How Ether May Add Value to a Portfolio

Some members of the digital asset community may question the benefit of adding ether to their portfolio given its historically high correlation with bitcoin. Although we acknowledge this correlation, we also believe trading behavior may increasingly diverge as more investors begin to recognize the distinct use cases and unique characteristics of both bitcoin and ether.

We will further examine this concept by exploring Ethereum's technological innovations and providing a rationale for why Ethereum is likely to remain the dominant smart contract platform over the long term. This article serves as a guide for investors seeking to understand why ether could be positioned as a complementary addition to bitcoin in a modern portfolio.

Key Takeaways:

• Ether’s portfolio metrics closely resemble those of bitcoin with a four-year lag allowing investors to potentially capitalize on earlier cycle gains.
• Although ether’s portfolio performance has been remarkably like bitcoin’s, ether’s divergence from bitcoin in utility and technology may lead to the longer-term dissolution of correlations between the two.
• Ether provides short-term differentiation from bitcoin and other digital assets as a leading stablecoin payment network.
• Ether offers long-term differentiation from bitcoin and other digital assets as the backbone of future technological innovation due to its dominant network effects.  
• We continue to view bitcoin as a monetary asset with the primary investment thesis of hedging against currency debasement which may preclude the need for additional digital asset exposure for some investors. 

Comparative Analysis: Returns

Quantitative metrics play a pivotal role in assessing performance, managing risk, and optimizing portfolio allocation. In this section, we present the following key portfolio metrics: Beta, Compound Annual Growth Rate (CAGR), Volatility, Sharpe ratio, Sortino ratio, and Correlations. Dissecting these measures can provide deeper insights into the comparative performance of bitcoin and ether, allowing investors to better understand how the assets have historically performed in a portfolio.

It is interesting to note that CAGR, the Sharpe ratio, and the Sortino ratio have all favored ether over the past four-year cycle  (04/30/2020–05/31/2024). This indicates that ether’s previous cycle not only outperformed bitcoin but also gave investors better returns in relation to its downside volatility.

These performance figures do not include any additional yield that could be gained through staking. However, considering that current staking yields are 3-5%, most of ether’s positive portfolio impacts come from its price appreciation.  

Due to the difference in maturity of the two platforms, we extended our analysis to include bitcoin’s performance over a previous four-year cycle (2016–2020). The new timeframe provided performance results that were almost identical to those reflected by ether in the most recent cycle. Notably, bitcoin’s CAGR during the 2016 cycle outperformed ether’s by 8%. Additionally, the Sharpe and Sortino ratios suggested a slightly better risk-adjusted return than ether’s recent cycle.

The only notable discrepancy found between ether’s 2020 cycle and bitcoin’s 2016 cycle was in the beta values. This is likely due to the significantly lower correlation between bitcoin and the S&P during that time compared to the most recent cycle.

Therefore, our analysis suggests that if the performance of bitcoin and ether follow their historical trends, ether potentially stands to outperform over the next cycle given its lagging performance. 

Comparative Analysis: Volatility

One of the most frequently cited hurdles for investing in any digital asset is an aversion to volatility. For some investors, there is a stigma attached to bitcoin and ether for having extreme cyclical drawdowns and recoveries since their inception. Moreover, both bitcoin and ether’s unique natures can make it more challenging for investors to fully understand and value these assets, which contributes to lower levels of conviction during the tumultuous downturns. 

For investors that have a more nuanced understanding of bitcoin and ether’s role in the future of money and technology, the ideal approach for managing downside deviation may center on proper allocation sizing and time horizon. As demonstrated below, the annualized volatility of both assets has been on a consistent decline, with the two converging significantly over the past year. Fidelity Digital Assets Research Analyst Zack Wainwright previously identified this trend and compared the volatility of bitcoin to some of the most popular stocks among investors here.

The rationale behind the importance of allocation size and time horizon can also be seen through the lens of rolling returns. Below is a chart of the three-year rolling returns for bitcoin and ether which shows that investors with the appropriate conviction and longer-term investment horizon are rarely in the red.

In fact, ether investors who held their positions for a minimum of three consecutive years experienced only a maximum of 78 days of unrealized losses out of a total nine-year period since trading began in August 2015. In comparison, bitcoin investors had just 33 days of losses over its longer trading history starting in July 2010.   

In summary, based on three-year rolling returns, both assets appear to reward patient, long-term investors. Ether does seem to skew toward higher volatility than bitcoin, emphasizing the importance of conviction and time horizon for investors.   

Comparative Analysis: Correlations

Correlations are a key metric for investors when determining whether ether is an appropriate addition to a portfolio. A commonly cited argument against allocating to ether has been the fact that its high correlation to bitcoin does not provide any valuable diversification. In short—for investors who feel this way—bitcoin is enough digital asset exposure.

It is important to note that there is a moderate degree of validity to this claim based on the weekly correlations below. However, this singular metric and overall stance may not capture the complete narrative in a way that supports a fully informed decision.

What may be more noteworthy is the high correlations alongside the clear divergence in the underlying technology and utility of both platforms. For instance, Ethereum’s Merge to proof-of-stake in late 2022 did not have much impact on the trading of the two assets even though the technical underpinning changed significantly. The Deneb-Cancun upgrade in early 2024 also did not provide any changes in correlations as Ethereum officially embarked on its scaling journey.

Interestingly, most of the divergence in 2024 was instead associated with the approval and launch of the spot bitcoin exchange traded products (ETPs) in the U.S., something most investors are more familiar with. Although Ethereum has diverged from bitcoin significantly in regard to its technology, investors have historically traded them as a similar asset.

Nonetheless, investors seem to be coming around to the idea that bitcoin and ether are completely different assets designed for their specific use cases. Just as businesses carve out specific markets and moats, Bitcoin and Ethereum will continue do the same. Their valuations and trading will theoretically reflect that over time.  

The portfolio analysis above presents investors with four important points:

1. Ether’s performance closely mirrors that of bitcoin’s with a four-year lag.
2. Both bitcoin and ether have more than made up for their downside deviation emphasizing the importance of proper allocation sizing and investment time horizon.
3. Both bitcoin and ether volatility have seen dramatic declines over the past cycles.
4. Bitcoin and ether have been closely correlated, but as the markets that each network serves continue to diverge, we expect this correlation to potentially decrease as well.  

Furthermore, we do not believe that all digital assets will behave this way due to the importance of network effects. This is why it may not be practical to invest in the newest digital assets and expect their performance to mirror bitcoin’s on a delay. We address the importance and difference in network effects later in this piece.  

What Might Differentiate Ether from Bitcoin and Other Digital Assets in The Future?

Bitcoin and Ethereum are likely to continue diverging technologically as we look toward the future. This divergence will result in more differentiated use cases and increase the potential to add further diversification to a portfolio.

One specific example of this phenomenon is the rise of stablecoins, as the medium of exchange use case is the clearest perceived overlap among the two networks. However, the recent rise of stablecoins on Ethereum has already made a case for Ethereum offering greater utility in this sector.

Another crucial factor that separates Ethereum from its smart contract competition is its powerful network effects. While Ethereum may not always outperform its competitors in terms of raw performance and user experience, it has a significant advantage in the form of its established network. Ethereum has had over eight years to build out a robust ecosystem of users and developers which is likely to continue driving its long-term dominance.

The following sections demonstrate how stablecoins’ role in the future of payment networks could further differentiate ether in the short term. Additionally, we also examine how Ethereum’s network effects may help maintain its dominance among smart contract platforms over the long term.

Differentiation from Bitcoin as a Payment Network

Investors seeking immediate drivers of Ethereum’s utility should closely monitor the adoption of stablecoins. These digital assets serve as a means of storing value, enabling trading, borrowing, lending, and facilitating borderless USD transactions. The advantages of Ethereum-based stablecoins over traditional financial systems are evident in three key areas:

Settlement

Another key emerging trend is the increasing percentage of all blockchain transfer value facilitated by stablecoins. In 2023, about $3.4 trillion, $1.4 trillion, and $3.5 trillion were transferred in bitcoin, ether, and Ethereum L1 stablecoins, respectively.¹  

This data does not detract from bitcoin’s store of value thesis but instead reinforces the idea that bitcoin investors typically hold for the long term. In fact, the bitcoin thesis hinges primarily on investors believing in its ability to hedge against currency inflation. This suggests that bitcoin and ether can complement each other in a portfolio by providing distinct types of utility and serving different markets.

The analysis above has supported the idea of why bitcoin and ether accomplish different things and therefore can add diversification to a portfolio. Next, we compare Ethereum to other smart contract platforms to determine why Ethereum may stand above its competition over the long term.

Instead of analyzing what markets Ethereum and its competition may consume over the next decades, we think it is prudent to use a more zoomed-out lens. In the following section, we focus on developer activity as a proxy for future innovation and liquidity as a driver to keep that activity over the longer term.

Differentiation from Smart Contract Platform Competition through Network Effects

Critics often argue that successful apps will create their own blockchain or migrate to a more efficient one. However, the network effects of Ethereum discourage this. Ethereum’s first-mover advantage as a smart contract platform made it the most popular platform for developers due to the initial lack of competition. 

Even though creating a new blockchain has become significantly easier over the years, accruing the validators required for sufficient security and decentralization remains a massive hurdle. For these reasons, it is often easier to bootstrap new networks as applications on Ethereum than to create a blockchain ecosystem from scratch.²  

This may lead investors to ask: What is keeping applications from moving to a different blockchain once they have acquired a sticky user base?  

The answer is that Ethereum’s substantial and distinctive liquidity base serves as a powerful incentive for developers to build and maintain applications within its ecosystem—even after achieving success. Chains outside of Ethereum lack the same level of liquidity, impacting token trading, capital access, and participation in decentralized finance (DeFi) activities.³ Therefore, developers must carefully weigh technical benefits against these liquidity limitations when deciding whether to transition away from Ethereum.

These are the primary drivers behind the popularity of Layer 2 platforms. Layer 2 platforms operate separately from the Layer 1, allowing developers to optimize their environment for specific purposes. This also allows Layer 2s to retain the security, decentralization, and easy access to liquidity that Ethereum provides. 

Although many developers would prefer to have a separate ecosystem of which they have full control over, many choose to launch as an application on the Ethereum Layer 1 or as a Layer 2 platform to reap these benefits.  

As of July 1, 2024, Ethereum had 36% of all full-time blockchain (not application) developers working on its core protocol. When the developers working specifically on Layer 2s are included, that number rises to a staggering 80%.⁴ This means that 80% of developers in the blockchain ecosystem are working directly within  the Ethereum network. In our view, full-time developers offer the most useful proxy for future innovation.

Overall, developers play a crucial role in evolving the Ethereum ecosystem toward the common goal of global adoption. The clear preference to build on Ethereum is what we believe may allow this network to continue to lead the smart contract platform space for many years to come.

In summary, Ethereum’s first mover advantage and large liquidity base have attracted and retained blockchain and app developers. The popularity of Layer 2 platforms, which operate separately from the Layer 1 but retain the security, decentralization, and easy access to liquidity that Ethereum provides, further underscores this point. 

An important nuance here is that the recent popularity of Layer 2s is not guaranteed and has been incentivized by the widespread practice of airdrops. To gauge true network effects, we will need further evidence that users prefer Layer 2 solutions because of their utility as opposed to monetary incentives.  

In the following section, we delve into the reasons why investors may hesitate to include ether in their portfolios, despite the compelling arguments presented above. This analysis will provide a balanced view, enabling investors to make informed decisions about the role of ether in their investment strategies.

Considerations If Excluding Ether from a Portfolio

We have demonstrated above why ether has had a positive impact on portfolios historically. We have also shown our reasoning for why ether is positioned to further diverge from bitcoin and other competition over the longer term. This divergence may or may not result in differentiated price performance, especially if the market still perceives them as similar assets.

Even so, a question to bitcoin-only investors: why are you not allocating an asset that has (at least historically) performed no worse than bitcoin, especially when ether may provide the added benefit of differentiating itself from bitcoin and other digital assets?

It is becoming common knowledge that bitcoin and ether serve different purposes and markets. If investors do not have an allocation to ether or other digital assets beyond bitcoin, they risk a lack of exposure to the future innovation of this industry. Below are some counterpoints to this view for consideration and potential thoughts as to why certain investors may want to keep their digital asset exposure solely to bitcoin. 

First, bitcoin serves a specific purpose. Bitcoin is commonly used to overcome the inflation and debt issues that plague many fiat currencies. Many investors may only be interested in this function and therefore can be comforted by the fact that bitcoin is likely to remain as the dominant store of value asset in the digital assets space for some time.  

Second, ether has specific risks that bitcoin may not face, which could be additional rationale for a lacking or underweighted allocation. These risks stem from the fact that the Ethereum network is more complex and diverse than Bitcoin.

Potential Risks for Including Ether in a Portfolio

There are several potential risks associated with including ether in a portfolio which are important to consider. Technical risk, which we address specifically in our investment thesis, is one of the most commonly cited of these.

Ethereum upgrades typically happen once every 12 months, giving investors ample time to research these upgrades ahead of time and adjust allocations accordingly. However, this requires investors to stay informed on the developments in the space and revisit their thesis as things change.

We understand many investors may not have the time, will, or expertise to do this. Furthermore, the second-order effects of some upgrades may not be easily understood ahead of time and can have unforeseen impacts on an investor’s investment thesis after they have occurred.

Additionally, there are other ways to invest in the Ethereum network outside of holding ether. Since most applications that live on Ethereum have their own token, this allows capital to flow into the Ethereum ecosystem without directly going into the ether token. Some may also argue that the applications on Ethereum may gather the largest share of revenue over the long term—as seen throughout the internet era—and will lead to lower long-term valuations of Layer 1s.

Lastly, another key consideration is competition outside of Bitcoin. Bitcoin is widely regarded as the best store of value in the asset class and will likely remain so for the foreseeable future. Ether has yet to receive this type of standing for what it does, partly because it does so many things. Ethereum is instead viewed as the most secure and decentralized smart contract platform, however it has had difficulty competing with the raw performance of other chains.

As with any asset, either traditional or digital, investors should consider these risks and their unique goals before moving forward with any portfolio planning decisions.

Conclusion

In summary, ether may have added benefits to many portfolios, but it also may not be suitable for all investors. Ether provides investors with a unique opportunity to capture a large sector of future technological innovation that is not reflected in the typical portfolio mix.

We believe  that although bitcoin and ether share similar histories, they will continue to diverge technically, socially, and financially as they continue to mature, offering investors even greater portfolio diversification.

The dominant network effects of Ethereum are a significant reason other smart contract platforms could have a continuously harder time catching up. Investors looking to venture further down the digital assets risk curve should heed this factor when seeking early cycle gains.

For these reasons, it is important to judge whether an allocation to bitcoin fulfills your investment profile. And for investors looking to get broader exposure into the technological innovations of digital assets, it may be time to consider incorporating ether alongside bitcoin in a portfolio.

Interested in learning more about Ethereum and its latest developments? Get in touch.