The Correlation Controversy

Part I: A Crypto Asset Class

Over the past few years, a multitude of perspectives have incentivized investors to expose their portfolios to the cryptocurrency domain. Probably the most straightforward argument considers the underlying blockchain technology as one of the most revolutionary developments in modern financial history. It essentially portrays cryptocurrencies as technology assets which are prone to above-average growth, much like most NASDAQ assets in traditional finance. Then there is the investor type that views the crypto market as the ideal opportunity to place their asymmetric bets. And while the huge upside potential is undeniably present, this argument is often disguised as the first one in hilarious attempts to deny greediness. But there is one more major reason that may dwarf the others in just a few years time.

An asset class is a set of assets that bear some fundamental economic similarities to each other, and that have characteristics that make them distinct from other assets that are not part of that class — Robert J. Greer, 1997

At the heart of investing lies the principle of asset classes. Some well-known examples are equities (e.g., stocks), fixed income (e.g., bonds) and commodities (e.g., precious metals). They partly determine the characteristics of an investment portfolio and reflect its underlying strategy. Think, for instance, of the famous 60/40 rule, which states that a good portfolio is allocated to both stocks and bonds for 60% and 40% respectively. Rules like this ensure that a portfolio is well-diversified, ideally limiting exposure to downward price movements.

The question now arises whether crypto should be considered a new asset class. Or in other words, whether the shared characteristics of the assets across the crypto space make them sufficiently different from other assets like stocks and bonds. In the context of governance this is definitely the case. This role is fulfilled by many different entities, for instance, blockchain and/or application developers, miners, validators, and many more. Obviously, there are no similarities here with any other asset class. Asset supply is also a crucial aspect in which significant differences can be found. If we, for example, take a look at the foreign exchange asset class, central banks hold the power to adjust the money supply. This enables them to increase or decrease the value of the currency that is held by the public. We find similar features for other asset classes, where companies can issue or buy back stocks and bonds, thus controlling their market value and affecting portfolios of investors. In contrast, crypto assets are subject to a predetermined supply schedule that is defined by the underlying protocol. And while some protocols may change over time, any adjustments are open-source and transparent. There are many more reasons to support the statement that crypto assets form their own asset class based on fundamental differences, for which I refer to the book Cryptoassets by Burniske and Tatar.¹

Where correlation comes in

So far, we have argued from a theoretical perspective that crypto is its own asset class. But is that perspective enough? For some individuals it might be, but for full acknowledgement, we need the practitioners on our side. They are after all the ones who are building portfolios, seeking the highest returns for the lowest risk.

Once again consider the 60/40 rule from earlier. In order for this rule to actually work (i.e., diversify the investments), it is important for the considered asset classes to actually behave differently. If your 60% allocation in stocks drops, at the very least you don’t want your 40% bond allocation to go down with it.

How do you gauge whether an asset mix adheres to this principle? Would combining crypto assets and other asset classes result in a well-diversified portfolio? The fundamental basics we discussed before have some impact on price movements, but they do not guarantee that the dynamics are fully independent. We also need to take into account that any hidden (or less obvious) drivers can impact two totally separate asset classes in the same manner. In the end, we want to find some measure that accurately captures the actual relationship between multiple price series. And contrary to popular belief, it is quite hard to do that.

Read Part II here.

References

[1] Burniske, C. & Tatar, J. (2018). Cryptoassets: The innovative investor’s guide to bitcoin and beyond. New York: McGraw-Hill Education.