Back to benchmarks: An intuitive framework for incorporating digital assets into diversified portfolios

CONTRIBUTORS

Max Gokhman, CFA

Deputy Chief Investment Officer
Franklin Templeton Investment Solutions

Lisa Wang, CFA

Head of Goals Based Solutions
Franklin Templeton Investment Solutions

Laura Green, CFA

Portfolio Manager
Franklin Templeton Investment Solutions

Introduction

The rapid rise of digital assets has presented unique opportunities and challenges for investors. Despite being a nascent asset class, its growth has been swift both in terms of the number of investors and the total amount invested. For financial professionals with clients seeking digital asset exposure, this paper aims to provide a framework for incorporating them into a multi-asset portfolio.

Recent research suggests that interested investors possess differentiated goals, preferences and risk tolerances. Before financial professionals begin adding digital assets to client portfolios, we think it is best practice to take a step back and start with adding them to the portfolio’s benchmark through a risk-forward lens. This intuitive approach better accounts for these clients’ risk tolerances and preferences. Once digital assets are in the benchmark, it is then possible to contemplate their funding sources, and other strategic tilts to optimize the portfolio’s risk-adjusted return. We elaborate on this approach in this paper.

Executive summary:

For clients interested in digital assets, we take a differentiated approach by integrating digital assets into the portfolio’s benchmark. This first step allows for the proper reflection of investor interest and appetite for risk.
We prefer a risk-based approach to determine the benchmark weighting of digital assets, given the higher volatility of the asset class. For example, in a 60% global equity, 40% US fixed income portfolio, a 3% allocation to bitcoin (funded from equities) equated to 11.4% of total benchmark risk. In a 100% global equity portfolio, a 6% allocation to bitcoin equated to 16.4% of total benchmark risk (both examples as observed from February 2015 to February 2025).
We believe it is prudent to fund digital assets from other high-risk assets or those with fatter tails,¹ such as emerging market equities and high-yield bonds.
Beyond funding digital assets, additional allocations away from the riskiest assets toward safe havens, such as US Treasuries, can potentially stabilize the portfolio and mitigate overall risk.

EndNotes

In finance, “fat tails” refer to a statistical phenomenon where a probability distribution has a higher than expected likelihood of extreme events occurring, meaning there is a greater chance of observing very large positive or negative price movements compared to what a normal distribution would predict. This is often visualized as “fatter” ends on a bell curve representing the data distribution; essentially, it indicates a higher risk of outlier events happening in the market.

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal.

Equity securities are subject to price fluctuation and possible loss of principal.

Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.

International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Blockchain and cryptocurrency investments are subject to various risks, including inability to develop digital asset applications or to capitalize on those applications, theft, loss, or destruction of cryptographic keys, the possibility that digital asset technologies may never be fully implemented, cybersecurity risk, conflicting intellectual property claims, and inconsistent and changing regulations. Speculative trading in bitcoins and other forms of cryptocurrencies, many of which have exhibited extreme price volatility, carries significant risk; an investor can lose the entire amount of their investment. Blockchain technology is a new and relatively untested technology and may never be implemented to a scale that provides identifiable benefits. If a cryptocurrency is deemed a security, it may be deemed to violate federal securities laws. There may be a limited or no secondary market for cryptocurrencies.

Digital assets are subject to risks relating to immature and rapidly developing technology, security vulnerabilities of this technology (such as theft, loss, or destruction of cryptographic keys), conflicting intellectual property claims, credit risk of digital asset exchanges, regulatory uncertainty, high volatility in their value/price, unclear acceptance by users and global marketplaces, and manipulation or fraud. Portfolio managers, service providers to the portfolios and other market participants increasingly depend on complex information technology and communications systems to conduct business functions. These systems are subject to a number of different threats or risks that could adversely affect the portfolio and their investors, despite the efforts of the portfolio managers and service providers to adopt technologies, processes and practices intended to mitigate these risks and protect the security of their computer systems, software, networks and other technology assets, as well as the confidentiality, integrity and availability of information belonging to the portfolios and their investors.

This document is intended to be of general interest only. This document should not be construed as individual investment advice or offer or solicitation to buy, sell or hold any shares of fund. The information provided for any individual security mentioned is not a sufficient basis upon which to make an investment decision. Investments involves risks. Value of investments may go up as well as down and past performance is not an indicator or a guarantee of future performance. The investment returns are calculated on NAV to NAV basis, taking into account of reinvestments and capital gain or loss. The investment returns are denominated in stated currency, which may be a foreign currency other than USD and HKD (“other foreign currency”). US/HK dollar-based investors are therefore exposed to fluctuations in the US/HK dollar / other foreign currency exchange rate. Please refer to the offering documents for further details, including the risk factors.

The data, comments, opinions, estimates and other information contained herein may be subject to change without notice. There is no guarantee that an investment product will meet its objective and any forecasts expressed will be realized. Performance may also be affected by currency fluctuations. Reduced liquidity may have a negative impact on the price of the assets. Currency fluctuations may affect the value of overseas investments. Where an investment product invests in emerging markets, the risks can be greater than in developed markets. Where an investment product invests in derivative instruments, this entails specific risks that may increase the risk profile of the investment product. Where an investment product invests in a specific sector or geographical area, the returns may be more volatile than a more diversified investment product. Franklin Templeton accepts no liability whatsoever for any direct or indirect consequential loss arising from use of this document or any comment, opinion or estimate herein. This document may not be reproduced, distributed or published without prior written permission from Franklin Templeton.

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