Although most have failed to recover fully from their deep drawdowns, they appear nevertheless to have benefited significantly from the simultaneous demand from investors for both riskier assets and safe havens.
Both these trends have been driven by the fall in real interest rates—the difference between nominal interest rates and inflation—on the back of trillions of dollars of asset purchases by central banks. This has caused shares, gold, silver, and safe-haven currencies such as the Swiss franc to rally. However, so far this year, Bitcoin has outperformed all these assets.
However, high volatility and large drawdowns on Bitcoin and other cryptocurrencies cast serious doubt on their suitability as a safe-haven asset. The growing correlation to other assets, if maintained, might also start to compromise their merits as portfolio diversifiers. As such, we think these assets should be viewed as speculative instruments rather than potential alternatives to safe havens or effective means of portfolio diversification.
Our analysis suggests the following observations:
1. Not suitable for standard risk profiles: An investor's risk tolerance must be high to tolerate potentially large losses. Trading-oriented investors might find appeal in such price swings, but our analysis shows that getting the timing wrong can result in destruction of capital.
2. Survivorship bias: Choosing the right cryptocurrency is of utmost importance; while Bitcoin has done fantastically well over a longer-term horizon, other cryptocurrencies have fared a lot worse. In our view, investors often focus on the performance of the winners, without taking into account the performance of the losers. Differentiating between the winners and the losers requires a good understanding of the demand and supply drivers of any given cryptocurrency.
3. The lack of dividend and coupon payments: The timing of investments in cryptocurrencies is of high relevance due to the combination of potentially sharp drawdowns and the lack of regular interest or dividend payments. Risk assets commonly experience large drawdowns, and without regular cash flows this can more easily result in a permanent loss of wealth.
4. Limited diversification benefits: Our Bitcoin back-test improved the returns of a portfolio given its high absolute returns and its low correlation to other asset classes. More recently, however, correlations have increased and returns declined, suggesting Bitcoin may now be less suitable as a portfolio diversifier.
For investors looking for a defensive tilt to their asset allocation, we recommend gold, investment strategies that exploit option-implied volatility to phase in market entry, and relative value positions, in addition to staying invested in a broadly diversified manner. We refer interested readers to UBS CIO's last monthly letter, The dog that didn't bark, Chief Investment Office GWM, 20 August 2020.
These strategies will admittedly not compete with another market frenzy in cryptocurrencies, but they appear very attractive when we look at expected, risk-adjusted returns. For investors who are aiming to preserve and grow their wealth over time, we think these solutions are more suitable than an investment in cryptocurrencies.
Main contributor: Michael Bolliger
For more, see Bitcoin and its siblings, an alternative to safe-haven assets? 9 September, 2020.