Grayscale analyst tells you: how to invest in Bitcoin?

Authors: Sarah Morton, Zach Pandl, CoinDesk

Compiled by: Song Xue, Jinse Finance

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

The battle for regulatory clarity seems to be progressing smoothly. With Bitcoin becoming the 11th largest financial asset by market capitalization globally, Zach Pandl from Grayscale leads us to understand Bitcoin's role in your portfolio.

Bitcoin and Your Portfolio

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

Bitcoin is both a technological marvel and a significant, liquid investable asset. Although public blockchain technology can be difficult to understand due to its highly technical nature, the role that Bitcoin and other crypto assets can play in a portfolio is relatively straightforward. The cryptocurrency market offers assets with high risk/high return potential that have not closely correlated with stocks over a five-year period, making them a useful component for investors with a high-risk tolerance to build an optimal portfolio.

Building a diversified portfolio with substantial returns has become more challenging. The classic 60/40 stock and bond portfolio will struggle to generate returns comparable to those of the past 40 years. We believe there is fundamentally no room for valuation expansion: stock price-to-earnings ratios are already high, and the long-term bull market in bonds has ended (due to consumer price inflation bottoming out). The correlation between stocks and bonds is also stronger now, meaning that investors gain less diversification benefit by pairing them together. Opportunities in the public markets are also shrinking: the number of IPOs has decreased compared to the 1990s, and the number of publicly listed companies has declined by about 30%.

To address these challenges, investors face a range of standard options (Chart 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, some investors have increased their allocations to alternative investments, including illiquid private assets such as private equity and real estate. While this is a successful approach, many individual investors do not have access to these types of tools.

Chart 1: Traditional assets provide standard risk/return trade-offs…

Chart 2: …Cryptocurrencies greatly expand the available options

Crypto assets offer something truly distinct. From an asset allocation perspective, Bitcoin and other digital assets significantly broaden the risk/return profile for public market investors (Chart 2). Bitcoin and other crypto assets like Ethereum exhibit high volatility and should be viewed as high-risk. However, over time, they have generated returns commensurate with their risk profile. In other words, while Bitcoin is highly volatile, its return-to-volatility ratio is roughly similar to that of other asset classes. Therefore, adding crypto assets to a portfolio can be seen as taking on additional investment risk in exchange for higher potential returns. Investors might consider replacing other high-risk/high-return assets, such as tech stocks, non-U.S. equities, and/or certain illiquid private investments, with crypto assets to enhance portfolio performance.

Despite the higher historical returns generated by the crypto asset class, its correlation with other risk assets is not high. For example, over the past five years, the correlation between Bitcoin and the S&P 500 index has been only 40%, while the correlation between the Nasdaq 100 index and the S&P 500 index is 90%. The lower correlation with stocks means that the allocation of cryptocurrencies in a portfolio should provide greater diversification benefits compared to certain other risk assets.

Cryptocurrencies are an emerging young asset class and should be viewed as relatively high-risk investment products. Bitcoin and other crypto assets may not be suitable for investors with clear capital needs in the near future (e.g., within the next three to five years). For instance, savings allocated for upcoming expenses related to college tuition or home purchases may not include a cryptocurrency allocation. Finally, investors prioritizing asset income should consider other options.

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

Quick Q&A

Q: What impact will a spot BTC ETF have on Bitcoin prices?

Bitcoin is one of the few assets that can directly influence ETF prices. Given that we know Bitcoin's supply is limited—there are a total of 21 million available, of which 19.5 million have been mined—the demand for a spot ETF will consume part of the supply, and as long as there is interest in the ETF, it must be held. This is a supply and demand situation.

Q: If demand for the ETF may decline, will Bitcoin's overall price drop?

The approval of a spot BTC ETF could have subsequent effects, as it may symbolize a thawing of regulatory resistance toward Bitcoin and the entire cryptocurrency space. The SEC's approval of a spot ETF would make it easier for institutions to embrace Bitcoin investments. We may also see more providers allowing Bitcoin as an investment option. Overall, the demand for Bitcoin post-approval could multiply compared to the demand for the spot ETF.

Q: I can't get my clients to invest in Bitcoin right now. How can I give them some exposure before the spot ETF is approved?

There are various ways to gain exposure to Bitcoin before approval while keeping clients within regulated investments held by custodians and asset management scales. Please remember that we do not provide investment advice.

Some examples include:

GBTC—Grayscale Bitcoin Trust is trading at a slight discount and may convert to an ETF upon the approval of other ETFs. This means that clients investing in this trust will gain a discount in addition to the appreciation of Bitcoin prices.

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 that their stock prices should also appreciate.

Coinbase—COIN is a publicly traded company that serves as both an exchange and a custodian and will benefit from increased overall interest in cryptocurrencies. They have a diversified revenue model, and a thawing of the regulatory stance would be very beneficial for them.