Bitcoin and Beyond: Crafting a Balanced Digital Asset Allocation Strategy

The question is how to optimize digital assets within a model portfolio.

Despite the promise and growing legitimacy of digital assets, cryptocurrencies like Bitcoin are still fraught with volatility and prone to wild price swings. That means finding the sweet spot for a model allocation is key.

The growth of Bitcoin and other digital assets has been breathtaking over the last five years. What started as a niche idea has quickly gone mainstream. The basics behind cryptocurrencies like Ether are pretty easy to understand. The best way to think of them is as “digital dollars” stored in the cloud or accessed through a digital key.

However, unlike the greenback, Bitcoin isn’t backed by the Federal Reserve or a regulatory authority. Cryptography is used to secure transactions and control the creation of additional units of the currency. Essentially, a code needs to be cracked to process transactions.

It’s here that Bitcoin, Litecoin, and other cryptocurrencies can serve as a medium of exchange or be traded between parties, and cryptography can be used to tokenize assets such as art or even a real estate deed.

This promise of crypto—both as a currency and as a process—has started to gain traction outside its dedicated fanbase. Today, Wall Street, banks, institutions, and even governments have started to back digital assets through new funds and supportive regulations. And with that, investors have taken notice.

There’s good reason to consider crypto for a portfolio.

First, the asset class doesn’t function like stocks, bonds, or even traditional alternatives like real estate. As such, Bitcoin and other cryptocurrencies can add essential diversification benefits to a portfolio. According to State Street, Bitcoin features a correlation to stocks (S&P 500), bonds (US Aggregate), and real estate (REITs) of 0.42%, 0.23,% and 0.38%, respectively. ¹

Additionally, the asset class features far greater historical and potential returns than stocks, bonds, and other alternatives.

With Bitcoin and other digital assets gaining steam and providing portfolio benefits, many advisors and investors have been clamoring to add them to a portfolio to gain from these benefits. But there is a catch: the asset class remains volatile.

Many of the promises of digital assets are still promises. The idea is that one day, you’ll be able to walk into a Starbucks or a Walmart and pay for your goods with Bitcoin, just as you would pay with U.S. dollars. However, not many places will accept digital assets for goods and services. Tokenization isn’t widespread. Today, these assets still trade solely based on their potential, creating plenty of volatility.

And too much volatility isn’t a great thing for a portfolio.

To that end, optimizing an allocation to Bitcoin, ether or other digital assets is key to using it effectively in a portfolio. This approach allows you to tap into their higher return potential while minimizing significant price swings. After all, that is the real goal of diversification and modern portfolio theory.

Recent studies may have the answer to this puzzle. The weighting? Between 5 to 6% of a portfolio when looking at a traditional 60/40 stock/bond split. This chart from Franklin Templeton shows the additional returns that a 5% weighting to digital assets via the CMC Crypto 200 Index can provide to a portfolio.

Source: Franklin Templeton

That extra return using that allocation percentage comes with a strong risk/reward profile and only a slightly higher drawdown potential. A study by asset manager VanEck tested 16 different 60/40 portfolios since 2015, showing incremental increases in cryptocurrency allocations — up to 6%. Max drawdowns for the portfolios only increased slightly, from -21.54 to -23.60, but saw significant increases in Sharpe Ratios, from 0.78 to 1.44. Sharpe ratios look at the excess returns versus per unit of additional risk. Investors are realizing more return without taking on more risk by adding digital assets in this allocation percentage. ²

Similarly, a study from asset manager Fidelity found that a 5% allocation to digital assets like Bitcoin could boost retirement readiness and spending by up to 8.5%.

However, anything above that 5 to 6% mark can lead to increased volatility. Sharpe ratios start to plunge, and overall portfolio returns begin to flatline.

So, having some exposure to digital assets within a model portfolio is a good thing. And a 5 to 6% weighting seems to be the magic number. Investors can gain some valuable diversification benefits and increase overall returns over time. Meanwhile, drawdowns from adding this amount of crypto are slight.

The issue remains on how to add this weighting to a model. That might come down to preference and where the digital assets are going.

Advisors and model designers can purchase cryptocurrencies directly for a model using a brokerage such as Coinbase or Fidelity. Plenty of asset managers have also unveiled SMAs that cover the asset class. However, numerous ETFs currently on the market could offer exposure with less tax headaches. Moreover, many advisors already use ETFs for their models, and this makes it an easy win for design.

These ETFs were selected based on their exposure to spot Bitcoin. They have AUM between $730M and $49B. They are sorted by their 1-year total return, which ranges from 84.5% to 103.2%. They have expense ratios between 0.19% to 1.50% and they currently do not pay any dividends.

Keep in mind that these studies focus on actual digital assets, not on companies involved in Bitcoin mining or storage. Investing in a stock like Riot Platforms (RIOT) isn’t equivalent to the results in these studies.

Overall, as Bitcoin and other digital assets become mainstream, adding them to a model portfolio seems to make some serious sense. Diversification benefits and higher returns await if investors look to add 5% or so of their models to digital assets.

Digital assets have grown in popularity and legitimacy, prompting advisors to include them in model portfolios. Optimizing allocations to get the best benefits without realizing the drawbacks is key.

¹ State Street (December 2024). Digital Assets: The Next Frontier for Markets and Investors

² Van Eck (November 2024). Optimal Crypto Allocation for Portfolios