Managing Cryptocurrency Risk via Portfolio Rebalancing

I wrote recently about how the addition of cryptocurrency to a portfolio over the last five years would have increased the risk-adjusted return of a portfolio as measured by the Sharpe ratio. In that article, I analyzed three possible portfolios; one with 5% bitcoin; one with 2.5% bitcoin and 2.5% ether; and one with no cryptocurrency (standard 60/40 allocation). In each of these portfolios, I assumed the allocations to each asset would be rebalanced annually.

I imagine that if you had actually held 5% of your portfolio in cryptocurrency back in 2016 (the beginning of the above analysis); you might find it a little difficult to rebalance annually like I assumed in that article. This is because it feels painful to sell off our winners to buy more of our losers (which is what you’re doing when you rebalance). The thought of missing out on future growth in your crypto holdings weighs more heavily than thought of a hypothetical crash.

Take ether (ETH) for example; it has grown at ~333% compounded annually since 2016. It grew at a jaw-dropping 8,882% in it’s best 1 year period. Bitcoin (BTC) has posted similarly amazing results; growing at a compounded annual rate of ~153% and posting a 1 year best of ~1,271% during the same time period. Now ask yourself how you might feel about selling off an asset that has between 150% – 330% annual returns to spread your money out across various classes of stocks and bonds? For me, it would be incredibly difficult. But it’s important to consider the consequences of not rebalancing. In the table below, you will see that while your “total return” might increase without rebalancing, your risk adjusted return actually drops. This means that with no rebalancing you are less efficiently trading risk for return.

Rebalancing vs. No Rebalancing

Metrics55% Stock, 40%, 5% BTC w/ annual rebalancing55% Stock, 40%, 5% BTC w/o annual rebalancing55% Stock, 40%, 2.5% BTC, 2.5% ETH w/ annual rebalancing55% Stock, 40%, 2.5% BTC, 2.5% ETH w/o annual rebalancing
Ann. Volatility14.15%36%33.15%103.7%
Sharpe Ratio1.621.291.321.21
Mean annual return (geometric) 25.69%50.55%48.58%120.11%
Portfolio Visualizer: Jan 1, 2016 – Mar 31, 2021 / Volatility spikes and Sharpe ratio drops with no rebalancing

During the same time period that BTC and ETH posted the stats above, they also showed remarkable volatility. BTC had a ~74% drop in value while ETH posted an equally cringe-worthy ~90% drop in value. Now, if you had a small portion of your portfolio dedicated to such assets when this happened; you would probably be ok.

But had you invested at the beginning of the same time horizon as our analysis (Jan. 1 2016) the only way a small portion of your portfolio could still be dedicated to BTC/ETH would be if you were continually selling off your crypto, i.e. rebalancing, as they grew. In fact, had you not rebalanced, a 5% stake in bitcoin in 2016 would have grown to nearly 70% BTC today!

Had you dedicated 2.5% of your portfolio to ETH and 2.5% to BTC in 2016, ETH would have come to represent a whopping 85.3% of your portfolio while BTC would represent 7.56%! The remaining ~7% would be spread out among “traditional” asset classes. 

As you might imagine a portfolio with >90% allocated to cryptos is going to behave far differently than a portfolio with 5%. Granted, you could argue that while crypto might grow to become the dominant holding in your portfolio, it represents value that would have never been there to begin with had you never invested in crypto. Along that line of reasoning you might convince yourself that a crash in your cryptocurrency holdings wouldn’t represent a set back to you or your goals because the wiped-out value would never have been there otherwise. Good luck with that reasoning when you see your portfolio crater.

What about taxes?

Another good consideration to have when it comes to rebalancing is taxes. Unlike stocks and bonds, it’s more difficult to hold cryptocurrencies in retirement accounts. Opening a Roth or Traditional IRA and allocating your dollars appropriately is a pretty straightforward process. But crypto will likely require going through a trust company that offers “self-directed” IRA accounts. Even with such accounts, you will have to move dollars between your standard retirement accounts and self-directed accounts when rebalancing. 

Since the IRS considers the selling or exchanging of cryptocurrencies to be a taxable event, rebalancing will mean introducing tax consequences. The only way to avoid such taxes is via a retirement account, but as described in the last paragraph, that’s not very easy currently. If you wanted to do things the right way and regularly rebalance your accounts, you will have to jump through more hoops than otherwise would be the case.

The reason for this wrinkle is that most large “custodian”, companies that hold your actual retirement funds, still do not allow you to hold crypto. The quickest way for that to change in the foreseeable future is via a crypto ETF. There again however, no such investment vehicles exist in the United States. The fate of future crypto ETFs lies with the SEC. Were the SEC to approve say a bitcoin ETF for example, then custodians could easily allow investors to hold crypto in their retirement accounts. Similarly, with a crypto ETF, investors would very easily be able to rebalance their accounts responsibly without the hassle of moving dollars between institutions.

Takeaway

If you are going to invest in crypto, strongly consider your rebalancing strategy. Are you going to use a self-directed account to avoid taxation? If so, just know that moving money between institutions might be a pain in the neck; and be sure to watch out for fees. Are you just going to use a taxable account with no rebalancing? If so, just know that your crypto holdings could quickly dominate your portfolio, especially if your portfolio is new and smaller. 

Are you going to bite the “tax bullet” and pay taxes to rebalance? If so, be sure to track what you paid for your crypto, how long you held it, and what you sold it for. You might also consider holding your crypto for over 1 year before rebalancing so as to take advantage of lower capital gains taxes (should you have a gain).  Or are you going to wait until custodians have access to ETFs? If so, don’t hold your breath!

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