Investing Billions - E126: How much Bitcoin should Institutional Investors hold? w/CIO of Bitwise

Episode Date: January 3, 2025

In this episode of How I Invest, I connect with Matt Hougan, Chief Investment Officer at Bitwise Asset Management. Matt shares his expertise on Bitcoin and cryptocurrency investments, offering actionable insights on portfolio allocation, valuation, and the evolving crypto market. From the benefits of a 2–5% Bitcoin allocation to the potential of Bitcoin as a global settlement currency, Matt provides a compelling case for crypto as a transformative asset class. This episode is a must-listen for institutional investors, financial advisors, and anyone curious about the future of digital assets.

The biggest risk in crypto is behavioral risk. And when you start going above 5% Bitcoin, historically, Bitcoin becomes the driver of what's called the maximum drawdown of your portfolio. That's when your portfolio goes from looking great to looking pretty poor during a big market pullback. And in our experience, when Bitcoin starts to be the tail that's wagging the dog of your portfolio, people panic when you have pullbacks. Again, this is a very volatile asset. It's had multiple 50% plus pullbacks. If you put too much of it in your portfolio and we get another one of those pullbacks and you sell at the bottom, then you've done real harm to your portfolio. What do you think the odds that the Trump administration will actually invest and put Bitcoin on the US balance sheet? Great question.

So how much Bitcoin should the typical institutional investor have in their portfolio? I'd say the starting point is at least 2%. If you think about Bitcoin, it's a $2 trillion asset. Globally, equities are about $100 trillion. From a benchmarking perspective, that gets you to an allocation of 1% to 2%, depending on how much equity you have. And that's just a starting point. If you're below 1% or 2%, I point. If you're below one or 2%, I'd argue that you're effectively short Bitcoin

versus your benchmark. How did you come up with this 2% number? Yeah, I think there are two ways to approach it. So one is that benchmarking exercise, which is just the starting point for most investors should be matching the benchmark of the global portfolio of assets. And again, Bitcoin has emerged as a multi-trillion dollar asset.

So if you have an allocation of zero, you're underweight versus the benchmark, 2% gets you up to neutral. So that's one way to approach it. The other way to approach it is we've done an extensive study of the impact Bitcoin has in a portfolio over long periods of time, looking at all available data. And what that data shows is that you can improve your sharp ratio, improve your Sortino ratio, improve your risk adjusted returns by adding more and more Bitcoin to the portfolio. Those studies actually suggest that up to about 5% of your overall portfolio,

you're getting historically what amounts to a free lunch, which is higher returns with no additional or low additional volatility. From a portfolio construction perspective, I can make the argument up to about 5%, but from a benchmarking perception, 2%, but certainly not 0%. In layman's terms, if you had invested in S&P 500, but you decided not to invest in one of the stocks, Tesla or a GM, you would essentially be short that stock. You would be making a directional bet against that at 2%, you're basically part of the overall capitalization for the market. That's exactly right.

Yeah. That's a great way of phrasing it. Yeah. Not investing in Bitcoin as part of your allocation policy is like deciding to have 0% invested in Apple or invested in Tesla or invested in Metta or another one of these Mag seven stocks. It's effectively just blanking out a part of the portfolio that everyone else is neutrally investing in.

And that's where we've gotten to Bitcoin. It's now part, in my view, of the global portfolio. And that means most investors should have some allocation to it. And then the extra 3% is analyzing the Sharpe ratio, which is a form of risk to reward ratio, which means that it's logical to hold another 3% based on the risk and reward of the portfolio. It's really interesting when you look at what would have happened if you added 1%, 2%, 3%, 5% Bitcoin to a portfolio historically. A lot of people think of Bitcoin

as this extremely volatile asset, extremely risky, which is true. It is itself very volatile. But because Bitcoin moves differently than stocks and bonds, because it has what's called a low correlation to stocks and bonds, when you add it to a portfolio, it doesn't necessarily make the total portfolio More volatile. In fact, historically what you see is you get higher returns without

Significantly increasing your risk and that's a beautiful thing when building a portfolio I like and it's a little bit like adding like spice to food If you add a little bit, it makes the food taste better. If you add a lot, for sure, your mouth will burn and it'll be risky. That's true with Bitcoin as well. To play devil's advocate, Bitcoin has always been sold as this inflation hedge, stock hedge,

but in 2022, we saw the entire market go down, including Bitcoin. So double click a little bit on when Bitcoin is actually a hedge to equities and when it actually correlates with equities. The real answer to that lies in your timeframe. From a short term perspective, it's absolutely true that if the market pulls back Bitcoin, which is a risky asset, tends to pull back as well. But what the data shows is that it historically recovers

faster than equities. In other words, it gets back up to even faster than stocks do. And then it continues to outperform equities as it rebounds. So if you have a view of the market that's, I'm investing for the next week or the next day, it's not a very good hedge. If you have a view of the market that you're investing for the next year or the next three

years, it's historically been a very, very good hedge and a very good way to, again, get those higher risk adjusted returns. So it comes down to your timeframe. And when you look at your portfolio construction, some people YOLO and put 20%, 50% of their portfolio in Bitcoin and crypto. Why is that not prudent? The reason it's not prudent is the biggest risk in crypto, bigger than regulation or volatility or tech risk or adoption risk.

The biggest risk in crypto is behavioral risk. And when you start going above 5% Bitcoin, historically, Bitcoin becomes the driver of what's called the maximum drawdown of your portfolio. That's when your portfolio goes from looking great to looking pretty poor during a big market pullback. And in our experience, when Bitcoin starts to be the tail that's wagging the dog of your portfolio, people panic when you have pullbacks. Again, this is a very volatile asset. It's had multiple 50% plus pullbacks. If you put too much of it in your portfolio and we get another one of those pullbacks and you sell at the bottom,

then you've done real harm to your portfolio. So you need to have just enough that it influences your portfolio but you're not going to panic. If the bottom falls out right i can withstand a five percent loss in my portfolio we see that in the s and p five hundred all the time i don't panic. What if it was thirty percent of my portfolio and it had a massive draw down i might have a bad bad behavioral action. And so that 5% limit is designed sort of to protect against that feeling you get in your gut when you have a big market pullback. And that is why we think that's an appropriate level. There was a famous study where they, the study showed that the more somebody opened their public portfolio, the worse their returns were. So their management of their public portfolios was inversely correlated with returns.

That's exactly right. Yeah. And that's especially true in Bitcoin. Remember, it's more volatile than almost anything most people invest in. It's also in the news. It's on the frontier of technology. That behavioral risk is absolutely the biggest risk when you're investing in Bitcoin, so you need to adjust for that when you're building your portfolio.

Recently, Michael Saylor made this convertible note product that was very popular with hedge funds and really almost levered himself into Bitcoin. What do you think about MSTR and what Michael Saylor did? I think what Michael Saylor is doing is fascinating from one perspective. He's found a way to raise money in the public markets through bonds that pay 0% interest and then to buy an asset that's appreciating historically at 100% a year, that's an incredible trade. And as a result,

MicroStrategy has been one of the best performing stocks in the world over the last few years. The challenge with MicroStrategy, which investors should think about, is that it trades at a premium to its Bitcoin holdings. What I mean by that is, let's it holds a thousand dollars of Bitcoin The stock has traded anywhere from a thousand dollars to three or four thousand dollars Now there is a mathematical argument for why it should trade to a premium to its Bitcoin holdings But should that premium be 10% a hundred percent two hundred percent three hundred percent That's very hard to figure out and it really based on momentum in the market 10%, 100%, 200%, 300%.

That's very hard to figure out, and it really based on momentum in the market. So the exciting thing for an investor investing in micro strategy is you get something like leveraged exposure to the price of Bitcoin, which can be great. The risky thing is if you buy it when it's trading at a 300% premium, and then it starts trading at 100% premium, you can lose money even though Bitcoin is flat. So it's a complex investment. Look, I love what Sailor is doing. He's a real leader in the Bitcoin community, but you need to understand this premium variation

element if you're going to buy micro strategy stock. We've known each other since 2018. You've always been a Bitcoin bull, but you're also not a Bitcoin maximalist, meaning you believe in other cryptocurrencies. Tell me about how institutional investors should look at other cryptocurrencies. I think blockchain is a fundamentally transformative technology. One of our most important technological leaps. It can be applied to do many different things.

Bitcoin uses blockchain to create a public form of money, a digital gold. And I think it's one of the most important financial innovations in a long time, has plenty of room to run. But there are other things you can do with blockchain. If you look at Ethereum, they're using blockchain to create sort of a new internet for money and finance and social networks. That's very exciting.

I think about Ethereum as a technology investment. Like it almost belongs in the NASDAQ. People are building applications on it. Like you would build an application in the Apple app store. So if Bitcoin is money or gold, Ethereum is technology, sort of belongs amongst the Mag-7 tech stocks. I think that's a good way for investors to start thinking about this asset class. What are the arguments for. Diligencing all the non-Bitcoin assets and picking your favorite versus buying a basket?

Man, it's so hard to diligence them and pick your favorites. I mean, I come- Why is that? I think it's always hard in early stage technology to predict the winners. My family owned a Betamax. That turned out to be the wrong bet. I remember Myspace before Facebook.

We all had BlackBerrys and then there were iPhones. Sometimes the first mover is the winner, right? Apple, Amazon, sometimes it's not the first mover. If we got into comparing Ethereum and its other competitors in these non-Bitcoin coins, if we talked about Solana, which is maybe the next largest coin after Ethereum, or Cardano, or Aptos or Monad. I could actually make a pretty good argument for each of them.

They all have different design choices. They all have different communities. There are reasons to be excited about each and every one of those. But how would I invest? I would buy the basket because I have a high degree of confidence that programmable blockchains are going to be more important in the future than they are today and a low degree of confidence that I can pick the winner. So it's like going back to the early days of search.

Could you have chosen Google over Yahoo? Maybe. But if you would just bet the field, you would have done extremely well. I think the same is true in crypto. I think most investors will be best served just by buying a basket of these and making sure they always own the leading crypto assets, then trying to pick and choose one or the other winners. I think it's interesting because it's one of these lessons that's consistent across many different platforms. You mentioned Amazon. If you had bought Amazon just at the IPO price, so as a public company and held it to say you would have a 2,500 X return. Now imagine that

there was another nine promising IPO companies or promising technology companies. If you had invested in each one of those and if nine of them would have gone to zero, you would have gotten a 250x return. Now, of course, 2,500 is much better than 250x. But if you want to make sure you're investing $100,000 and you want to make sure that you take advantage of a platform shift or a new technology, I think it's hyper rational to actually diversify. I think that's right. You know, it's better to be generally right than precisely wrong. And it's absolutely true. Look, if you're thinking about crypto today in a serious format, you're ahead of most investors in the world.

That, to me, is your alpha opportunity. Do you really want to conflate that alpha opportunity with trying to pick Ethereum, Solana, et cetera? It's just, it's very hard. I'd rather get the big trend right than try to focus on the specifics. But I know that people love to go and try to chase things, particularly in crypto.

If you talk to people who love Ethereum, they only love Ethereum. If you talk to people who love Solana, they only love Solana. I do this 24-7-365. I can't tell you exactly how it's going to turn out. So just buy the basket. Make sure you get that 250X return. I love that analogy.

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And the reason for that is that the cryptocurrencies are driven by developers and communities, which are very difficult to predict. This is beyond just the technology. You need to see where the developers are going to developers and communities, which are very difficult to predict. This is beyond just the technology. You need to see where the developers are going to, and that could change on the dime. Sometimes these are irrational decisions. Sometimes the founder of a cryptocurrency could do something that the developers don't like, and they just switch chains. So I don't even know if it's possible to have a quote unquote right answer. I think that's exactly right. And in fact, we have already seen that in the crypto space over the last five years.

We've seen exactly the example you gave. I agree. It's probably unknowable. And so, you know, why make a hundred percent bet on something that's unknowable? It's just not how I approach any other part of the market. And it's not how I approach crypto either. What are the first principles reasons why crypto is so cyclical? It's because it's so early and it's so promising. Let me unpack that a little

bit. Mostly, traditional investors don't get involved in markets until they're relatively mature, right? Until they're public equities and these are companies that have grown up and maybe have a hundred million dollars in revenue or more and they're well established. Crypto opens that up. You can invest in a protocol that is just emerging today. Indeed, when Bitcoin started, it was publicly traded before basically anyone knew what it was. So you're getting in early.

And then these are very exciting, promising technologies that are going after very large markets. Bitcoin is the best performing asset of all time. It's compounded at 100% per year. What happens in markets that go up a lot? And this explains the cyclical piece of it. What happens in any market that goes up a lot is investors start building leverage on top of their positions. They start maybe over investing.

They get overexcited and overhyped. We see this outside of crypto. You see this in any technology area. It goes from skeptics to mainstream to overhyped. And then there is a reset. The same thing happens in crypto. Because it performs so well, it attracts a lot of money and the market gets overheated and then there is a pullback.

But the important thing to remember is we've had multiple of these sort of boom and bust cycles in crypto, but when it pulls back, it doesn't go back to where it started. I think there's a mix of fundamental investors and fundamental market changes and then speculators that ride on the growth of Bitcoin. No other asset class in the world has this reflexivity to it where everybody's tracking and it goes up. If you look at NASDAQ, people aren't obsessed with NASDAQ always refreshing it or they don't feel FOMO for missing on it. So I think what happens fundamentally, to give an example, a sovereign country like an El Salvador may switch to having Bitcoin on their balance sheet. That's a fundamental change in the TAM or the total addressable market for Bitcoin.

That's really good. That also means that maybe other countries will also join. So that increases the price, let's call it by 20%. And then there's another increase of 20, 30% of the speculators that are literally buying it because it has gone up, which is the worst possible reason to buy an asset. And then it basically draws back to this new normal. That's absolutely right. And what you would expect with that characterization is this effect will reduce over time. And that's in fact what we're seeing.

You would expect the volatility of Bitcoin to reduce over time. And I know it feels like it's still extraordinarily volatile and it is, but the volatility is down about 50% from 10 years ago. So we're making progress, but it's exactly the mechanism that you described that drives this. Just to double click on that, the reason it's becoming less altos because there's a shift from speculators to more fundamental investors or is it just because it's larger?

It's there's two, one, there's a shift from speculative to more fundamental investors. That's absolutely true. And there are more types of investors coming into the market, right? institutional investors, financial advisors, those didn't exist in the market beforehand. But there is also just the reality that it's becoming less risky over time. You know, 10 years ago, there was a reasonable chance that there was some unknown in crypto that would cause it to not work in the market, right? There was something that would blow up in the space that That no longer exists.

We've now been around for 15 years. The likelihood that crypto goes to zero has been dramatically reduced, and that naturally compresses the volatility in the market. I know you take a very precise and academic view on Bitcoin. I'm going to ask you a question. What do you think the odds that the Trump administration will actually invest and put Bitcoin on the US balance sheet? Great question. I think I'm going to answer it at two levels. So the first level is the US already owns about 200,000 Bitcoin from seizures, particularly in the very early days of Bitcoin

from Silk Road in 2013 and 2014. I think the odds that we keep that Bitcoin instead of selling it are extremely high, I would say above 90%, almost a certainty. And that's really important. One of the reasons Bitcoin traded sideways for much of 2024 is that governments were selling their Bitcoin around the world. So will we keep that Bitcoin? Almost certainly. The likelihood that the government starts buying Bitcoin, I think is something like 25%. I should put a note on that. 25% doesn't sound like much, but that is an extraordinary fact compared to where we were. Is it already priced in? No, I think it's not priced in at all. I think if the US government's not one bit, not one bit,

if the US government starts buying Bitcoin, I think you're looking at Bitcoin at $500,000 or a million dollars a coin within a period of a year. Because it won't just be the US government. If the US government is buying Bitcoin, you can believe that nearly every other country or where in the world is going to buy Bitcoin. And if that happens, the supply demand imbalance will be so large that I think it'll put past bull markets in Bitcoin to shame. So the fact that I'm talking about, there's a real chance we could see this is an extraordinary fact. And I don't think it's priced in in any way into the market.

think it's priced in in any way into the market. We've all seen our friends in Silicon Valley be drafted into the incoming Trump administration. What practical effects will the Trump administration have on crypto? It's going to be an extraordinary change on crypto. And I think it's going to unleash thousands of high quality entrepreneurs and bring many institutional investors into the space.

I'll hit on that last point first. We've done a survey of professional investors in crypto every year for the past six years and asked them, what's keeping you from investing in crypto? And you might think it's something like Bitcoin is so volatile, or I don't know how to value it, or I don't fully understand it. What they've said in each of the last six years on an overwhelming basis is the number one thing keeping institutions out of the market is regulatory concerns. The fact that we now have a pro crypto administration and a pro crypto Congress means we're going to have regulatory clarity in the U.S. on crypto. And that means that I would argue the vast majority of institutional investors who are currently on the sidelines are going to come into this market and start building that one, two or 5% position that we spoke about earlier. That's a sea change. The other half of the piece is I think crypto has been sort of held down by this regulatory cloud.

sort of held down by this regulatory cloud. And that has kept entrepreneurs from coming into this space and building massive real-world crypto applications. If you were a promising entrepreneur or a promising developer, you could build in AI, you could build in crypto, you could build in any other area of the technology. You might've stayed away from crypto because it had this regulatory cloud over it. Once that's removed, once we establish, as the Trump administration

has said, that crypto is a major part of the US economy and the US wants to win in crypto, you're going to see those entrepreneurs come in. So I think we're going to have a golden age of crypto applications and crypto development that the market probably isn't expecting. I think it's a real change. I want to double click on both of those because I think there's a lot to unpack there in regards to the regulatory uncertainty for institutional investors. A lot of people might not be aware is that when you're managing pension funds, when you're managing endowments, when you're managing very large family offices,

it's as much of a asset management game as sometimes a political game. And specifically, you could get your hands burned by investing in the asset class that maybe the expected value was very high, but for some reason, you know, went to zero or had a huge swing. So there's a lot of career risk that has thus far been institutions. That's why, as far as I understand, only one pension fund has actually invested in crypto. Swib, Chris Presto, who was on the podcast previously. The second thing goes back to the developer and the career risk.

If you look at what's more risky than putting five, 10, 20% or whatever amount of money into crypto is actually betting your entire career on it. If you're a really top engineer and you have the choice to work at OpenAI or set crypto company and you have a family, that's gonna dissuade some meaningful percentage from going into crypto knowing that, your equity overnight could evaporate.

That's exactly right. And I think people underestimate the impact that that's had, right? Because people are asking, where are all the real world applications? And there's a few explanations for that. But one is that we've been keeping the talent out of the industry.

And they're now flooding into this market because it has everything else going for it. It has a breakthrough disruptive technology. It has a lot of money that is looking at it. It has large addressable markets. I think there's going to be this incredible flowering of really exciting crypto applications that we start to see hit the market as soon as the next six to 12 months. Do you foresee that Bitcoin specifically will have any other application except a store of value in the future? I absolutely do. Yeah. I think what's going to happen is it's establishing

itself as a store of value, a form of digital gold. But I think sometime in the next five years, it's going to be used to settle international transactions between countries to unpack that a little bit. Today, most international trade is settled in dollars, but there are an increasing number of countries who are uncomfortable doing it, and they're investigating different ways to settle their transactions, be it in the Chinese renminbi,

be it in current the BRIC nations, be it indeed in gold. They're searching for alternatives to just relying on the dollar because the US has sort of politicized the dollar and made it a geopolitical weapon. So we're moving into this new multipolar world. My bet is that at some point in the near future, in a multipolar world, countries will want to settle transactions using a non-political currency.

In other words, not the renminbi, not the dollar, not the rupee, a currency that belongs to no state or government. The only currency where you can settle meaningful transactions that's non-political is Bitcoin. So as we take these continued steps into this multipolar world, I think you're going to start to see Bitcoin used for major transactions around the world between different trading parties that can't agree on the currency to use. And that's, again, a multi-trillion dollar use case that I think is not that baked into

the market at all, but I do think is coming in the next few years. Given that Bitcoin doesn't produce cash flows, it has no dividends, one of the reasons Warren Buffett hasn't liked it historically, how do you go about valuing Bitcoin today? It comes down to supply and demand. And in fact, you know the supply of Bitcoin, there will only ever be 21 million Bitcoin. So it really comes down to demand. What I do is I look at the size of the markets that Bitcoin is going after. Right? Let's say Bitcoin is trying to match gold.

Gold is, say, an $18 trillion asset. If Bitcoin indeed rises to be as important in the world as gold, every Bitcoin will be worth roughly a million dollars. So what do you do with that? Well, you look at Bitcoin today at $100,000 and you say it's about 10% penetrated into the market for gold. Over the next five years, do you think that penetration will go up or down? I think it might go up significantly.

In fact, I think it could reach parity with gold within that timeframe. You can use that to then discount backwards to a net present value for today. So I think it's as easy as thinking about how big are these markets that Bitcoin is going after? How many Bitcoin exists? How much of that market will it take? And you do a simple division and you end up with a price target.

When I look at Bitcoin at $100,000, I know people are very impressed that it's gone from a dollar to $100,000. I think it has a long way to go, right? I think until it matches gold, it's still at the early stage of its development. I actually think its market that it's addressing is much bigger than gold. As I mentioned, I think it's going after international trade and a handful of other markets. But at least that gold level, which is about a million dollars a coin, I think would mark sort of where it goes from early to mature. Taking a step back, your chief investment officer of Bitwise.

What is Bitwise? Bitwise is a specialist crypto asset manager that helps everyday investors gain high quality exposure to the opportunities in crypto. We started way back in 2017. We created the first crypto index fund, sort of the S&P 500 of crypto, designed to give you broad-based exposure to the space. We've been running that strategy for seven plus years now.

We've avoided the largest blowups in the space. We didn't invest in FTX. We didn't invest in the Luna stable coin, but we've had exposure to the most successful assets like Bitcoin and Ethereum. We've built on that to offer Bitcoin ETFs and Ethereum ETFs and alpha strategies and other funds that gain exposure to all the opportunities in crypto.

But effectively, we want to be the bridge between investors who are interested in this space and high quality exposure to this space. And we've been doing it through bull and bear markets for seven plus years, and we'll be doing it through bull and bear markets, ideally for decades into the future. So how would people go about following you? Yeah, I'd say two things. One, you can follow me on Twitter, at Matt underscore Hogan. It's H-O-U-G-A-N.

I post a lot of my insights there, but I've come over to the Bitwise Investments website. If you go to the insights tab on that website, I write a weekly memo called the CIO memo that's free, and you can get my thoughts on the market every week. It's short. I tend to write about 500 to 800 words because I know you have a lot going on. But that would be a good way to get an institutional investor's view of what's really happening in this market, where the most interesting developments are and where we're going tomorrow.