Grayscale analysts tell you: How to invest in Bitcoin?

In such a short week, the US regulatory landscape has experienced an active week. Binance CEO resigned and reached a settlement with the Department of Justice for more than $4 billion; the SEC is suing Kraken for operating as an unregistered exchange; and Bittrex Global announced its closure.

The battle for regulatory clarity appears to be well underway. As Bitcoin becomes the world's 11th largest financial asset by market cap, Grayscale's Zach Pandl walks us through Bitcoin in your portfolio.

Bitcoin and Your Portfolio

Bitcoin is a high-risk, high-return potential asset with a low correlation with stocks. Therefore, Grayscale Research believes that for many investors, the best portfolio should include a moderate allocation to Bitcoin.

Bitcoin is both a technological marvel and a huge, liquid, investable asset. While public blockchain technology can be difficult to understand due to its highly technical nature, the role Bitcoin and other crypto assets can play in a portfolio is fairly straightforward. The cryptocurrency market offers high risk/high reward potential assets that are not tightly correlated to stocks over a five-year period and can therefore be a useful component in constructing an optimal portfolio for risk-tolerant investors.

Building a diversified portfolio with respectable returns has become much more difficult. A classic 60/40 stock and bond portfolio will struggle to generate returns comparable to the past 40 years. We think valuations simply have no room to expand: equity multiples are already high, and the long bull market in bonds is over (due to the bottoming out of consumer price inflation). Stocks and bonds are also more correlated now, so investors get less diversification benefit by pairing them together. Public market opportunities are also shrinking: there are fewer IPOs and the number of public companies is down about 30% compared to the 90s.

To address these challenges, investors face a standard set of options (Exhibit 1). To improve the balance between risk and return in their portfolios, they can reallocate to asset classes that offer better risk-adjusted returns, lower correlations, or both. For example, in recent years, certain investors have increased their allocations to alternative investments, including illiquid private assets such as private equity and real estate. While this has been a successful approach, many individual investors do not have access to these types of instruments.

Chart 1: Traditional assets offer a standard risk/return trade-off…

Chart 2: … Cryptocurrencies have greatly expanded the available options

Crypto assets offer something truly different. From an asset allocation perspective, Bitcoin and other digital assets greatly expand the risk/return profile of public market investors (Exhibit 2). Bitcoin and other crypto assets such as Ethereum have high volatility and should be considered high risk. However, over time, they have generated returns commensurate with their risk profile. In other words, while Bitcoin has high volatility; its return to volatility ratio is roughly similar to other asset classes. Therefore, adding crypto assets to a portfolio can be viewed as taking additional investment risk in exchange for higher potential returns. Investors may consider substituting crypto assets for other high risk/high return assets such as technology stocks, non-U.S. stocks, and/or certain illiquid private investments to improve portfolio performance.

Despite the high historical returns generated by the crypto asset class, it is not highly correlated with other risk assets. For example, over the past five years, the correlation between Bitcoin and the S&P 500 was only 40%, while the correlation between the Nasdaq 100 and the S&P 500 was 90%. The low correlation with stocks means that a cryptocurrency allocation in a portfolio should provide greater diversification benefits than certain other risk assets.

Cryptocurrency is an emerging, young asset class and should be viewed as a relatively high-risk investment product. Bitcoin and other crypto assets may not be suitable for investors who have clear capital needs in the near future (e.g., within the next three to five years). For example, savings allocated for upcoming expenses related to college tuition or home purchase probably should not include a cryptocurrency allocation. Finally, investors who prioritize income from assets should consider other options.

However, for investors with relatively high risk tolerance, cryptocurrencies greatly expand the risk/reward opportunities available in the public markets. Due to the high return potential of these assets and their low correlation with other risk assets, for many investors, the optimal portfolio should include a modest allocation to cryptocurrencies.

Quick Questions and Answers

Q: What impact will the spot BTC ETF have on the price of Bitcoin?

Bitcoin is one of the few assets that can directly impact the price of an ETF. Since we know that Bitcoin has a limited supply — 21 million total available, 19.5 million mined — demand for spot ETFs will take up some of that supply, and as long as there is interest in the ETF, it must be held. It’s a supply and demand situation.

Q: The demand for ETFs may decline, so will the overall price of Bitcoin fall?

The approval of a spot BTC ETF could have cascading effects as it could symbolize a thawing of regulatory resistance to Bitcoin and cryptocurrencies as a whole. The SEC’s approval of a spot ETF would make it easier for institutions to accept Bitcoin investments. We may also see more providers allow Bitcoin as an investment option. Overall, demand for Bitcoin after approval could increase exponentially compared to the demand for spot ETFs.

Q: I can’t get my clients into Bitcoin right now. How can I get them some exposure until a spot ETF is approved?

There are ways to gain exposure to Bitcoin prior to approval while still keeping clients in regulated investments within their custodian and AUM. Please remember that we do not provide investment advice.

Some examples include:

GBTC — Grayscale Bitcoin Trust is trading at a small discount and could potentially convert to an ETF if other ETFs are approved. This means that customers who invest in the trust will receive a discount in addition to Bitcoin price appreciation.

Bitcoin mining stocks like Riot Blockchain and Marathon Digital are publicly traded companies that do nothing but mine Bitcoin. If the value of their product increases significantly, logic tells us their share prices should appreciate as well.

Coinbase — COIN is a public company that is both an exchange and a custodian, and will benefit from more interest in cryptocurrencies overall. They have a diversified revenue model, and the thawing of the regulatory stance helps them a lot.