In my last article, I covered some of the fundamentals of Ethereum for investors curious about the cryptocurrency space. This article focuses on Ether (the official name for the local currency of the Ethereum Protocol) as a fixed asset.
Ether is so volatile that one could argue (and crypto lovers probably will) that it doesn’t really fit into a traditional portfolio analysis framework. It’s more of a speculative game with the long-term shift towards digital money and an ongoing revolution in the financial technology landscape. Even so, investors tempted to bet on ether should proceed with caution, bearing in mind that even small doses of ether can dramatically change a portfolio’s risk profile.
From an investment perspective, the arguments in favor of ethers are extremely mixed. Investors who got in early have literally made millions, as the chart below shows. But Ether has shown even more volatile price movements than Bitcoin, with increases of up to 9,900% in 2017 (no, that’s not a typo), followed by a loss of 82% in 2018. Like other cryptocurrencies, Ether has been exposed to extreme price fluctuations in the last few months. For example, in the third week of May, the price of ether fell about 38%, although it has since made up most of its losses.
Big risks, big rewards
This high price volatility makes owning ether more difficult than bitcoin. For the past five years, the standard deviation of ether has actually been more than 9 times that of the Morningstar US Market Index, a broad benchmark for US stocks, and almost twice that of Bitcoin.
To quantify the potential impact of Ether as a portfolio addition, I looked at the impact of adding various percentages of Ether (using the CMBI Ethereum Index as a proxy for Ether) to a portfolio that had an 80% weight in the Morningstar US Market Index and 20% in the Morningstar US Core Bond Index. In either case, I’ve taken the cryptocurrency allocation out of the portfolio’s stock weighting and kept the bond weighting constant.
As the following table shows, a little bit of ether is enough. While Ether’s generally low correlation with stocks and bonds helps mitigate the effects of its stratospheric volatility when combined with traditional portfolio holdings, it still doesn’t require much commitment to dramatically change a portfolio’s risk profile. (This result is similar to what my colleague Adam Millson found in his recent study that tested the effects of different Bitcoin weights on a traditional 60/40 portfolio). In fact, even a meager 2% stake in Ether would have more than doubled the portfolio’s standard deviation in the final five-year period through June 2021.
Investors willing to take the extra risk would have borne plenty of fruit: A 2% stake in Ether would have more than doubled the portfolio’s annualized return over the five-year period. However, on a risk-adjusted basis, a tiny splinter of ether looked best. The portfolio, which had only 0.5% of its assets in ethers, ended up with the highest Sharpe ratio.
The role of ether in a diversified portfolio
Of course, Ether’s portfolio performance is likely to change over the next five years. For one, volatility has decreased somewhat as cryptocurrencies have moved more towards the mainstream. Over the past three year period, the monthly standard deviation of Ether averaged 107.5%, compared to 81.1% for Bitcoin and 19.3% for the Morningstar US Market Index. That’s still high in absolute terms, but a drop enough to make Ether look more attractive from a portfolio perspective in recent years (despite its sharp decline in recent months).
The role that ether can play in a diversified portfolio also depends on shifts in correlation trends. Over the past five years, ether has had very low correlation with most major asset classes, as shown in the chart below. The correlation to US stocks and bonds, for example, was only 0.12. Like Bitcoin, ether has shown a negative correlation with the US dollar, making it a potentially valuable hedge against long-term weakness in the greenback.
Despite its enormous past gains, Ether’s extreme volatility is likely to rule this out for many conventional investors. As with Bitcoin, it is also difficult to set the underlying value as it does not generate any cash flows. The price is largely based on investors’ willingness to pay, which can change dramatically from week to week or even day to day. On the plus side, ether plays a unique role in the cryptocurrency space. While Bitcoin primarily serves as a digital currency and store of value, Ether also functions as a utility. As I discussed in my previous article, it is used to boost computing power on the network, execute smart contracts and compensate the miners who validate and verify the transactions to add them to the blockchain. This utility function should support the current demand and offer a (theoretical) lower price limit.
The Ethereum Improvement Protocol 1559, which is to be implemented in August, is also intended to make Ether more attractive. Among other things, EIP “burns” a small amount of Ether when someone enters into a transaction, effectively reducing the supply of Ether and increasing its value over time.
For now, however, ether remains a fairly speculative asset. For conventional investors, it is probably best to use in (very) small doses as a hedge against dollar weakness and major disruptions in the global financial system.
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