It seems these days that you can’t turn on CNBC or read the Wall Street Journal without seeing Bitcoin (BTC) in one of the headlines. The usual headline reads, “Bitcoin Surges” or, “Bitcoin Plummets.” These articles tend to get a lot of interest and make for a great story, one that does not seem likely to end any time soon. But that begs the questions, what really is Bitcoin and why all the excitement?
Bitcoin, a digital currency without the need for a central bank, was created in 2009 by the mysterious pseudonym Satoshi Nakamoto1. There are no physical coins associated with Bitcoin but rather balances kept on a public ledger that everyone has transparent access to. Bitcoins are not backed by any bank or government; in other words, they are the antithesis of a fiat currency (e.g. the U.S. dollar, the Euro, or the Japanese yen). The supply of Bitcoin is limited to just twenty-one million Bitcoins with the last Bitcoin to be released in the year 2140. As of February 2021, there are about 18,624,350 Bitcoins in circulation, or 89% of the total supply.
The most plausible use case for Bitcoin is for payment.
Bitcoin can be transferred from person to person for payment much easier and more efficiently than a wire transfer (in which money is sent from bank to bank). A typical wire transfer fee from a bank is roughly $302, but a wire transfer for $500,000,000 is much more expensive. Typical transfer fees for wires over $10,000 can be 1%3 of the total wire. If you transfer money via the Bitcoin network, the fee is minimal. In 2019, there was a transfer of $450,000,000 worth of Bitcoin from an unknow wallet to another unknown wallet and the fee for the transfer was only $4404.
To create a Bitcoin, you must “mine” it with a computer.
Bitcoin mining involves using computing power to solve complex problems on the Bitcoin network. Whoever solves the problem first is awarded a block. That block contains a certain number of Bitcoin. The current amount of Bitcoin per block is 6.25 Bitcoins, but that number is halved, roughly every 4 years. In the media you will hear talks about the “halvening” as an inflexion point; the reduction in the amount of Bitcoin mined by 50% is what it is referring to.
The price of Bitcoin recently rose above $50,000 USD/Bitcoin. You may be wondering how something that isn’t tangible, is not controlled by a central government, and can’t really be used to broadly purchase goods has any value.
The value of Bitcoin is derived from a few sources. The most obvious is supply and demand. Its limited supply (21,000,000 Bitcoin) creates a demand issue. The more that companies and people adopt Bitcoin, the more the price will be driven up due to the limited supply. From a BTC investment “language” perspective, you will hear both bullish proponents cite the “stock to flow” valuation model to justify and/or project the price of Bitcoin; “stock to flow” is another way of saying supply and demand. From a portfolio perspective, many investors are correctly asking the question: Does Bitcoin belong in my portfolio? For the bullish proponents of the digital currency, the answer is yes, while prominent bears, like gold enthusiast Peter Schiff, say the asset is nothing more than a bubble because “a financial asset is in a bubble when its price has no relationship to its underlying present value or a reasonable expectation of its future value, and investor conviction in price appreciation is high and fear of loss is low. At $50k bitcoin is the biggest bubble of them all.5” Prior to making the previous statement, Mr. Schiff said “a temporary move up to $100k is possible, a permanent move down to zero is inevitable.6”
Like most things in life, and investing, the answer is more nuanced than a simple black or white explanation/answer.
Using one of the most liquid and easy to access vehicles for Bitcoin as a proxy for BTC, the Grayscale Bitcoin Trust7, Bitcoin has some interesting diversification properties that in a vacuum may be attractive from a portfolio construction and asset allocation point of view. However, like the old adage says, there is no such thing as a free lunch, and with Bitcoin, those valuable diversification properties and tantalizing returns comes with a hefty amount of volatility (as measured by standard deviation). This was never more evident than the 15% correction that occurred on February 23rd after comments from Elon Musk8 in which he suggested the crypto currency was overvalued at the $1 trillion market capitalization. Mr. Musk’s comments came alongside Treasury Secretary Janet Yellen opining that Bitcoin was “extremely inefficient.”9 The chart below shows the YTD chart on Bitcoin with several wide swings just in the last 44 days.
As the Risk-Reward chart below demonstrates (the bright green circle represents BTC proxy Grayscale Bitcoin Trust), over the most recent three-year period from (2/1/2018 through 1/31/2021), GBTC delivered an annualized return of ~50% (really good) with an annualized volatility of ~82% (enough to rattle even the most steeled and tenured investor).
The GBTC return/risk (~50%/82%) profile is contrasted with a broad array of equity indices that are huddled close together in the lower left-hand corner of the below chart; as an example, the three-year annualized return of the S&P 500 over the same time period referenced above is ~11.7%, with annualized volatility of 18.7%.
Looking at the correlation of BTC to a diversified portfolio of stocks and bonds as well as other equity indices (chart below), BTC has shown only a modest correlation, making it a potentially viable diversification asset.
After highlighting the benefits of BTC (potential return, diversification/correlation properties), it is natural that we would explore some of the drawbacks.
At a very high level, what has given much of the investing world pause (institutional and retail investors alike) is the volatility of Bitcoin (to say nothing of trying to derive an underlying value estimate for the asset). The below chart shows a five-year window (from February 2016 through January 2021) that exhibits significant drawdowns. As indicated in the thick green line, the volatility of BTC is significantly higher relative to more traditional equity indexes. During the COVID lockdown-induced market sell off in February and March of 2020, GBTC still sold off along with regular equity indexes; it did not protect on the downside. Prior to 2020, GBTC saw an almost ~77% drawdown from late 2017 to early 2019. As a potential investor follows the green line in the chart, even recoveries in the asset are not clean by any stretch, with investors forced to weather extreme moves in both directions.
Mohammed El-Erian, Chief Economic Advisor for financial conglomerate Allianz, recently spoke about BTC in terms of mitigating risk.
In a world awash with liquidity (e.g. fiscal stimulus from governments and monetary accommodation from global central banks), signs of yield curve steepening, and the potential for surprise inflation as the global economy comes out of its self-induced “COVID Coma,” this line of thinking has some merit. However, for most clients, especially risk-averse clients well into the “distribution” phase of their financial life cycle, the asset is likely far too volatile to hold in a client portfolio. For clients with longer-time horizons and/or the appetite for greater risk, the case for putting BTC in a client portfolio is stronger, yet still inconclusive. At a time in capital markets where we are at all-time high valuations in the equity market, near all-time low yields across the fixed income complex, and at an inflexion point caused by a one in one hundred year global pandemic, the need to view non-traditional assets like crypto currency, and Bitcoin more specifically, through a different lens is an undeniable and necessary part of our job as asset allocators and wealth management advisors.
Schneider Downs Wealth Management Advisors, LP (SDWMA) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). SDWMA provides fee-based investment management services and financial planning services, along with fee-based retirement advisory and consulting services. Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice. Registration with the SEC does not imply any level of skill or training.
 No one knows the identity of Satoshi Kakamoto to this day.
https://grayscale.co/bitcoin-trust/ GBTC is passively invested in Bitcoin and allows investors to gain exposure quickly to Bitcoin without the challenges of buying, storing, and safekeeping of Bitcoin.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.
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