Bridgewater & bitcoin

This note is written as a discussion/response to the recent bitcoin research piece by Bridgewater.

I have read the article by Ray Dalio and the Bridgewater team with great interest. It is an important voice about bitcoin and cryptocurrencies from one of the world’s premier asset managers and it is likely that it will help to legitimize this asset class in the eyes of institutional investors and their clients. My previous experience and analyses are in agreement with many parts of their analysis. There is the regulatory section, where I cannot provide perspective, as the situation substantially differs, depending on jurisdiction and investor or organization type. I decided to concentrate on several areas, where I thought my experience and analyses coming from nearly 10 years of investing in bitcoin may be of interest to the reader. Mr Dalio shared his thoughts on the topic in the introduction, and then deferred to his research/analytical team. I will, therefore, provide a perspective to and discussion of the main body of their research.

Before I start the main part of my commentary, I think it may be worthwhile to share some of my background, which may have influenced my thinking. I have been an investor in bitcoin since June 2011 and have co-founded a start-up in cryptocurrency area. This may have resulted in me having a pro-bitcoin bias. I have invested in precious metals since 2004 and have been a portfolio manager for several precious metal mutual funds in 2012-17. It is possible that I have a pro-precious metals bias. Discussions concerning bitcoin to some extent circle around it being a competitor to gold, so it is my hope that these two biases of mine largely cancel one another out.

Bridgewater team analyses the nature and future of bitcoin as a potential new asset class. I have decided to discuss these three areas:
1) Volatility
2) Liquidity
3) Bubble dynamics and speculation

1) Volatility
One of the main concerns of the Bridgewater team was that bitcoin remains an “extremely volatile asset”. I propose that, in fact:
A) bitcoin’s volatility, while high compared to other asset classes, “should” have been substantially higher in the past,
B) asset class volatility can be a neutral factor in many portfolio implementations,
C) in some portfolio implementations high volatility can be a positive factor and add to portfolio return and Sharpe ratio.

A) Bitcoin’s volatility has undoubtedly been nominally high when compared to other asset classes. Annualized volatility between September 2011 and January 2021 has been unusually high at 99%. This is more than six times higher than S&P 500’s volatility that was 16% over the same period. US Treasuries with 7–10 years to maturity were less volatile still – just 5.8%. However, any risky investment should be considered in conjunction with the return it provides(d). Bitcoin delivered annualized return of 157% over these 9+ years, which resulted in an exceptional Sharpe ratio of 1.58. Stocks have delivered a respectable SR of 0.76, while bonds a more modest SR of 0.16. Averages for most asset classes have been around 0.30-0.35 over the very long term. It is quite clear that holding bitcoin over the past 9 years has been an excellent proposition from a risk–adjusted standpoint, as much as 4.5 times better than long term averages recorded for other asset classes.

In this context, I do not consider bitcoin’s past volatility to be high. It could have been as much as 4x higher and it would still be a reasonable investment. 80% corrections in bitcoin are obviously painful, but admittedly they could have been much deeper. The question still remains concerning future expected returns and whether they will be high enough to compensate for the heightened volatility. It is certainly reasonable to expect bitcoin’s returns and Sharpe ratio to drop in the future towards levels typical for established asset classes. However, as it will be shown in point C), even in a scenario of zero price appreciation bitcoin can potentially be a valuable addition to diversified portfolios.

B) I feel a bit eerie writing this part in a response to Ray Dalio and the Bridgewater team. Ray was THE person that invented what was subsequently named Risk Parity and Bridgewater is running the biggest Risk Parity fund in the world. They helped to popularize the idea that assets should be evaluated based on the risk-adjusted basis and that investments characterized by both very high and very low realized and expected volatilities could be considered equals in a rational and well constructed portfolio. As Risk Parity’s universe is very wide and most implementations span government bonds and commodities, it is reasonable to assume that as of this moment the All Weather portfolio holds both the 2 year Treasuries and natural gas futures. The first asset class had an annualized volatility of 1.2% over the past year (as measured by the volatility of SHY ETF), while the second had the volatility of 58.4% (as measured by the volatility of UNG ETF). So, asset class with the highest volatility held by a Risk Parity fund can experience as much as 46 times (!) higher volatility than the asset class characterized by the lowest volatility. A wide asset class universe is similarly used by other asset managers, beyond Risk Parity implementations. In that light, adding bitcoin to a portfolio, with historical volatility of just 1.7 times higher than that of natural gas futures does not seem too extraordinary to me. Once an analysis is performed that takes into account portfolio assets’ historical and expected returns and volatilities as well as their correlations, it is quite reasonable to assume that assets with annualized volatilities of 1%, 10% or even 100% can be valuable additions. The exposure to each asset class could, obviously, be scaled by the inverse of expected volatility, which would make bitcoin’s share proportionately lower. An asset class does not have to be excluded just because its volatility is unusually high. To the contrary – there is one good reason to include it, as described in the following section.

C) It seems that it is still a relatively little-known fact, that there are portfolios in which the higher the volatility (ceteris paribus) – the better. For those who have not looked closely at the nature of the rebalancing return (RR) this may sound like a heresy. One reason RR is relatively unknown may stem from the fact that it is an insignificant part of returns in traditional portfolios consisting mostly of stocks and bonds. A portfolio consisting of 50% bonds (IEF ETF) and 50% cash would record a RR of just 0.01% over the past year, while in a portfolio with 50% of stocks (SPY) and 50% of cash RR would add 0.29% to its overall return. In contrast, rebalancing return would add as much as 7.8% annual return to a portfolio consisting of 50% bitcoin and 50% cash. The second reason is that for securities which receive return from income and/or growth, additional volatility is obviously an anathema – it “dilutes” the main sources of return and results in a lower Sharpe ratio. For instruments and portfolios that receive no income and have no growth component (such as commodities), rebalancing return is the only viable source of return.

So, how does RR work? One of the first systematic reviews of the topic was performed by Willam J. Bernstein in 1996 (Rebalancing Bonus: Theory and Practice). He provides the following equation for a portfolio of two assets:

 Where RR is rebalancing return, w1 and w2 are weights of the rebalanced securities, σ2 are their variances. σ1,2 is the covariance between the two. To simplify a bit, let’s assume we analyse a portfolio consisting solely of a single instrument and cash. We get:

As we see, rebalancing return is proportional to security’s variance. This means, that as volatility increases, Sharpe ratio INCREASES in direct proportion to volatility. Rebalancing return is also dependent on weights. The first two terms reach a maximum at 50%/50% weights, which is one reason why equally-weighted portfolios may be optimal in many implementations.

Let’s see how this works in practice. We will look at the impact of rebalancing return on two portfolios – one consisting of 50% bitcoin and 50% cash, the second with 10% bitcoin and 90% cash. The portfolio is rebalanced weekly and cash yields zero. We look at the period of nearly 3 years – from the peak of 19,200 BTC/USD on Dec 16, 2017 to Nov 24, 2020 when it again reached that level. This is to show, that an investor can still enjoy gains, even in a period when bitcoin’s total return was exactly zero. Portfolio holding 50% of funds in bitcoin would have delivered 28.1% return (annualized to 8.7%), while portfolio holding 10% of funds in bitcoin would have recorded 9.1% return (3.0% annualized). Results are summarized in the table and illustrated in the figure below.

As we see, a low 10% allocation to bitcoin would allow to realize a Sharpe ratio of 0.38, which is comparable to long-term averages for most asset classes. This has been achieved in a period of zero overall price change. Further reduction in bitcoin allocation results in only small Sharpe ratio increase – a portfolio holding 1% in bitcoin and 99% in cash would enjoy a SR of 0.396.

To summarize: while nominal volatility of bitcoin has been high in comparison to traditional asset classes, it has been quite low, when compared to returns that the instrument delivered, resulting in an exceptionally high Sharpe ratio of over 1.5. It could still be held in traditional portfolios in low allocations of 1-10%. Even in times of overall zero price appreciation for bitcoin, such implementation would result in achieving a Sharpe ratio of 0.38-0.40, assuming the remaining components were uncorrelated to BTC. A low allocation to bitcoin would help with another problem flagged by the Bridgewater team – liquidity.

2) Liquidity
The Bridgewater team writes:
“current levels of liquidity still constitute real structural challenges to holding Bitcoin for large traditional institutions such as Bridgewater and its clients”

While one does not need liquidity to “hold” an asset, just to enter or leave a position, we can understand what was meant here by the Bridgewater team. Bitcoin is, as of now, an emerging asset class, and any institution and its clients need to have an OPTIONALITY to close a part or the whole position at any given time. There is a possibility of a better crypto implementation, regulatory risk, etc., that may prompt a client to liquidate a position at a moment’s notice. Even the simple strategy that I analysed in the previous section (hold 10% of portfolio in bitcoin) needs some liquidity for weekly or monthly rebalancing, although in one implementation variant the investor pursuing such a strategy would be a liquidity provider rather than a taker.

Bridgewater is one of the most successful asset managers of all times. They know what they need to implement their proven strategies and liquidity is one of prerequisites. However, there is the possibility that profit opportunities in crypto area may be to a substantial degree inversely proportional to liquidity. This may or may not be equivalent to traditional illiquidity premium – due to market fragmentation and lack of sophisticated institutional investors. As an extreme exercise, almost ad absurdum, let’s consider what would happen, if an institution such as Bridgewater, disregarding miniscule liquidity available at that time, invested a paltry one million US dollars in Q4 of 2011. Total supply was just 4-5 million BTC at that time, while the average price was ~3.25 USD. Accumulating 6-8% of total BTC supply would be a very difficult task indeed, although devoting several offices at Bridgewater’s HQ to BTC mining rigs would certainly be of substantial help. By late January 2021 this very modest investment would turn into a cool 10 billion dollars – a substantial sum, even for a giant like Bridgewater. It is obvious that this opportunity is gone and instead of a 10000x increase we are looking at 10x increase, at the most. However, it is possible that liquidity-constrained opportunities are still there, proportionally reduced in potential percentage increase, but not necessarily in the absolute dollar size.

As a separate observation, I would like to draw the reader’s attention to the large disparity that spans this section and the next. When discussing liquidity constraints, Bridgewater assumes that daily liquidity available to their strategies amounts to ~7.4 USD bln in cash and derivatives or 1.3% of total BTC supply. When discussing speculative excesses in contrast to long-term-store-of-value trades, they provide a chart that documents daily liquidity some 15 times higher – amounting to ~19% of total BTC supply. In their defence, they do admit that the 1.3% daily-liquidity-available-to-our-strategies figure is likely conservative and the 19% speculation-not-long-term-investment figure is likely impacted by “questionable volume data reported by unregulated exchanges”. There is always a spread between the bid and the ask, but I leave it up to the reader to decide, whether quoting two estimates of the same metric in one document that differ ~15-fold when supporting the “take the risk” and “do not take the risk” arguments is justified to such an extent.

3) Speculation & bubbles
First, some of my general thoughts about speculation and bubbles, and how they relate to bitcoin. documents 396 instances of different websites declaring bitcoin’s apparent death. The first entry is from late 2010, when BTC price was 0.23 USD. In the past there were hundreds of failed predictions of bitcoin being in a bubble and there may be dozens more. There will likely only ever be one prediction that will come true. The Bayesian in me takes these odds/probabilities as priors.

I suppose most observers who declared bitcoin being in a bubble in the past might not have noticed one important aspect that made this particular asset class different from many other asset classes that underwent substantial price appreciation. Satoshi Nakamoto went public with the concept before the first bitcoins were mined. Everybody on the planet could have gotten first bitcoins by the thousands – for free. It is likely that their value was negative, as valuable computers and electricity had to be used to create assets of zero value. Anybody with the basic understanding of maths can calculate what the expected return is, when an asset that was initially worth zero increases in value to be worth SOMEWHAT – whether that somewhat is a million USD or a trillion USD. Yes, it is +∞ (plus infinity). In theory, there is an infinite number of sequential “bubbles”, of any size, that can “fit” in an advance from a value of zero, to any finite value – whether that value is a million or a trillion. In practice, when the first transaction is made, this collapses to some finite number of sequential “bubbles”. Laszlo Hanyecz agreed in May of 2010 to pay 10 thousand bitcoins for two pizzas, worth approximately 25 dollars, thus setting the price of BTC to 0.25 US cents. Oftentimes an asset class is called a “bubble” when it advances 5-10 fold. Since that first transaction, bitcoin’s price increased some 12 million times, which allowed for about seven back-to-back bubbles, each advancing 10-fold. We could add several more bubbles, if we included the intermittent corrections in the process. With bitcoin market capitalization of 600 billion USD as of this writing and value of all the gold used as an investment worth about 5 trillion USD, it seems, at least to this author, that bitcoin can scarcely be expected to deliver one more 10-fold bubble.

I think the reader would agree that it is generally accepted that bubbles are considered unwise and irrational; there is a negative aura attached to them. However, I propose that FASTER advance from zero value to the final value of an asset may be a sign of rationality, rather than irrational behaviour. This can be demonstrated by near-instantaneous vertical advances that follow many economic and earnings releases. Slower price advance might mean that information is being absorbed at a slower pace. In this light, unusually fast advances in the price of bitcoin (especially in comparison to other asset classes) may simply be a sign of it being substantially below its target price and absorption of this information by new market participants.

Now, back to commentary on the Bridgewater article. I think they provide a rather balanced and guarded assessment of bitcoin being in a bubble or a speculative asset. On the one hand, they draw the reader’s attention to some concrete metrics: volume traded, rising financing rates and option pricing. On the other hand, they admit that such bubble dynamics “can persist for extended periods”.

Concerning volume traded, I’m not sure if it supports the thesis of bitcoin being in a bubble, but it likely supports the thesis that there is substantial amount of speculative trading going on in cryptocurrencies. I have no strong conviction here, as Bridgewater rightfully draws attention to “questionable volume data” provided by some exchanges. I will not delve deeper into this topic but would like to point out the fact, that volumes traded as percentage of supply reached the maximum when BTC fell in March 2020 from about 9000 BTC/USD to the low of 3600 BTC/USD – the very opposite of it being in a bubble.

I am in full agreement, that rising borrowing rates (and higher financing rates embedded in futures pricing) correlate with increased speculative fervour. In my experience they coincided with later parts of consecutive price advances since at least 2016. Financing costs are currently lower than in late 2017, but this may reflect higher availability of capital earmarked for lending and futures financing than 3+ years ago.

I’m not sure, if the details concerning options pricing support the speculation/bubble argument. Bridgewater team writes: “Bitcoin options are currently pricing a very wide and highly optimistic cone of outcomes for future returns”. In support they provide a chart, that indeed is that of a cone. However, in the period analysed (Sep-Dec 2020) bitcoin’s price increased about threefold. As the Y scale on their chart is an arithmetic one, not logarithmic, the shape of 10%-50%-90% outcomes over time SHOULD look like a cone when bitcoin price advances, even with no change to other parameters. 10% and 90% outcomes could still be in similar distance “away” from the 50% outcome when measured in terms of percentages, but “further away” when measured in thousands of dollars. It is not readily obvious to me, which is the case here. Additionally, between September and late December there was an increase in 3M implied volatility of bitcoin options, from about 3-4% daily to 5-6% daily. A similar, but perhaps smaller, increase for 6M options IV could be expected as well. So, the widening of the “cone” could come not only from bitcoin’s price increase, but also from increased implied volatility. This is a sign that market participants price in additional risk (both to the upside and to the downside), not optimism.

It is possible that the 50% outcome for June 2021 has been higher than the spot price throughout the analysed period. This may be due to higher financing costs which, as I agreed to earlier, likely is a sign of optimism. As the cryptocurrency markets are not yet fully integrated into the overall financial system, there is no capital available at 0.25% per annum to finance crypto derivatives, such as futures and options. A crypto-specific interest rate (“Risk free” rate) needs to be used, in order to bring options and futures prices to some equilibrium.

Therefore, in order to estimate what can be read from bitcoin option prices concerning market sentiment it would, perhaps, be helpful to disaggregate “the cone” into four effects:

  • Bitcoin price increase
  • Change in implied volatility
  • Change in (crypto-specific) financing costs (that could move outcomes vs. spot price)
  • “Smirks” that may indicate optimism or pessimism embedded in option pricing.

To summarize my commentary: I recognize that bitcoin’s volatility is high in comparison to other asset classes. However, given returns and the Sharpe ratio it delivered in the past, it (ex-post) made sense to take such high risks in the past. It may continue to do so for some time into the future, though not indefinitely. One could treat bitcoin’s volatility a bit like ethanol or acetic acid. These substances are highly toxic at 100% concentration, but safer and potentially beneficial, when thinned to 3-6% and used as light beer or vinegar. Similarly, an allocation of several percent of assets to bitcoin may be beneficial for portfolio’s performance, especially due to the benefits realized from the Rebalancing Return.

I understand that the sheer size of Bridgewater Assets Under Management precludes the institution from taking a substantial position in cryptocurrency markets. I propose that the scale of profit opportunities is likely inversely proportional to liquidity and institutional presence. Perhaps it is also a signal to smaller and non-institutional participants that the opportunities are there, but large and successful institutions cannot engage in them as much as they would like to.

Concerning bitcoin’s bubble-like behaviour, I propose that in the past it largely stemmed from the fact, that this asset class started its ascent from a value that was as close to zero as possible. In such a situation multiple bubbles of 10-fold increases can form in sequence, before an asset class reaches its “fair” value, whatever that value is. Fast price increases may be coming from the fact that new market participants are being familiarized with bitcoin’s target value and consider it substantially higher than current spot price.

In any case, I am grateful to the Bridgewater team for sharing their thoughts in such an extensive and thorough research piece. It has stimulated my thinking and allowed to look at bitcoin from several new angles.

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