The People vs Bitcoin?: An Analysis of Bitcoin as an Institional Investment
Introduction
The implementation of Bitcoin [1] as open-source software twelve years ago has turned out to be a pivotal moment for the financial markets. Bitcoin was conceived in a whitepaper published on 31 October 2008 as a decentralised digital currency. It is decentralised in the sense that as a cryptographic currency - dubbed 'cryptocurrency' - it is neither issued nor managed by a single administrative authority such as a central bank. Instead, Bitcoin relies on a peer-to-peer bitcoin network, and is created as an incentive for node operators to engage in a process called mining. Transactions, through which the currency is sent or received, are conducted on the bitcoin network. The transactions are cryptographically verified by nodes on the network and recorded in an immutable, publicly distributed ledger called a blockchain.
Considering its initial intended utility as a currency, it is difficult to assert whether Satoshi Nakamoto envisioned the technology as a mainstream financial asset. There are currently ongoing intense debates about the investment credibility of digital cryptocurrencies such as Bitcoin, with some investors hailing them as 'sound money', while others view them as nothing more than a speculative bubble. The criticisms for Bitcoin range from its alleged usage in criminal activity, to its energy consumption during mining, and even to questioning of the need for a different currency to exist at all. Regardless, in 2021 alone, Bitcoin had notable successes such as its adoption as legal tender by El Salvador [2], and reaching an all-time high of over US$68,000 per bitcoin on the publicly traded markets. The former was a clear signal of Bitcoin's increased adoption and quashed the slowly prevailing opinion at the time: that Bitcoin was not useful as a currency or medium of exchange. The latter, spurred by increased adoption and the introduction of an American Bitcoin futures exchange traded fund, cemented Bitcoin's place as a legitimately tradable financial asset in the world's largest economy. Bitcoin's fixed supply, which stands in stark opposition to fiat currencies' potentially unlimited supply, seems to be the most compelling reason for investing in the cryptocurrency. This is the view expressed by institutional investors such as Michael Saylor [3], who refers to Bitcoin as property, and continues to add the asset to MicroStrategy's balance sheet.
The most prominent criticism when it comes to investing in Bitcoin is that of price volatility. The bitcoin price has gone through dramatic cycles of appreciation and depreciation. Indeed, this has become a defining feature of cryptoassets in general, with other popular cryptoassets such as Ethereum (the second largest cryptoasset by market capitalisation) exhibiting similar tendencies. The cryptoasset class is historically known to be several times more volatile than other traditional asset classes such as gold and equity indices. However, is this reason enough for an investment fund to completely avoid investing in Bitcoin? After all, high volatility can also present an opportunity for higher returns. This report seeks to provide answers to this question, based on recent market data. The aim of the report is to assess the suitability of investing some of a fund's assets into Bitcoin. This will be accomplished by analysing Bitcoin purely from an investment perspective, and comparing the asset to two traditional assets, namely gold and the S&P 500 index. The research conducted in the report is guided by the following questions:
- How does the performance of Bitcoin compare to the S&P 500 and the price of gold?
- Could adding Bitcoin improve the performance of a portfolio?
- Can Bitcoin be used as a hedge against inflation?
- Can we build a portfolio using some or all of these assets?
The investment fund's CFO is seeking to lower volatility in the fund. Therefore, the recommendations from this report prioritise the minimisation of overall risk.
Disclaimer: Past performance is not indicative of future performance. The work presented herein is not to be taken as financial advice; please consult with a financial advisor and/or do your own research research before investing.
Executive Summary
Using historical prices for three assets (Bitcoin, S&P 500, gold), augmented with inflation data, the research in this report has established the following facts:
- Bitcoin significantly outperformed both the S&P 500 and gold during September 2014 and November 2021. Bitcoin returned 14,000%, the S&P 500 returned 130%, and gold returned 40% over that period.
- Most of the gains in the S&P 500 came before the onset of the Coronavirus pandemic, whereas most of the gains in Bitcoin and gold came after the Coronavirus pandemic began.
- Bitcoin is the most volatile asset in the study, but it is also the most profitable.
- Bitcoin is approximately 7 times more volatile than gold.
- Bitcoin is approximately 6 times more volatile than the S&P 500.
- There is very little correlation among the three assets. The most correlated pair of assets, bitcoin and the S&P 500, exhibit weak positive correlation.
- The best hedge for inflation during the seven year period was the S&P 500, and Bitcoin was a better inflation hedge than gold.
Based on the findings herein, a Global Minimum Variance portfolio, heavily weighted towards gold but including approximately 1% Bitcoin, should be recommended to the fund manager due to its low risk.
Data and Methods
Libraries
import math
import numpy as np
import pandas as pd
import seaborn as sns
from scipy import stats
import matplotlib.pyplot as plt
plt.style.use('seaborn-paper')The Data Set
Bitcoin Data
bitcoin_prices = pd.read_csv('./data/bitcoin-usd.csv', parse_dates=['date'])
bitcoin_prices = bitcoin_prices.sort_values(by='date')
bitcoin_prices.set_index('date', inplace=True)
bitcoin_pricesbitcoin_prices.info()S&P 500 Data
sp500_prices = pd.read_csv('./data/sp500.csv', parse_dates=['date'])
sp500_prices = sp500_prices.sort_values(by='date')
sp500_prices.set_index('date', inplace=True)
sp500_pricessp500_prices.info()Gold and Inflation Data
monthly_data = pd.read_csv('./data/monthly_data.csv', parse_dates=['date'])
monthly_data = monthly_data.sort_values(by='date')
monthly_data.set_index('date', inplace=True)
monthly_data