expects the value of an investment in the Account to decline proportionately.

Cybersecurity. The cybersecurity risks of virtual currencies and related “wallets” or spot exchanges include hacking vulnerabilities and a risk that publicly distributed ledgers may not be immutable. A cybersecurity event could result in a substantial, immediate and irreversible loss for market participants that trade virtual currencies. Even a minor cybersecurity event in a virtual currency is likely to result in downward price pressure on that product and potentially other virtual currencies. Further, cryptocurrency transactions are irrevocable and stolen or incorrectly transferred cryptocurrencies may be irretrievable. Cryptocurrency transactions are not reversible without the consent and active participation of the recipient of the transaction. Once a transaction has been verified and recorded in a block that is added to the blockchain, an incorrect transfer of cryptocurrencies or a theft of cryptocurrencies generally will not be reversible and the Account may not be capable of seeking compensation for any such transfer or theft. As technological change occurs, the security threats to the Account’s cryptocurrencies will likely adapt and previously unknown threats may emerge. The Account’s and the cryptocurrency custodians’ ability to adopt technology in response to changing security needs or trends may pose a challenge to the safekeeping of the Account’s cryptocurrencies.

Opaque Spot Market. Virtual currency balances are generally maintained as an address on the blockchain and are accessed through private keys, which may be held by a market participant or a custodian. Although virtual currency transactions are typically publicly available on a blockchain or distributed ledger, the public address does not identify the controller, owner or holder of the private key. Unlike bank and brokerage accounts, virtual currency exchanges and custodians that hold virtual currencies do not always identify the owner. The opaque underlying or spot market poses asset verification challenges for market participants, regulators and auditors and gives rise to an increased risk of manipulation and fraud, including the potential for Ponzi schemes, bucket shops and pump and dump schemes. Cryptocurrencies are controllable only by the possessor of unique private keys relating to the addresses in which the cryptocurrencies are held. There is a risk that some or all of the Account’s cryptocurrencies could be lost, stolen or destroyed.

Virtual Currency Exchanges, Intermediaries and Custodians. Virtual currency exchanges, as well as other intermediaries, custodians and vendors used to facilitate virtual currency transactions, are relatively new and largely unregulated in both the United States and many foreign jurisdictions. Virtual currency exchanges generally purchase virtual currencies for their own account on the public ledger and allocate positions to customers through internal bookkeeping entries while maintaining exclusive control of the private keys. Under this structure, virtual currency exchanges collect large amounts of customer funds for the purpose of buying and holding virtual currencies on behalf of their customers. The opaque underlying spot market and lack of regulatory oversight creates a risk that a virtual currency exchange may not hold sufficient virtual currencies and funds to satisfy its obligations and that such deficiency may not be easily identified or discovered. In addition, many virtual currency exchanges have experienced significant outages, downtime, thefts and transaction processing delays and may have a higher level of operational risk than regulated futures or securities exchanges.

Regulatory Landscape. Virtual currencies currently face an uncertain regulatory landscape in the United States and many foreign jurisdictions. In the United States, virtual currencies are not subject to federal regulatory oversight but may be regulated by one or more state regulatory bodies. In addition, many virtual currency derivatives are regulated by the CFTC, and the SEC has cautioned that many initial coin offerings are likely to fall within the definition of a security and subject to U.S. securities laws. One or more jurisdictions may, in the future, adopt laws, regulations or directives that affect virtual currency networks and their users. Such laws, regulations or directives may impact the price of virtual currencies and their acceptance by users, merchants and service providers. It may be illegal, now or in the future, to own, hold, sell or use cryptocurrencies in one or more countries, including the United States. Although currently cryptocurrencies are generally either not regulated or lightly regulated in most countries, including the United States, one or more countries may take regulatory actions in the future that severely restrict the right to acquire, own, hold, sell or use cryptocurrencies or to exchange cryptocurrencies for fiat currency. Such an action may restrict the Account’s ability to hold or trade cryptocurrencies, and could result in termination and liquidation of the Account at a time that is disadvantageous to Client, or may adversely affect an investment in the Account.

Technology. The relatively new and rapidly evolving technology underlying virtual currencies introduces unique risks. For example, a unique private key is required to access, use or transfer a virtual currency on a blockchain or distributed ledger. The loss, theft or destruction of a private key may result in an irreversible loss. The ability to participate in forks could also have implications for investors. For example, a market participant holding a virtual currency position through a virtual currency exchange may be adversely impacted if the exchange does not allow its customers to participate in a fork that creates a new product. If an event should occur, the Account could be adversely affected by not being entitled to the benefits of such fork and the Account could be left holding a cryptocurrency that no longer has any value or a low value. The cryptocurrency network operates based on an open-source protocol maintained by the core developers of the cryptocurrency network and other contributors dedicated to cryptocurrency development. As the cryptocurrency network protocol is not sold and its use does not generate revenues for its development team. Consequently, there is a lack of financial incentive for developers to maintain or develop the cryptocurrency network and the core developers may lack the resources to adequately address emerging issues with the cryptocurrency network protocol. A disruption of the internet may affect cryptocurrency operations, which may adversely affect the cryptocurrency industry and an investment in the Account. Cryptocurrency networks’ functionality relies on the internet. A significant disruption of internet connectivity could prevent cryptocurrency networks’ functionality and operations until the internet disruption is resolved. Third parties may assert intellectual property claims relating to the operation of cryptocurrencies and their source code relating to the holding and transfer of such assets. Regardless of the merit of any intellectual property or other legal action, any threatened action that reduces confidence in a cryptocurrency network’s long-term viability or the ability of end-users to hold and transfer the relevant cryptocurrency may adversely affect the Account. Additionally, a successful intellectual property claim could prevent the Account from accessing the cryptocurrency network or holding or transferring their cryptocurrency, which could force the Account to terminate and liquidate the Account’s cryptocurrencies (if possible).

Transaction Fees. Many virtual currencies allow market participants to offer a fee. While not mandatory, a fee is generally necessary to ensure that a transaction is promptly recorded on a blockchain or distributed ledger. The amounts of these fees are subject to market forces and it is possible that the fees could increase substantially during a period of stress. In addition, virtual currency exchanges, wallet providers and other custodians may charge high fees relative to custodians in many other financial markets. As a result, these transaction fees may act to reduce and even eliminate any performance that has otherwise been achieved by the Account.

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