Are you interested in an intelligent exposure to Bitcoin or other digital currencies? Wondering if this is a good addition to your current portfolio, and if so, what the right amount is?
We’re joined today by Ben Jacobson, principal at IDX, to discuss these issues and more, starting with a broad overview of how you can invest in Bitcoin today.
(Note: This isn’t cryptocurrency 101. If you’d like a primer on crypto, please contact us directly.)
3 Ways to Invest in Bitcoin
There are three main ways to invest in Bitcoin and other digital currencies at this stage.
1. Direct Holding
The first way is direct, with digital currency exchanges or wallets like Coinbase. With these platforms, you hold the digital currency itself.
One benefit of this method is that you’re actually holding the digital currency. One drawback, however, is that it’s not a very easy process to get set up with a wallet. And if you do take your Bitcoin off of the exchange, don’t put it in a wallet, and lose your private key, you could lose those Bitcoin.
More importantly, this is long-only exposure. That means you profit if it goes up and only if it goes up.
Also, there’s no true downside protection or risk management in place, and these are very volatile asset classes. That’s often important for investors.
That’s the first option — going onto an exchange and purchasing the digital currency. The next option is what are called trusts.
These trusts look and feel like an exchange-traded fund (ETF). Without going too deep into the mechanics of how they work, these ticker symbols, if you will, are something that you can buy on Charles Schwab, TD Ameritrade, or any major exchange.
Just like direct investing in Bitcoin, those are long-only in the sense that you’re only making money if it goes up. If it goes down, then you’re going down with it.
3. Hedge Funds
The third option is hedge funds. Many of you are familiar with hedge funds, but now, hedge funds can go in there and actively trade as well.
The drawbacks of that format are, generally speaking, they’re pretty black-box. You don’t really know what they’re doing. They like to have their secret sauce, and there isn’t a lot of transparency.
Also, the fees can get pretty extensive. They often charge what’s called a two and 20. That’s 2% of the assets under management and 20% of profits. In other words, if they make you $100,000, they’ll keep $20,000 for themselves.
Those are really the three main ways that you can invest in Bitcoin these days.
IDX takes a risk-managed approach, primarily using the second method. We use trusts to actively manage that exposure by getting in when it makes sense and getting out and protecting against risk when the market shifts.
Hedge funds can also have a significant lockup period, but that depends on the hedge fund. Almost all of them have lockup periods as long as six months or a year.
Also, even when you do go to make your request to withdraw from these hedge funds, they can have contract language in place so that they can give you just 5% or 10% of your money back at a time.
Further, during the financial crisis in 2008, a lot of these hedge funds just said, “No, we’re not doing any redemptions right now. We’ll go out of business if we do.” So there are additional risks with that form.
Creating a Bitcoin Strategy
Creating a strategy for digital currencies requires certain parameters. The best way to explain, though, is with a story.
Our chief investment officer at IDX, Ben McMillan, is a brilliant statistician and a brilliant mathematician. He’s a big data guy.
Back in 2011, 2012, where Bitcoin was really starting to take off, he actually started his own mining operation. At the same time, because he’s a finance wizard, he was creating a trading philosophy around it and looking to reduce the downside.
Well, it didn’t take him long to realize, as he was trading with this model for his own account, that he could make more money trading the intelligent exposure to Bitcoin strategy than actually mining Bitcoin.
Reducing Downside for Wealthy Organizations
Now, at IDX, we primarily work with big institutions, endowments, foundations, and groups like that. And we took this strategy out to our current clientele base. These are already massively wealthy organizations. Their goals aren’t necessarily, “Hey let’s go make as much money as we can.” It’s more like, “Let’s make sure we stay rich.”
These groups want to invest and create some return, but what’s even more important is protecting against the downside and lowering the volatility so that it’s not as risky of an investment for them. They don’t need to be swinging for the fences. They’ve already got plenty of money.
So the parameters were, “Can we build an intelligent exposure to Bitcoin, and digital assets generally, that won’t succumb to all the downsides?” Because we have seen tremendous Bitcoin drawdowns, and those drawdowns can really impact your ability to compound wealth over time.
Intelligent Exposure to Bitcoin Strategy Performance
Focusing on downside risk mitigation was essential, but we also need to discuss how this intelligent approach to Bitcoin strategy performed historically.
The Grayscale Bitcoin Trust is actually what we trade in and out of to get our exposure. And by being invested for 146 days, or 40% of the year, we were able to keep up on that return with long-only exposure as if you would have been just in Bitcoin or just in the trust.
That’s kind of the idea — winning by not losing. Spend less time in the market, but make sure that we’re in the market at the right times. And if we can avoid that other 50-60% of the time where there isn’t compensated risk with Bitcoin, then we’ll do much better for our clients over time.
Remember, we’re managing risk here. So we won’t always keep up with Bitcoin or the Grayscale Trust. But by removing those drawdowns, and keeping your ability to compound as opposed to catching up after a big loss, you can make more money over time.
Again, this is a long-only approach. And when you manage the risk, you end up winning over time.
Also, much of this is back-tested. We started managing money with this strategy in June 2019. And the model was working well prior to that, but it actually has worked better with live client dollars since that start date.
Bitcoin Volatility & Downside
For comparative purposes, it’s important to be aware of how volatile Bitcoin is on the downside. In other words, if you’re maintaining wealth, when Bitcoin goes down, it goes down a lot.
That’s why an intelligent exposure to Bitcoin requires so much care. Because if you have a 50% loss, you’ll need a much higher return just to get back to where you were.
For example, if you lose 50% of $100 and you’ve got $50 leftover, you’ll need a 100% return on that $50 to get back to where you were. And Bitcoin has these drawdowns all the time.
Last year, 2020, was a fantastic year for Bitcoin. You heard a lot about it on the news. It was up 300% at one point. Most people don’t realize, however, that from the middle of February to the middle of April there was a drawdown of about 45%. And that was a great year. If you look at 2018, Bitcoin was down over 80%. You would have needed a 400-500% return just to get back to where you were.
At IDX, we did better than a long-only exposure last year is because we avoided these drawdowns. We got out of the way when Bitcoin went down, and we didn’t have to catch up as much. We could spend more time compounding those dollars.
Accessing the Strategy
This risk-managed approach that cuts the downside uses an algorithm, or “secret sauce,” but the bottom line is it’s an accessible strategy for retail investors. It’s not a hedge fund, there isn’t a million-dollar minimum, and there aren’t long lockup periods.
This intelligent exposure to Bitcoin is a strategy that can work with an everyday portfolio, in part because it’s still such a new space. There aren’t a lot of great options out there for investors to jump into this asset class.
What makes the IDX strategy work is that the risk mitigation makes it applicable for a wider range of investors and the ease of use factor. You can go in, open up an account, and be trading in a couple of days. It doesn’t require accredited investors or million-dollar minimums. It’s something that you can own in the retirement account and in a Roth or an IRA.
How Does Intelligent Exposure to Bitcoin Help a Diversified Portfolio?
Investors always hear about making sure you’re diversified, with stocks, bonds, and such. The next question about intelligent exposure to Bitcoin is, how does it help performance if you add it to a portfolio?
Most people see the headlines about Bitcoin and say, “Oh my gosh, look at that return.” They’re not wrong — that return is very much a positive thing, but there’s more to it than that.
There isn’t much correlation between the digital currency index and the rest of your portfolio. In other words, it tends to do its own thing. It doesn’t necessarily move up and down with stocks or with bonds the way that other asset classes will.
For example, in the fourth quarter of 2020, while stocks slowed down around the election, the digital currency index was performing well. And a lack of correlation means that when other pieces in your portfolio are not doing as well, crypto can offset those losses. It really helps balance the whole portfolio.
Of course, that can cut those both ways. There will be times where your stocks and your bonds are up, this strategy is down, and that’s okay. It’s important to have different pieces in the portfolios that zig while others zag. You aren’t putting all of your eggs in one basket.
Full disclosure: FFF uses this strategy in our portfolios and it has helped with our total return. However, this is not a solicitation for investments or an official recommendation. Discuss investing in digital currencies with your professional advisor.
The Thought and Action Podcast, hosted by Erik Flegel, is where you can learn about what’s going on in the world of wealth and what you can do about it. Click here for more episodes!