- A new Man Group paper gives an investor’s guide to the cryptocurrency space, comparing popular valuation methods and trading strategies.
- It finds volatility-targeting methods effectively control risk, and trend-following strategies help maximise return.
- From an asset allocation perspective, investors should recognise the high correlation between equities and crypto during drawdowns.
Crypto markets have suffered considerably over the last six months. For the optimistic investor, however, bitcoin’s current price offers the opportunity to enter the market at the same level as that of late 2020. So, if you feel you missed out before, this bear market may have given you a second (or third?) bite of the cherry.
Accordingly, a new Man Group paper provides an overview of what has and has not worked for crypto investors since 2017. From valuation tools to the best trading strategies, the authors ‘provide an investor’s perspective on how to approach the space’. So, in this Deep Dive, we summarise their findings.
Investors can gain exposure to crypto markets in several ways. The simplest is through futures contracts or other securities like ETFs. Alternatively, you can invest with a venture capital (VC) fund, buy physical coins, or earn a return for supplying liquidity.
One key challenge for crypto investors is volatility. Bitcoin, for example, has experienced six drawdowns of greater than 60% over the last 12 years. So, once every two years, you could face financial ruin. Entering the space without a risk-management strategy is discouraged.
You should not confuse volatility for a bubble, however. The authors compare bitcoin’s price action with six famous bubbles: Tulipmania, Mississippi, South Sea, US Roaring 20s, 1980s Japan and the DotCom. None recovered as quickly, if ever, as bitcoin has from its troughs.
So, if crypto is not a bubble, prices must somewhat reflect a fundamental value. The challenge is that the diversity of cryptocurrencies means that different models may be needed for different cryptocurrencies – the market comprises more than just bitcoin and ether. The authors provide four popular valuation metrics.
This metric captures the notion that a cryptocurrency’s network size, i.e., number of participants, positively contributes to its valuation. Metcalfe’s law suggests a telecommunication network’s value will be proportional to the square of the number of users connected to the system.
This heuristic has proven useful for valuing platforms like Google or Meta, but does it work for cryptocurrencies? Maybe, for bitcoin and ether. It can explain 54% of the variation in coin market cap across cryptocurrencies (Chart 1). But, once you remove these two, the relationship is weak. Also, because people routinely create new addresses, the number of addresses versus the number of users is likely overstated.
Bitcoin as Digital Gold
Gold obtains its value from being accepted across most national currency networks. Its durability, divisibility, transportability, homogeneity and rarity has made it the most popular unit of account since the fifth century BC.
Bitcoin, you can argue, also satisfies many of these conditions. Were it the ‘digital’ alternative of gold, you would expect it to take some market share. If global wealth is $446tn, and gold represents around $15tn of that, then taking just 10% of that market would give bitcoin a value of $72,270.
More recently, however, bitcoin has shown itself to be more of a risky asset, giving less weight to this valuation metric. Then again, it will always contain some scarcity value, with just 21mn coins due to ever be created.
Value as a Multiple of Mining Costs
Another way to value bitcoin is as a multiple of its mining costs and comparing that with other assets that require a process of prospecting, such as copper, gold or oil. The average price to mining costs of these commodities is roughly between 0.9 to 2.3. For bitcoin, it has oscillated between 4x and 220x.
Based on current hash rates and electricity prices, the authors value bitcoin at $11,450 if the mining cost multiple were to converge on traditional commodities.
Flow Versus Stock Analysis
This relies on the ratio of new currency creation to the total stock of currency – the so-called flow vs stock ratio. The idea is that if the value of the stock of cryptocurrencies to the flow becomes closer to the average of fiat currencies, then the value of bitcoin and ether could substantially appreciate. However, the flow of bitcoin will eventually go to zero, meaning its value would be infinite!
You could also infer valuations from the spot versus the futures/forward prices. Think of the covered interest parity condition for exchange rates. The authors use the following example:
On 17 February 2022, the 12-month DeFi lending rate for bitcoin was 6.2% and the USD 12-month LIBOR was 1.3% implying a spread of 5.9%. Given a bitcoin spot rate of $42,340, we would expect the one-year forward price of bitcoin to be $44,388. However, the exchange-traded bitcoin futures one year out recently traded at $47,183, suggesting the token was a little under 6% overvalued.
While this gives a relative value, it does not tell us the absolute value. It could also be that the forward price is mispriced, or even both the forward and spot – we know nothing about the fundamental value.
Accounting for Volatility
Cryptocurrency prices are volatile. Daily bitcoin returns can frequently reach plus or minus 10%, with an annualised volatility of around 80% since 2017. In contrast, the annualised volatility of the S&P500 is 19%.
However, bitcoin and ether have experienced fewer tail events than US equities. That is, the S&P500 has more regularly moved at least three standard deviations away from its mean over the last five years.
So, while the higher returns come with higher risk, the risk appears relatively consistent and persistent. Indeed, bitcoin and ether returns are very persistent in their volatility (Chart 2). High volatility over the previous five days tends to be followed by high volatility over the next five days.
This persistence is an important feature that investors can counter by scaling the size of their investment by the current volatility level. This is what the authors do, illustrating the impact of volatility targeting on bitcoin, ether and the S&P500 (Table 1).
The Sharpe ratio of an investment in bitcoin is typically modestly higher when volatility scaling. Also, returns are more stable in the sense that the annualized one-year rolling volatility of 21-day return volatility (or ‘vol-of-vol’ statistic) is substantially reduced, as we can see in the second-last column. The max drawdowns have also been reduced. The strategy is less effective for ether.
Most macro assets display time-series momentum. So does crypto. The authors run a series of trend strategies that have outperformed a constant investment in the coin itself. The average of a 22-day and 261-day long-only momentum strategy on bitcoin, scaled to 10% vol, has a significantly higher cumulative return and Sharpe ratio than a simple buy-and-hold strategy (Chart 3).
For investors convinced about adding crypto to their portfolio, correlation is important. First, the authors look at the correlation between pairs of coins at an intraday (15-minute) and daily (20-day) frequency.
While many blockchains differ significantly in their functionality, the role of speculators results in a relatively high cross-correlation. The pairwise correlations range between 0.4 and 0.8, implying only modest diversification.
Next, the paper looks at the correlation of bitcoin to other assets in drawdowns of (i) less than 5% (ii) between 5% and 10%, and (iii) greater than 10%, over rolling quarters.
While the correlations are low outside a drawdown, they can be as high as 0.6 in larger drawdowns (Chart 4). Only Trend (Man AHL global trend proxy) and L/S Quality equities are good complements to a cryptocurrency allocation in a risk-off environment.
These correlations were taken on daily price movements between July 2010 and October 2021. More recently, since 2020, the correlation between bitcoin and the S&P500 has been closer to 0.5, even when quarterly drawdowns in equities are less than 5%.
Crypto markets offer a unique opportunity for retail investors. Unlike traditional markets, there are no restrictions on what you can invest in or how much you can invest. That, alongside a wider array of investment tools, the availability of better research, and greater safeguards, means retail investors may be well placed to benefit from the recent drawdown in crypto.
The paper provides a good overview of what new investors should consider if they decide to add cryptos to their portfolio. Volatility is key, so accounting for it should help limit the downside and help you chase that upside!
Sam van de Schootbrugge is a Macro Research Analyst at Macro Hive, currently completing his PhD in international finance. He has a master’s degree in economic research from the University of Cambridge and has worked in research roles for over 3 years in both the public and private sector.