On the investment value of Bitcoin: Exploring the correlation between Bitcoin and other financial assets

I am considering investing heavily in Bitcoin as part of my poorly managed portfolio. Before I start investing in Bitcoin, I think I should first think about the following two questions to understand the role Bitcoin plays in my portfolio.

1. What is the correlation between Bitcoin and other financial assets?

2. Can Bitcoin exposure ^[1] be replicated using existing financial assets?

My basis is whether it is possible to replicate Bitcoin exposure through existing financial assets, after all, holding Bitcoin still requires a lot of risk. I first listed the Bitcoin linear and logarithmic price trend as the basis for the following analysis.

Is Bitcoin a financial asset?

Before evaluating the correlation between Bitcoin and other financial assets, we should first take a step back and think about whether Bitcoin can be considered a financial asset based on its fundamentals. Assuming that Bitcoin is a financial asset, how should we classify it?

To find the answer to this question, Robert J. Greer's paper "What is an asset class?" can provide effective help. In the paper, Greer defines asset classes as "a series of assets that are basically similar in economics. Assets with different characteristics do not belong to the same asset class."

He believes that there are three broad categories of assets:

1. Capital assets (fixed assets)

A capital asset is any asset that generates future cash flows, such as stocks that generate cash flows in the form of dividends and bonds that generate cash flows in the form of coupons. The fundamental characteristic of a capital asset is that it discounts the cash flows that may be generated in the future, so capital assets are easily affected by changes in the discount rate.

2. Consumable/Convertible Assets

These assets can be consumed or converted into another asset, but they do not generate future cash flows themselves. In other words, they are physical commodities. Convertible assets differ from capital assets in that they cannot be valued by discounting future cash flows. Instead, it is more appropriate to analyze the supply and demand characteristics of the asset.

3. Preservation of value

These assets cannot generate income or be consumed, but they have economic value. The value of these assets lies in the recognition of investors. Currency and collectibles are typical examples of value-preserving assets.

In real life, not all assets can be clearly divided into the above three categories. For example, gold has the characteristics of both a consumable asset and a value-preserving asset. US sovereign bonds are capital assets, but they can also be classified as value-preserving assets. However, the above classification method is still of reference value when building an investment portfolio.

So what kind of asset is Bitcoin? Bitcoin is more consistent with the characteristics of a store of value asset, because it cannot generate income and has no economic value itself, but you can use it. People often refer to store of value assets as "safe haven assets" and "safe assets". Therefore, we can infer that there is a high correlation between Bitcoin and other store of value assets, including gold, other precious metals, Swiss francs, US dollars, and Japanese yen. Safe haven currencies.

Simple method to test the correlation between Bitcoin and other assets

In the past few years, ETFs (Exchange Traded Funds) have become a trading channel for investors in major countries and regions around the world. ETFs can list almost all types of assets. The assets listed on ETFs can promise high-quality returns.

First, I used the brute force method (the brute force method is the simplest, most intuitive and easiest to understand method to solve the problem) to test the correlation between Bitcoin and other financial assets: I calculated the correlation between the weekly returns of Bitcoin and the weekly returns of ETF assets (each worth more than 10 million US dollars), and made the results into the following bar chart.

The results show that the correlation between Bitcoin and other financial assets is extremely low , mostly concentrated between -0.1 and +0.1. The abnormal performance of a small number of ETFs may be because they were launched relatively recently, and the correlation with Bitcoin is actually a false state.

I am a little disappointed with this result, because I was trying to replicate Bitcoin exposure through a series of highly correlated ETFs. In other words, this also proves that Bitcoin can play an important role in my portfolio as a risky asset. However, adding an asset with low correlation to other assets can effectively diversify the portfolio and improve the Sharpe ratio (a measure of the average return per unit of risk). The number of assets with low correlation to other assets is very scarce, which makes Bitcoin an indispensable part of the portfolio.

Using complex methods to test the correlation between Bitcoin and other assets

Next, I decided to test Bitcoin's correlation using a more complex and sophisticated method. I calculated the 1-year volatility correlation from the weekly returns of Bitcoin and certain ETFs. There is evidence that Bitcoin is becoming more like a mature asset class, with decreasing volatility and being more easily associated with macroeconomic factors and geopolitical events rather than Bitcoin events themselves.

Below is the volatility correlation chart I drew.

The results show that even from the perspective of a 1-year volatility comparison, the correlation between the two is still very small , although Bitcoin has gradually moved closer to orthodox asset classes.

Keep in mind, my original assumption was that Bitcoin would be highly correlated with these types of assets. I was hoping to replicate Bitcoin exposure through gold, treasuries, and foreign currencies. The above results prove that this is not possible. Bitcoin is a unique asset class that has no correlation with other assets. Unlike other assets, Bitcoin is not affected by macroeconomic factors.

After this analysis, I am convinced that Bitcoin should be part of my investment portfolio. First, my portfolio lacks value-preserving assets, currently only gold, government bonds, and safe-haven currencies; second, I am surprised that Bitcoin has little correlation with other assets, even other value-preserving assets.

At the same time, Bitcoin can effectively avoid the harm caused by geopolitical events due to its decentralized nature, which has strong theoretical support. Brexit and the price fluctuations when Trump won the US election can provide strong evidence to support this.

Bitcoin's unique positioning enables it to avoid geopolitical risks. At the same time, unlike other hedging assets, it is not affected by macroeconomic factors.

Notes (↵ returns to text)

1. Exposure refers to the location of financial risk in financial activities and the degree of impact of financial risk. The more common term for exposure is used in risk analysis, indicating the location of risk exposure.