The case for ETH in an institutional portfolio

The case for ETH in an institutional portfolio
Introduction

Institutional investors often seek to optimize their portfolios through portfolio construction.  This is usually achieved through diversification, rebalancing and sizing using uncorrelated assets.  We have found statistical evidence showing a small portion of this new asset class delivering significant contribution to the portfolio without material impact on the risk profile.

In this section, we analyze the case for adding Ethereum to a traditional portfolio of 60% stocks and 40% bonds for the 5 year period ending June 30, 2022.  The allocation ranged from 1% to 5% in increments of 0.5%.  The analysis showed allocating any of these ranges to Ethereum would have contributed positively to the traditional portfolio risk-adjusted return over the course of 1, 3 and 5 years on an annualized basis, assuming quarterly rebalancing.  For example, allocating 2% would have enhanced the risk-adjusted returns by 0.15 points for 1 year, 0.12 points for 3 year and 0.12 points for 5 year.  From a contribution to return perspective, the traditional portfolio would have increased its 3 year cumulative return by 6% and 5 year cumulative return by 10% with similar levels of volatility.

The analysis captures one of the worst drawdowns happening this year for Ethereum.  However, in order to be more comprehensive the study further reviewed across different rolling time periods, a range of potential allocations and several rebalancing strategies.

While there is no guarantee Ethereum’s performance and its relationship to a traditional portfolio will continue into the future, the results are significant enough for institutional investors to consider Ethereum as a new asset class in a traditional portfolio.

Method

The traditional portfolio is composed of 60% Vanguard Total World Stock ETF (VT) and 40% Vanguard Total Bond Market ETF (BND). VT tracks global stocks providing exposure to developed and emerging equity markets while BND tracks investment-grade, fixed rate, taxable U.S. bonds. Historical price data was sourced from Yahoo for the traditional portfolio while Coingecko served as the pricing source for Ethereum. Risk-free rate of 2.97% per year was used to calculate the Sharpe ratio which was the 10-year Treasury yield at the cutoff date of our analysis (June 30, 2022). The analysis focused on the time period between September 1, 2016 and June 30, 2022 to analyze comprehensive data that’s inclusive of recent macroeconomic headwinds and crypto-liquidity events. We also analyze the 1, 2 and 3 year rolling periods across all time periods to eliminate potential biases in cherry-picking specific time periods. In addition to Ethereum’s contribution to return, the analysis also looked at other portfolio metrics such as standard deviations, sharpe ratio and maximum drawdowns.

Ethereum's impact on a traditional 60/40 portfolio

The study starts with a 60/40 traditional portfolio representing a diversified portfolio of stocks and bonds for the 5 year period ending June 30, 2022. The cumulative return for this portfolio was 14.2%. A 2% Ethereum allocation to the traditional portfolio, rebalanced quarterly, significantly enhanced the cumulative returns from 14.2% to 24%. It is important to note that this was achieved with slightly higher volatility (7.1% with Ethereum up from 6.5% without). As a result, the annualized Sharpe ratio,which measures excess return per unit of risk, improved by more than 500%.

It’s easy to understand how Ethereum may have contributed positively to a traditional portfolio as it experienced extraordinary returns in a relatively short period of time when compared to a traditional portfolio.  Therefore, we also wanted to look at how a 2% Ethereum allocation to a traditional portfolio would have looked like during stressful periods for ETH.  One example was to look at the most recent drawdown where Ethereum declined nearly 50% for the 12 months ending June 30, 2022.  In this scenario, a 2% Ethereum allocation, rebalanced quarterly, would have delivered a slightly worse return by 0.1% and higher volatility by 1.5%. However, the Sharpe ratio would have improved by 0.15 points which can be explained by the effects of diversifying and rebalancing a volatile asset with idiosyncratic risks.

While it may be helpful to analyze the impact of allocating Ethereum to a traditional portfolio during recent periods, we also looked at 1, 2 and 3 year rolling returns for all possible holding periods using a quarterly rebalancing frequency. The findings showed that 2% Ethereum allocation would have contributed positively 100% of the time to the 3 year annualized returns of a traditional 60/40 portfolio for every possible holding period whereas for 1 and 2 year it contributed positively 83% of the time.

The following question to address is whether the positive contribution came at the expense of excess volatility. The findings showed 2% Ethereum allocation had a positive impact on traditional portfolio’s annualized sharpe ratio for every possible 3 year period as well. Despite the volatility Ethereum may add to a traditional portfolio, the median contribution of 0.15 points demonstrates that it is more than compensated for by its excess returns.

Minimum acceptable holding period for a ethereum allocation

To understand the appropriate holding period for Ethereum, we looked at 1, 2 and 3 year rolling returns on an annualized basis along with the Sharpe ratio across all periods using a 2% Ethereum allocation and quarterly rebalancing as base case. As mentioned above and illustrated below, the analysis showed that Ethereum generally contributed positively to the overall portfolio. This was especially true for the 3 year holding period. Although the 1 and 2 year rolling annualized returns contributions were also generally positive, there were periods where it was negative as shown in the charts below, indicated by the red dot.

The table below further shows detailed results for 1, 2 and 3 year holding periods. Although the median positive return contribution was higher in the 2 year window, the 3 year window offered 100% positive contribution across all periods. Also, the median positive Sharpe ratio contribution was similar across all windows, however the 3 year window offered 100% positive contribution across all periods. Reviewing these historical patterns, evidence for including Ethereum for a minimum 3 year holding period is certainly compelling.

Optimal rebalancing strategy for a ethereum allocation

Rebalancing a portfolio often enhances returns while reducing risk. But what is the optimal rebalance strategy for a traditional portfolio consisting of an asset that has been extremely volatile such as Ethereum?

We looked at 3 different rebalancing strategies: monthly, quarterly and annual rebalancing.  The table below shows how a particular rebalancing strategy can impact a portfolio’s performance and its risk profile for the same percentage of Ethereum allocated to the portfolio.  Unsurprisingly, less frequent rebalancing (annual) has produced higher cumulative and annualized returns at the cost of relatively higher volatility.  Conversely, frequent rebalancing (monthly) has produced lower cumulative and annualized returns but at a lot lower level of volatility.   The dramatic change in the risk return profile of the portfolio can be seen when analyzing the Sharpe ratio.  Based on our observations and as illustrated in the chart below, rebalancing quarterly certainly is compelling as the increase in volatility would be compensated by a higher return; monthly rebalancing would have yielded a slightly higher Sharpe ratio by +0.1% but with less return by -0.3%.

Sizing ethereum in a traditional 60/40 portfolio

The chart below examines the average rate of contribution for the Sharpe ratio for the 3 year rolling period and its volatility across all periods between 9/1/2016 to 6/30/2022, assuming quarterly rebalancing.  It also includes the change in the average rate of contribution to determine compelling reasons to allocate beyond a certain amount.

As you can see from the chart, increasing allocation to Ethereum becomes less compelling up until a certain point. The change in the average rate of contribution rises sharply then continues to flatten out after 2% while the volatility of its contribution continues to rise steadily.  In other words, adding Ethereum to a portfolio tends to increase risk-adjusted returns but the benefits diminish consistently beyond 1-2% range.  Therefore, a 1% to 2% Ethereum allocation to a traditional portfolio can be an optimal position that offers relatively stable contributions overtime.

Conclusion

The study showed that adding Ethereum to a diversified portfolio of stocks and bonds would have generally contributed positively from a risk-adjusted return perspective over various time periods, assuming a rebalancing strategy was in place. Despite the volatility Ethereum may add to a traditional portfolio, the annualized Sharpe ratio had a positive impact for every possible 3 year period between September 1, 2016 to June 30, 2022; demonstrating that it is more than compensated for by its excess returns. Zooming further in on Ethereum’s most recent period, where it experienced a 50% drawdown for the year ending June 30, 2022, allocating to it would have still enhanced the Sharpe ratio by 0.15 points. This supports the case that an asset with idiosyncratic risks can enhance a traditional portfolio during a down market due to volatility harvesting and disciplined rebalancing strategies.

By analyzing these historical patterns, institutional investors may be better equipped to address key questions around acceptable holding period, optimal rebalancing strategies and sizing for Ethereum in a traditional portfolio. While there is no guarantee Ethereum’s performance and its relationship to a traditional portfolio will continue into the future, the results are significant enough for institutional investors to at least consider Ethereum as a new possible asset class and bring value to their clients portfolio.