BUILDING A CRYPTOCURRENCY PORTFOLIO
Market capitalisation or equal weighted?
Given the phenomenal increase in cryptocurrency prices this year investors might question how to build a portfolio to gain exposure to this emerging asset class. Like on the stock market, cryptocurrency investors might not want to put all eggs in one basket and consider building a diversified portfolio. As the chart below shows, there are currently 14 cryptocurrencies with a market capitalisation above $1 billion. Bitcoin (BTC) dominates the cryptocurrency space.
Source: CoinMarketCap, CQR
A portfolio of cryptocurrencies can be constructed in many ways, but two common approaches from the index-world would be to allocate by market capitalisation or equal weight. Most indices like the S&P 500 are weighted by market capitalisation, which has the advantage of minimising trading costs as it is cheaper trading large stocks like Apple than small stocks. In cryptocurrencies this approach would imply giving a 60% weight to Bitcoin (BTC), if we only consider the 14 cryptocurrencies above $1 billion market capitalisation. The chart below compares the performance of market capitalisation weighted portfolio of cryptocurrencies to Bitcoin. Given that Bitcoin comprises 60% of the portfolio and many of the other cryptocurrencies were created only recently, the performance profiles are almost identical.
Source: CoinMarketCap, CQR
An alternative approach to building a portfolio would be equal allocations, which would maximise diversification benefits. The chart below compares the performance of the market capitalisation and equal weight portfolios on logarithmic scale and we can observe that the equal weight portfolio shows a significant outperformance over time, reflecting that smaller cryptocurrencies have outperformed Bitcoin, which dominates market capitalisation portfolio, significantly since 2014.
Source: CoinMarketCap, CQR
The key reason for building a portfolio is to capture diversification benefits and avoid too much exposure to a single cryptocurrency, which should result in reduced drawdowns. The chart below shows the drawdowns for both portfolios and Bitcoin and highlights only a marginal reduction for the equal weight portfolio. However, these max drawdowns occurred in 2015, where both portfolios only contained six cryptocurrencies, i.e. the diversification potential was somewhat limited. The current portfolio today contains fourteen cryptocurrencies, which means the single cryptocurrency risk is much reduced.
Source: CoinMarketCap, CQR
Empirical research of stock markets shows that portfolios are efficiently diversified when they contain more than 25 stocks. Although there are many cryptocurrencies and even more tokens, investors should consider the transaction costs of trading these. Cryptocurrency funds are an alternative to creating portfolios and cryptocurrency ETFs are likely not too far away, given the rapid evolution of this emerging asset class.
Twitter: CryptoQuantResearch
