Cryptocurrencies not only diversify other assets, they diversify … each other
Why it makes sense to invest in a basket of cryptocurrencies
In our first article, we spoke at length about the diversification benefits that crypto as an asset class can bring to your portfolio. There, we spoke about crypto as if it were one single entity. Many of you might be wondering then — why don’t I just buy BTC or ETH and HODL it over time, rather than go through the hassle of constructing a broad crypto portfolio?
This is what we’ll address in today’s post.
The reality today is that the media likes to focus on the largest currencies. By far, Bitcoin, Ethereum, Ripple, and Litecoin tend to generate the most public attention. And it’s hard to blame them, as these four currencies make up around three-quarters of the entire crypto universe by market cap. But it does create the unfortunate impression that the crypto universe should be judged through the lens of these four coins alone. It also gives rise to the belief that all coins are alike.
The truth is a bit more complex than that. We don’t ignore that in recent years (especially during the speculation-driven boom of 2017 and the crash that followed in 2018) cryptocurrencies have exhibited very high correlations to one another. But if we take a more fundamental view of the crypto landscape, it doesn’t have to be this way at all.
This is because individual cryptocurrencies differ fundamentally in their use cases. Starting with the top four we listed above, the distinguishing factors become quickly apparent. Bitcoin (and to a certain extent Litecoin) are used primarily as an alternative payment method, and also (at least for many) serve as a store of value. Ethereum, on the other hand, adds value primarily through its smart contract capabilities, and its role as an infrastructure on top of which a wide range of more complex blockchain applications can be built. Ripple, for its part, serves primarily as a vehicle for facilitating cross-border payments.
The list goes on and on. As this Hackernoon post does a good of explaining, there are so many ways to slice and dice the crypto landscape at a fundamental level. Feel free to read the full analysis if you wish, but we’ve taken the liberty of reproducing below their classification of a broader basket of cryptocurrencies.
- Store of Value — Bitcoin, Digix
- World Computer- Ethereum, NEO, EOS, Cardano, Tron
- Payment Rail- XRP, Stellar, Bitcoin Cash, Monero, Dash
- Connected IoT — IOTA
- Cloud Storage — Siacoin, Storj
- DAPPs- Basic Attention Token, Steem, Augur, Funfair
- Decentralised Finance- Maker
- Cryptocurrency Exchange Utility Tokens- Binance Coin, Kucoin, Qash
- Tradeable Digital Assets — WAX
Source: Ly, W. How to Diversify Your Cryptocurrency Portfolio. 9 Jan 2019.
With so many diverse use cases out there, there’s no logical reason why these coins should be treated as identical assets to one another. And as more sophisticated institutional investors play a bigger and bigger role in the crypto markets, this more nuanced, fundamentals-driven view of individual cryptocurrencies should manifest itself much more in investing behavior as well, leading to more differentiated performance between coins. This greater performance differentiation should, in turn, reduce inter-coin correlations and increase the diversification benefits of holding a basket of crypto assets, rather than just individual coins.
And don’t just take our word for it. A recent academic study used modern portfolio theory to model eight separate crypto portfolios, each with different weightings of the top 20 most liquid cryptocurrencies. These included equal-weighted and market cap-weighted portfolios, a minimum-volatility portfolio, as well as portfolios with different risk calibrations based on the model. The study’s researchers then backtested these portfolios over a 3-year period from 01/01/2015 to 12/31/2017 — using various rebalancing periods — versus 59 single cryptocurrencies.
The results of the study (shown below) suggested that all portfolio strategies brought significant risk-reduction benefits — as we’ll explain in a moment, the “maxR Portfolios” were in effect single cryptocurrencies, not true portfolios. All portfolio strategies were clustered at the low end of the volatility distribution. And even while exhibiting lower volatility, the portfolio strategies performed similarly or better than HALF of the sampled individual coins, including all of the so-called “maxR portfolios” (i.e. individual coins that exhibited the strongest 6-month backward-looking returns). The remaining single coins, though they outperformed the portfolios, did so at the cost of much higher volatility. The results do seem to give empirical support to the virtues of diversifying your portfolio not only via a cryptocurrency allocation, but also within the cryptocurrency allocation.
Source: Brauneis, A. and Mestel, R. Cryptocurrency-portfolios in a mean-variance framework. March 2019.
There’s no denying that cryptocurrencies have been highly correlated with one another in the past. But as crypto moves past its initial “hype” stage, we expect it to shift away from being primarily a tool of speculation — to being a vehicle to access innovative blockchain-based use cases. A natural corollary of this shift will likely be greater differentiation between individual coins. Should this play out, those who are diversified within the crypto asset class stand to benefit.