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The Institutional Cryptocurrency Portfolio Theory

|Includes: SPDR S&P 500 Trust ETF (SPY), VIXY

Cryptocurrencies have few reliable fundamental drivers.

Higher correlation to the stock market since futures trading indicates institutional money flows.

Perhaps BTC price behavior can be predicted using traditional portfolio volatility management theory.


For the longest time investors and speculators alike watched in awe (and terror) as the prices of cryptocurrencies swung wildly up and down like some kind of insane natural disaster, generating lifetimes of capital gains for holders and capital destruction for panic sellers and people that "FOMO'ed" in. Like all markets, waves of people come to the table with their theories on how to value cryptocurrencies and predict these life changing surges, some more plausible than others.


First, lets face some difficult facts: Cryptocurrencies have few reliable fundamental drivers.

We can know with fair amount certainty what we don't know. Cryptocurrencies have no earnings, so they cannot be valued using a P/E ratio, they have no tangible assets, so they cannot be valued using P/B ratios, they don't even have cash-flows, so determining their discounted net present value is impossible... All very important traditional asset valuation tools become useless when viewed in the light of cryptocurrencies.

In the absence of quantitative valuation, most go for qualitative analysis by asking questions such as: 'How trustworthy is the team?', 'How realistic is their vision?', 'Is the technology secure/feasible/usable?', 'Who are they partnered with?', 'Whats the latest news?'. While more down to earth than non-existent traditional quantitative valuation measures, they still don't provide investors the timing they need in order to avoid the regular 50-90% drops in price that cryptocurrencies often suffer.

This lack of actionable data has lead investors and speculators to rely heavily on technical analysis which is subject to Data Mining Bias and Subjective Interpretation, and therefore cannot be used as a primary or definitive source of trading information (Source).

What Is Left?

Not much, that is, until COBE Bitcoin futures started trading in December 2017. For what was essentially a very obscure speculative asset with no immediate use in the economy, something very unusual started to happen:

Bitcoin, the largest and most influential cryptocurrency began to move very close to the movements of the total stock market itself. Surprisingly this has gone mostly undetected by analysts as most have been focusing on 60 and 90 day rolling correlations rather than longer term 365 day correlations (Shown here as 0.8).

The reasons for this wouldn't be apparent at first when considering the controversy surrounding Bitcoin and its incredible volatility, but perhaps the most eloquent description for Bitcoins use as an investment asset came from Fundstrat's Tom Lee in this presentation:

When included within a diversified portfolio, it generates:

  • Higher Returns
  • Lower Volatility

You can see that under this interpretation, thousands of competitive investment banks, private equity firms and hedge funds would be naturally drawn to an asset with these beneficial portfolio characteristics and the launch of Bitcoin futures was the catalyst needed to bring this asset in reach of these institutions on a global level.

The Global Portfolio

The idea of diversification within a portfolio is nothing new, in fact it has been in use ever since markets began. A typical portfolio has its assets split into classes like so:

Portfolio managers walk a fine line by trying to have just enough of an asset in their portfolios to extract positive returns while lowering the risk of the overall portfolio, most traditional assets have very clear fundamental drivers that can be used to predict their behavior where Bitcoin does not. Therefore it is reasonable to assume portfolio managers will acquire and retain Bitcoin provided there is sufficiently low risk in the remainder of the portfolio and have no other special opportunities available to them, otherwise the portfolios are managed in line with future market expectations through a re-balancing process called re-risking and de-risking.

Portfolio Asset Risk

As risk rises in the portfolio, how does a portfolio manager determine which assets to sell first and which ones to hold on to? Primarily, this is achieved though the Risk/Return framework which displays the relationship between how risky an asset is and how high its returns must be to justify its existence in the portfolio.

Being an asset with no truly reliable valuation measures, Bitcoin naturally occupies the 'Speculation' definition displayed in the upper right hand corner, on the chart bellow this would be shown as a big fat '8' in the top right hand corner of risk/return slope.

As expected, when volatility/risk rises within a portfolio, to get the biggest safety benefit per dollar in the portfolio, the assets with the highest risk are sold first to protect the rest of the portfolio. Traditionally this always began with risky small-cap/foreign stocks as these were the highest risk assets for most of history, this has changed with the advent of publicly traded cryptocurrencies and now Bitcoin has taken position above stocks.

With extremely large illiquid holdings of stocks being an important part of institutional portfolios, portfolio managers gain the greatest benefit in portfolio safety (de-risking) by selling their Bitcoin when stock market volatility rises (VIX), this has naturally lead to Bitcoin being more closely correlated to the stock market.


The implications of this analysis would suggest if one can predict stock market volatility, then predicting the movements of Bitcoin would be significantly easier. While this is true, market timing is still a highly speculative venture and cannot be taken as a guaranteed source of future price information.

This being said, several methods can be overlayed onto this hypothesis to gain an idea of potential future movements.

In order of importance, these would appear as:

  1. Implied Volatility
  2. Stock Market Macroeconomic Fundamental Drivers
  3. Stock Sentiment
  4. Cryptocurrency Sentiment

Implied Volatility

Low volatility is low risk and high volatility is high risk. The Commitment of Traders data on volatility positioning can indicate opinions on the future behavior of volatility (Sourced from here):

Stock Market Macroeconomic Fundamental Drivers

Good future economic prospects reinforce the stock market over the long term, volatility under positive conditions indicate a buying opportunity. The most basic analysis available for free is the Conference Board Leading Economic Index ('Press release' in the top right hand corner):

Stock Sentiment

Closely related to volatility, but with a broader combined array of indicators to give a more comprehensive view of market sentiment (Found here):

Cryptocurrency Sentiment

Used in conjunction with the previous indicators to judge the timing of Bitcoin. Pay close attention to the early 2018 double bottom pattern in both this sentiment chart and the previous sentiment chart. Confluence between these indicators signal positive future returns (Found here):


Bitcoins future value will follow the largest movements of money, these money flows are primarily controlled by large institutions such as investment banks, private equity firms and hedge funds. Since the inclusion of Bitcoin provides positive portfolio effects, it will be included as a result of market competition, but it will still respect traditional portfolio management theory as all assets in the past have. Portfolio management events are almost entirely correlated to future expectations of risk (implied volatility) and as a result can be analyzed using quantitative methods.

A testable systematic approach to Bitcoin movements, based on evidence is far superior to qualitative analysis in isolation and should be part of any professional investment plan. This basic approach to long term price behavior also implies Bitcoin is a cyclical asset, which means it's value is unlikely to rise in the event of a recession. Only after all fundamental analysis is considered, should long term technical analysis be deployed.

Disclosure: I am/we are long Bitcoin.