Wednesday, January 17, 2018

Bitcoins for institutional investors? What happens when you put this investment into an optimizer

"A grand jury will 'indict a ham sandwich' if that is what you want" - Sol Wachtler, former chief justice of New York Court of Appeals

An optimizer will give any asset an allocation if it is uncorrelated with other assets. This is one of the key takeaways I learned from a new paper called "The Case for Bitcoin for Institutional Investors: Bubble Investing or Fundamentally Sound" by Jim Lieu and Levar Hewlett. I am not against new research that tries to apply classic techniques and this paper does a sound job of showing how bitcoins could be added to a portfolio and adds diversification. But, it is a stretch to conclude that just because it is uncorrelated it should belong in a portfolio. 

The authors show that bitcoins have a volatility that is greater than large cap stocks by a factor of 20 but still has an information ratio of over 1. This is before the run-up of the last few weeks. Surprisingly, as seen in the table below, if you want diversification through negative correlation, stick with long bonds. 

The authors show that holding bitcoins (BTC) would have improved the performance of 60/40 stock/bond even if the allocation was only 2%, but that does not mean it should be added to a portfolio.

Forget the investment fads and focus on the simple questions:
  • What is the fundamental economic thesis for any investment?
  • Why should it make money?
  • Why should it have a different return stream than other assets and strategies?
  • Is there a theoretical reason for its diversification properties?
If you don't have good answers to these questions, don't use an optimizer to make the portfolio decision for you. An investment is not a "ham sandwich" that will always fit into a portfolio.

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