Fidelity's Bitcoin investment report helps you understand the reasons behind mainstream financial institutions' increased Bitcoin holdings

PayPal's support for digital asset transactions and Singapore's DBS Bank's preparation for a digital asset trading platform were announced in the same month, showing that mainstream financial institutions are interested in Bitcoin. In an environment where listed companies' stock valuations are high, bond yields are low, and wealth is shifting to millennials, people's interest in alternative investment solutions is growing.

In late October, Fidelity Digital Assets, a subsidiary of traditional asset management giant Fidelity Group, released the report " Bitcoin Investment Theory: Bitcoin's Role as an Alternative Investment ", which detailed the reasons for allocating funds to Bitcoin and pointed out that Bitcoin's native digital assets will not be affected by the economic impact of the new crown pneumonia epidemic. If Bitcoin only occupies 5% of the alternative investment market, the market size of Bitcoin will expand to US$670 billion.

The report has attracted a lot of attention in the traditional investment market. Lianwen has selected and translated most of the content of the report for readers.

Written by: Ria Bhutoria, Director of Research, Fidelity Digital Assets Translated by: Perry Wang

01
Count down the reasons why traditional investors allocate funds to Bitcoin

Some Bitcoin holders have similar reasons for allocating funds to Bitcoin as they do to alternative investments . In addition, with the Federal Reserve (and many other central banks) cutting their benchmark interest rates to zero (or even below zero) this year, interest in Bitcoin and other non-yielding alternative investments may also increase. In a world where global benchmark interest rates are close to, equal to, or even below zero , the opportunity cost of not allocating funds to Bitcoin is higher .

Most people over-allocate their capital to bonds. Funds cannot all be invested in the stock market. People initially started out to outperform inflation. Some of the funds that flowed out of bonds were absorbed by Bitcoin, which is a natural result.

Cathie Wood, the head of ARK Invest, is known as the "female version of Buffett"

Portfolio Diversification

Although Bitcoin has been correlated with the performance of traditional assets over shorter periods of time, few assets have been able to remain uncorrelated with traditional assets over longer periods of time (e.g., months or years) like Bitcoin. Therefore, investors looking to rebalance their portfolios should evaluate the effectiveness and impact of an allocation to Bitcoin to determine whether Bitcoin can play a role in a multi-asset portfolio.

I consider Bitcoin to be my safest asset. It is a store of value with low or even zero negative returns.

Elisabeth Préfontaine, founder of Octonomics, a fintech research, consulting and advisory firm

From January 2015 to September 2020, Bitcoin’s positive correlation with other assets (as shown in the table below) averaged 0.11, indicating that there is little correlation between Bitcoin returns and other assets. The “correlation index” we refer to has a value ranging from -1 to 1, with a correlation of 1 indicating a perfect positive correlation, meaning that the two variables move completely together. A correlation of -1 means a perfect negative correlation, with the two variables moving in opposite directions. A value of zero (no correlation at all) or close to zero means that there is no correlation between the variables.

Low correlation is an encouraging sign for evaluating alternative investments through portfolio diversification tools. It is also important to explore why Bitcoin’s correlation with traditional assets is low and whether it will continue to be this way :

1. Different return and risk factors : The factors that explain Bitcoin’s returns are different from those that drive returns in other asset classes.

2. The value narrative is constantly evolving : There are various narratives about what people expect Bitcoin to be and what it will do in the future. Bitcoin’s changing narrative can explain why Bitcoin is not correlated with other assets.

3. Greater overlap between market participants : Bitcoin is a young asset that has only recently been unlocked by traditional markets. Bitcoin is slowly being integrated into institutional portfolios, so the connection with other assets may become closer and closer.

4. Retail-driven phenomenon : Bitcoin is unusual as an asset because it was first favored by retail investors, and then institutional investors became interested in it.

Different return and risk factors

Alternative investments can generate returns that differ from traditional assets and carry unusual risk exposures. A study conducted by Yale University economists Aleh Tsyvinski and Yukun Liu examined whether the returns of digital assets ( specifically Bitcoin BTC, Ethereum ETH and Ripple XRP) are similar to the returns of other asset classes (stocks, traditional currencies and precious metals). According to their research analysis, the return behavior of all digital assets (including Bitcoin) cannot be explained by the risk factors that explain the returns of stocks, currencies or precious metals, nor can it be explained by macroeconomic factors such as non-durable consumption growth, durable consumption growth, industrial production growth and personal income growth.

Instead, the two economists found that Bitcoin’s performance was driven by “ cryptocurrency-specific factors ,” such as momentum (inertia) effects, as well as average and negative proxies for investor attention.

The momentum effect refers to the tendency that if an asset is rising, its value is likely to continue to grow. This is consistent with the view that Bitcoin is self-reflexive , with a self-reinforcing effect on its price and sentiment. The second factor that influences Bitcoin's price is investor attention , which is measured by the number of tweets about "Bitcoin" in Twitter and Google search data series (for example, if Bitcoin mentions are unusually high, the asset value will increase) .

Figure: Bitcoin 30-day price and sentiment rolling changes

It is important to note that the factors that drive returns on digital assets such as Bitcoin may change as digital assets mature. For example, historically, Bitcoin blockchain performance has not been correlated to changes in fundamental metrics of Bitcoin price . We believe that " fundamentals " in the context of digital assets refer to information, indicators, and models that provide insight into the health and growth of digital assets and networks. Those who closely follow digital assets know that the performance of digital assets is not always determined by "fundamentals" due to high levels of speculation and sentiment-driven trading activity. Over time, as investors and market participants' analysis and Bitcoin market participation behavior develop, its price performance may become more correlated to "fundamentals" and less correlated to reflexivity and emotion.

Global investor sentiment will certainly affect the price of Bitcoin, but Bitcoin has unique fundamentals that are not affected by the health and economic conditions caused by the COVID-19 pandemic (for example, there has not been any contraction in Bitcoin's cash flow or production) .

Demand shocks (decreased consumer demand for goods and services due to lockdowns and job losses) , supply shocks (constrained production or supply chain shutdowns) , and the subsequent policy responses by governments and central banks (quantitative easing and record low interest rates) have direct, fundamentally negative effects on equities and fixed income, commodities, and fiat currencies. On the other hand, declining profitability or production, or increases in money supply, do not directly impact Bitcoin’s fundamentals and utility. On the contrary, these headwinds may increase the attractiveness of investing in Bitcoin , and investors are indeed watching closely.

For me, Bitcoin is the only thing that I've seen so far that is not at all tied to government decision-making processes and decision-making bodies, because at the end of the day, any other asset class, like stocks, debt, real estate, commodities, they are all tightly tied to the legislative framework , the intertwined interactions in the financial markets, which allow many governments to act in this way to intervene together.

Chamath Palihapitiya, founder of venture capital firm Social Capital

Publicly traded MicroStrategy (MSTR) has included Bitcoin in its portfolio for the first time due to its unique risk/return characteristics. In August 2020, the company announced plans to use Bitcoin as a treasury reserve asset. In its second-quarter financial report, MicroStrategy detailed a new capital allocation strategy that includes plans to invest no more than $250 million in one or more alternative assets. These may include stocks, bonds, commodities such as gold, digital assets such as Bitcoin, or other asset types with excess free cash flow.

It is worth noting that MicroStrategy chose to invest all $250 million in Bitcoin in August 2020, buying a total of 21,454 Bitcoins, and added another $175 million in September 2020 to invest in 16,796 Bitcoins, totaling 38,250 Bitcoins , which is worth about $425 million at current prices. MicroStrategy's reasons for this move are the economic and public health crisis, unprecedented economic stimulus measures, global political and economic uncertainty, and the risks of storing too much free cash flow in the form of fiat currency or in the form of assets commonly used by corporate finances.

We believe that these and other factors combined are likely to have a significant depreciating impact on the long-term real value of fiat currencies and many other conventional assets, including many types traditionally held as corporate assets. We find Bitcoin’s global acceptance, brand awareness, ecosystem vitality, network dominance, architectural resilience, technical utility, and community spirit to be persuasive evidence of its strength as a long-term store of value asset class.

Michael Saylor, Founder and CEO, MicroStrategy

The evolving value narrative

Another angle to Bitcoin’s lack of correlation with traditional assets is the lack of a consensus value narrative . One of the reasons we started this series of research reports is to explore the dynamic narrative of Bitcoin. At any given time period, Bitcoin’s value narrative varies from a means of payment, a reserve currency for digital assets, a store of value asset, or a portfolio optimization tool. The lack of consensus on this issue may be an important reason why Bitcoin has not traded in line with other assets so far.

If there is still a lack of consensus on Bitcoin’s value narrative, then it may continue to be uncorrelated with all other assets. On the other hand, if Bitcoin’s value narrative converges on a single thesis, then its price trajectory may also converge with other assets with similar investment value.

Jeff Dorman, chief investment officer at digital asset manager Arca, made it clear in our conversation that changes in the value narrative around an asset can determine its behavioral trajectory and relevance.

Correlations are often driven by value narratives. Often based on people’s expectations . If Bitcoin’s value narrative starts to become more consistent, then Bitcoin’s correlation with certain asset classes could rise.

Jeff Dorman, Chief Investment Officer, Arca

The most compelling value narrative this year is that Bitcoin is an emerging store of value asset . We discussed this theory in detail in a report, Bitcoin as an Aspirational Store of Value. Recently, Bitcoin's price trajectory has been erratic, with prices moving in sync with different asset classes on a weekly basis. However, more and more market participants are allocating funds to Bitcoin due to its bullish long-term potential. Interestingly, Bitcoin's 60-day correlation with gold reached a record high in early September due to concerns about real interest rates and inflation.

Figure: Bitcoin 60-day correlation with gold and S&P 500

While this is a noteworthy development, it is debatable whether the Bitcoin/gold correlation will hold up in the long run. In the past, Bitcoin has seen brief spikes in correlation with specific assets , including gold and stocks , but the relationship has broken down over longer periods of time .

Greater overlap between market participants

In the early days of Bitcoin, events and sentiment that affected traditional markets had little impact on the Bitcoin market. Bitcoin’s trading infrastructure was completely independent of traditional market infrastructure, and Bitcoin’s ability to react in real time to current events that affected traditional markets was limited because Bitcoin trading was not integrated into traditional market infrastructure.

As the infrastructure matures, participants in the Bitcoin market and traditional markets begin to overlap . Institutional investors can trade Bitcoin futures and options on the same platform where they trade derivatives of other assets (e.g., CME, Bakkt) . Retail investors can buy and sell Bitcoin on certain platforms that allow them to trade stocks (e.g., Robinhood, Square Cash) . As Bitcoin matures and the coverage of Bitcoin market participants expands to include more participants from traditional markets, Bitcoin may become more correlated (positively or negatively correlated) with other assets.

Retail investor driven phenomenon

As more institutions allocate funds to Bitcoin, this group of investors will certainly have a greater impact on the Bitcoin market. However, there is reason to believe that the influence of retail investors will continue.

Bitcoin started out as a retail asset and continues to attract the attention of many retail investors. One potential proxy for retail investor interest is the number of addresses holding less than 10 Bitcoins (although there is no way to be sure that all of them belong to retail investors) . As shown in the chart below, the number of addresses holding less than 10 Bitcoins has been steadily increasing. In fact, when plotting the month-over-month changes, we can see that the month-end count change in the number of addresses holding less than 10 Bitcoins has only been negative seven times since January 2012.

Figure: Number of addresses holding less than 10 Bitcoins

Figure: Monthly changes in the number of addresses holding less than 10 Bitcoins

Retail and institutional investors may behave differently, which could be another factor contributing to Bitcoin’s lack of correlation with other assets, most of which are driven by institutional sentiment .

We can look at evidence of retail and institutional investor behavior during the March 2020 market dive. Companies that cater primarily to retail investors, such as Coinbase, River Financial, and Sipex, reported record-breaking retail buying of Bitcoin at a time when traders and institutional investors were unwinding their Bitcoin positions. Coinbase said its retail trading desk saw a significant increase in cash and crypto deposits, new user registrations, and total trading volume within 48 hours of the sell-off, compared to the 12-month average. Coinbase also emphasized that the majority of retail users active during this period were buyers.

However, the extent of the market downturn suggests that even with many retail holders, the level of Bitcoin held by non-retail holders is much higher. In the chart below, we demonstrate that the total number of Bitcoins held by addresses with <1 Bitcoin is approximately 5% of the current supply (18.5 million) . While this number is low, the number of Bitcoins in addresses with <1 Bitcoin has been rising .

Figure: Number of Bitcoins owned by addresses with holdings < 1 Bitcoin (in native units)

We are also beginning to witness an era of retail resurgence in traditional markets, driven by the rise of zero-fee trading at major brokerages and the proliferation of easy-to-use trading platforms – a trend highlighted by CoinShares Chief Strategy Officer Meltem Demirors in his conversation with us. The channels that retail investors rely on for financial information and advice are also shifting to social platforms such as Twitter, Reddit, Telegram, YouTube and Tik Tok, where information spreads more virally and much faster than traditional closed channels. Bitcoin adoption has been and will continue to be driven by the aforementioned platforms, explaining the connection between Bitcoin price performance and the buzz in the aforementioned social media. As a new wave of retail investors become familiar with these channels, some of their attention will undoubtedly flow to Bitcoin and other digital assets .

What is unique about Bitcoin is that it is driven by retail investors . Financial media and the way people consume investment information are changing, with influencers getting more attention than institutions. This is happening against the backdrop of a massive generational wealth transfer . As wealth and power shift from older to younger generations, Bitcoin is the first asset to multiply in value by capitalizing on the shift in the narrative of value we create and consume investments.

Meltem Demirors, Chief Strategy Officer, CoinShares

02
Increased revenue

Acceptance of Bitcoin in institutional portfolios today can be compared to the inclusion of emerging and frontier market equities in portfolios in the late 1980s and early 1990s. At the time, resistance to the inclusion of emerging market equities came from concerns about factors such as volatility and liquidity. However, over time, investors recognized the growth rates of these markets, as well as the low correlation between developing and developed market equities. As of 2018, emerging and frontier market equities (approximately $5 trillion) accounted for approximately 11% of the global investable equity market (US$43 trillion) .

Emerging market stocks were not considered worth investing in at the time. There were such short-sighted people everywhere in the United States. A similar analogy can be made now. At the time, allocating 1% to emerging market stocks was considered an experiment. Bitcoin can be incorporated into this line of thought.

Cathie Wood, the head of ARK Invest, is known as the "female version of Buffett"

Bitcoin’s current market cap is $197 billion (as of October 7, 2020) . This total value is a drop in the bucket compared to the traditional markets that Bitcoin could disrupt (e.g., store of value, alternative investments, settlement networks) .

Let’s take alternative investments as an example. According to the Chartered Alternative Investment Analysts Association (CAIA), the size of the alternative investment market was $13.4 trillion in 2018 (12% of the $116 trillion global investable market) . According to CAIA, if Bitcoin can capture 5% of the alternative investment market , it would be equivalent to an increase of $670 billion in its market size. If it can capture 10% of the market, that would expand its market size to $1.3 trillion .

We can also consider the impact of Bitcoin diverting some of the potential flows away from fixed income markets as investors desperately search for yield and returns. As Cathie Wood and Chamath Palihapitiya have highlighted, as central banks around the world cut benchmark interest rates to near, at, or even below zero, interest in alternative investments such as Bitcoin and other digital assets is likely to increase.

The traditional way to invest for retirement is 60% stocks and 40% bonds. If your goal is to get a 10% return per year, you can do it in the 80s, 90s and 00s. Not anymore… now bonds are at zero . So will a 40% return go to zero? What do we put in place of bonds?

One idea might be to increase exposure to alternative assets . Cryptocurrencies, cars, art, baseball cards, etc. Most people have 0-5% in alternatives. If bonds continue to pay zero interest, that may change...it's just math.

Chamath Palihapitiya, founder of venture capital firm Social Capital

Data released by the CAIA Association shows that the size of non-US dollar and US dollar bonds was US$50.3 trillion in 2018. If 1% of bond investments (measured by CAIA values) flow into Bitcoin, it is equivalent to an increase of US$500 billion in Bitcoin's market value.

Although a simplified algorithm, the purpose of this hypothesis is to study the potential asymmetric upside potential of Bitcoin, which, in addition to its lack of historical correlation with other assets, may also be an attractive factor for investors.

Bundled Together

Traditional institutional participation in Bitcoin is at its highest level to date. As Bitcoin becomes more intertwined with traditional markets , external events could have an increasing impact on Bitcoin, especially if Bitcoin’s value narrative converges on a single use case. In other words, given this underlying trend, if Bitcoin becomes more correlated with certain assets, the portfolio diversification benefits of Bitcoin relative to certain assets could decline.

But fundamentally, Bitcoin is not subject to the long-term economic headwinds that other assets may face in the coming months and years. Combined with its multi-layered value narrative, continued retail investment interest, and the interesting impact of growing institutional sentiment, it could become a potentially useful and uncorrelated addition to investors' toolkit.

Incremental benefits

In order to obtain higher returns and diversification effects from certain conventional alternative investments, investors usually have to accept certain limitations, such as reduced liquidity, limited accessibility, and high fees. Bitcoin allows holders to supplement their illiquid alternative investments with another liquid, accessible, and low-fee asset, thereby providing similar benefits in the portfolio.

1. Liquidity . Bitcoin is traded 24/7, with large volumes (from $200 million to $12.4 billion per day as of July 2020) , relatively easy to enter and exit, inexpensive, and with easy-to-observe returns. Depending on how Bitcoin exposure is obtained, there are no lock-in restrictions that prevent it from being sold immediately. Bitcoin can provide investors with the flexibility to meet unforeseen liquidity needs, make short-term tactical decisions, and rebalance portfolios.

2. Accessibility . Access to certain alternative investments is also limited. The most lucrative alternative investment options (e.g., venture capital and private equity, real estate, art, and collectibles) may be reserved for the largest institutional investors. Bitcoin is unique because its accessibility is very democratized. While certain entry and exit ramps restrict access (e.g., only to people in a given area or those willing to undergo customer identity verification KYC) , Bitcoin itself is not divided into different levels based on the background or geographic location of the investor. Anyone with a mobile phone or computer and an internet connection can publicly access Bitcoin.

3. Low fees . Alternative investments may be accompanied by fees that reduce investors' net returns, such as management fees and performance fees. The only fees associated with direct Bitcoin investment are transaction costs and asset custody costs using third-party custody providers. In addition, similar to natural resources such as oil or commodities such as gold, Bitcoin also has a considerable futures and options market , and investors can use Bitcoin futures to replicate "physical" exposure to Bitcoin.

03
Impact on Traditional Investment Portfolios

So far, we have discussed the qualitative explanations behind the rationale for considering an allocation to Bitcoin, and we have also shown the quantitative impact of including Bitcoin in a portfolio from a historical perspective.

From January 2015 to September 2020, an allocation to Bitcoin in a traditional 60/40 equity and fixed income portfolio, rebalancing assets quarterly, would have improved risk-adjusted returns, as measured by the Sharpe ratio, by as much as 34% . The portfolio with the highest allocation to Bitcoin (3%) had an annualized return that was 341 basis points higher. While the Bitcoin portfolio was also more volatile, the increase in volatility was significantly lower compared to the increase in returns. Surprisingly, the maximum drawdown (the maximum loss a portfolio experienced from peak to trough in a given period) was also slightly lower for all portfolios with Bitcoin exposure.

In the chart below, we summarize the impact of different allocations to Bitcoin on the annualized return and cumulative excess return, annualized volatility, and risk-adjusted return of the portfolio, depending on the investment period (as of the present time in 2020, and no longer than 5 years)*, where all holding periods are until September 2020.

We evaluate the impact of a 1%, 2%, and 3% allocation to Bitcoin within a 60/40 equity and fixed income portfolio. We use the iShares MSCI ACWI ETF (lACWI) fund, which includes developed and emerging market stocks, as a proxy for global stocks . We use the Vanguard Total Bond Market ETF (BND) as a proxy for the USD-denominated bond market. We use data from the Fidelity Bitcoin Index to indicate Bitcoin in the portfolio. The index starts on December 31, 2014, which is why our analysis starts at the beginning of 2015.

We use a total return calculation, assuming all dividends are reinvested. However, expenses associated with building and maintaining the portfolio are not deducted in our hypothetical analysis. Bitcoin gains are not accounted for from hard forks or airdrops. The portfolio is assumed to be rebalanced on a quarterly basis.

Figure: Portfolio summary indicators (January 2015 to September 2020)

For all time periods shown here (through September 2020) , the annualized return of the portfolio allocated to Bitcoin exceeded the return of the portfolio not allocated to Bitcoin . As we mentioned earlier, the volatility of the portfolio allocated to Bitcoin also increased, but the increase was less than the increase in returns, resulting in risk-adjusted returns increasing with the increase in Bitcoin exposure.

04
Summarize

It could be beneficial if investors view Bitcoin as part of an alternative investment solution , as interest in alternative investment solutions is growing amid a climate of high valuations and low returns for listed companies, with the potential for funds to flow from fixed income assets to other asset classes.

Part of the reason for the lack of correlation between Bitcoin and other assets in the early days may be due to retail-driven markets , the separation of Bitcoin from traditional markets, and the lack of overlap between institutional participants in traditional and Bitcoin markets. The growing institutional investor base in the Bitcoin market may lead to an increasing correlation with other assets, depending on their value narrative for Bitcoin.

But there are reasons why Bitcoin can continue to serve as a portfolio diversifier and return enhancer . Notably, the factors that explain Bitcoin's returns are different from those that explain returns in other asset classes. Bitcoin's fundamentals are relatively immune to the economic impact of the COVID-19 pandemic because its function is not based on profitability or production volume, and Bitcoin is natively digital . Bitcoin is also unique in that it continues to be influenced by retail investor sentiment and can take advantage of changes in how retail investors interact with traditional markets and how they obtain consumer financial information, as well as the transfer of wealth to millennials over the next decade.

Our report explores the reasons why investors believe Bitcoin can play a similar role as other alternative investments in their portfolios. A simpler explanation is that Bitcoin simply does not fit into an asset class (as Blockchain Capital general partner Spencer Bogart described it: Bitcoin is a platypus) . Bitcoin's value narrative is also dynamic, making it difficult to define (calling it an "alternative investment" is a simplistic approach).

Currently, Bitcoin is a very small asset class in terms of market size and trading volume, and is considered an independent asset class with a strategic portfolio allocation. However, as Bitcoin grows and matures, and investors understand its characteristics, Bitcoin, which is currently classified as an alternative investment , may gradually mature into an independent asset class. Independent and alternative are not necessarily mutually exclusive - depending on the investor, many independent asset classes (e.g., commodities, real estate, infrastructure) can be classified as alternative investments at the same time.

Adhering to conservatism and allocating to "new" institutional investment categories risks missing out on improved diversification and potentially missing out on early, generous first-mover returns .

Donald R. Chambers, CAIA, Keith H. Black, CFA, CAIA, Nelson J. Lacey, CFA

Risk warning : The content of this article is only the author’s personal opinion, does not represent the views or position of Zhikuang University, and does not constitute any investment opinion or recommendation.