Cryptocurrency as a New Asset Class Part 3
In Part II of this series, we looked at the returns and volatility of bitcoin versus traditional assets. In this article, we will look at bitcoin’s correlation with equities, gold, and other crypto assets.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) tells us that we can maximize the expected return of a portfolio by taking on a quantifiable amount of risk, a la diversification. In fact Harry Markowitz, the creator of MPT, is quoted as saying, “Diversification is the only free lunch in investing”. Almost always, owning different types of financial assets is less risky than owning one type.
Diversification of equities helps reduce idiosyncratic risk for a given company or industry, but systemic risk is more difficult to diversify away. An asset that provides strong expected returns without correlation to the rest of your portfolio should be considered an opportunity for increased diversification.
We make the case that bitcoin acts as the perfect asset for improved diversification due to its historically low correlations with traditional assets.
For the purposes of this analysis we will be using Pearson 180-day arithmetic correlations. Charts provided by Coinmetrics.
Correlation with the S&P
Below is a chart showing the correlation of bitcoin and the S&P over the last 6 years.
BTC has hovered between -0.1 and 0.1 correlation with the S&P for the majority of the period. The highest 180-day average reached was during early 2018 with 0.24. Even at the highest point, it still falls in the range of -0.3 to 0.3, implying a weak correlation.
For reference, let’s layer on gold’s (GLD) correlation with the S&P as well.
Both BTC and GLD maintained low correlations with the S&P over the last 6 years. One interesting thing to note from this chart is the correlations seem to diverge consistently in opposite directions.
Correlation with Gold
Since we know that BTC and GLD both have a low correlation with the S&P, what about their correlations with each other?
BTC does not appear to have any more of a correlation with GLD than it does with the S&P. This is significant in that BTC does not have to act as a replacement to GLD in a portfolio but as a complement.
Correlation with other Crypto Assets
Throughout this analysis we have been using bitcoin as a representation for crypto as a whole, largely due to its age, liquidity, and relative quality of data. Another reason bitcoin acts as a strong proxy for the crypto market as a whole is because of its’ strong correlation with other crypto assets. The market currently thinks of crypto as a single entity which naturally leads to higher correlations.
Below is a chart that shows BTC’s correlation with some of the other high market cap crypto assets.
The primary observation from this chart is the correlation among large crypto assets and bitcoin increasing over time. We offer two considerations that may help in explaining the trends seen in this chart:
- Crypto assets have very low liquidity early in their lives, which leads to extreme price swings that can be triggered by a few large trades. We can expect this will lead to lower correlation with the larger liquidity assets (bitcoin) until a threshold of maturity is reached. Many of the assets in the analysis above were not created until after 2015: Tezos (2018), Binance Coin (2017), Bitcoin Cash (2017), et. al.
- 2017 was a year with massive, many-times irrational, price gains. This was especially true for “alt” coins, or non-bitcoin crypto assets.
The combination of a frantic bull market with low liquidity coins was the reason for lower correlations between crypto assets prior to 2018. With the the market normalizing and some of these coins maturing, we saw a convergence of correlations to BTC.
In Part I of this four-part series, we discussed the diverse use cases for crypto assets, which may lead some to expect lower correlations among them. The tight correlations between these assets is due to a lack of understanding of these differences. As the different use cases for these assets become more understood, we expect the correlations between fundamentally different blockchains, such as BTC and ETH, to trend lower into the future.
Conclusion
Bitcoin can improve the expected return of a well-diversified portfolio due to its lack of correlation with the S&P and even gold.
The correlation between crypto assets and BTC has trended stronger over the last two years, but we expect there to eventually be a divergence. This implies that there may be diversification implications within the crypto portion of a portfolio.
In the next and final article of this series, we will add crypto to a diversified portfolio in various allocation amounts to evaluate the impact on risk and return.
Disclaimer: The views expressed in this article are solely opinions of the author and do not represent financial or legal advice whether to buy, sell or hold shares of a particular cryptocurrency, cryptographic asset, stock or other investment vehicle. Prior to trading, investing or purchasing any assets, individuals should consult with their own tax, financial or legal advisor. Past performance is no guarantee of future price appreciation.
