“Il ne faut pas mettre tous ses oeufs dans le même panier”, which translates to “don’t put all your eggs in one basket”. In this CryptoCurious series, I will write on the benefits of diversification and how it can be achieved using correlation matrices, the stock market and rebalancing methods.
Investing is a long term process, a lifelong one and it’s all about DIVERSIFICATION.
Diversification comes from uncorrelated assets (correlation coefficient close to 0). In the Table 1, I computed the correlation matrix for a group of assets including my CryptoCurious Portfolios (ref:12/9/2018). You’ll notice 2 distinct shades of colors: a dark green and a pale red/green.
The dark green shows the assets that are highly correlated between each other, meaning that if you buy them together, their price will most likely go up and go down together. You won’t benefit from diversification. In our case, you can see that the CryptoCurious portfolios don’t diversify each other (correlation around 0.9), except for the stable coin portfolio (0.15) as it is pegged to the USD. We get the same result for the regular markets like the S&P500, Nasdaq etc…(correlation around 0.8).
The pale/green shade represents the uncorrelated assets that are good at diversifying when bought together. Here, when combined together, the stock market and the crypto market diversify each other. To visualize the diversification effects, I constructed a simple portfolio combining both the regular financial markets and crypto markets. It is 50% invested in the S&P 500 and 50% in my CryptoCurious Top20 portfolio. The results are shown in Chart 1.
Stock markets and cryptocurrency markets diversify very well.
The red line, corresponds to the CryptoCurious Top20 portfolio, the yellow line to the S&P500 (.INX) and the blue line to the hybrid 50-S&P500/50-Top20Crypto. The blue line remains all the time between the yellow and the red line as it’s around 50/50 of both lines. When the crypto market is suffering, it holds better thanks to the S&P 500 and vice versa.
The stock market has gone through a lot of turmoil these past few weeks, with rate hikes, a less accommodative FED policy, tax cuts fading, trade wars and global growth slowing. It was more than markets could handle, the S&P 500 lost more than 10% from its all time high.
If S&P 500 market participants would have allocated a part of their funds in the crypto market, they would have suffered less important losses.
Metrics are shown in Table 2. The benefits of this hybrid portfolio is that it is much more stable in time, its price is less volatile than being all invested in crypto (56% vs 112%), and it has lower drawdowns (peak-to-trough decline -> 18% vs 30%).
In terms of returns, +/- 50% of returns will come from the S&P 500 and the Top20 crypto portfolio. This strategy won’t allow you to get the best performance but it will mitigate the downfall when one markets falls.
Rebalancing helps portfolio diversification.
Rebalancing is the process of realigning the weightings of a portfolio of assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original desired level of asset allocation.
I took our hybrid portfolio mentioned above and created two versions of it. One where the weights were rebalanced, and the other one where no allocation change was made. I rebalanced the portfolio as well as all my other CryptoCurious portfolios on December 24th, one month after starting this experiment.
In the below PieChart 1, the left chart corresponds to the hybrid portfolio weights before rebalancing, 45% of its value is in the S&P500 and 55% in the Top 20 Crypto portfolio. These weights are a result of the crypto market performing better than the S&P500 over the course of the experiment, hence the higher crypto weight.
The target allocation for rebalancing is 50/50, you have to increase the S&P weighting to 50%. You will therefore need to sell some of the Top 20 Crypto portfolio and invest the remaining into the S&P500 in order to get the portfolio back to the original target allocation.
In Chart 2, I compared the performance of rebalancing to no rebalancing. Ceteris paribus, the rebalanced portfolio (blue line) is outperforming the non-rebalanced portfolio by 1% and has a lower volatility (56.2% vs 58.6%).
In this case, it was a better choice to rebalance the portfolio as it boosted its return. But as we will see later on, rebalancing our CryptoCurious portfolios don’t always give the same results. Nevertheless,
Rebalancing lowers portfolio volatility which in return results in lower drawdowns.
How are the CryptoCurious portfolios doing?
If you want to know more about the specifications of the CryptoCurious portfolios, please review the following Medium article: The CryptoCurious Portfolios.
I have made some changes on the Index I chose for the cryptocurrency market, I will now use the CCI30 (as some of you suggested it would be more appropriate). The CCI30 Index is a rules-based index designed to measure the overall growth of the blockchain sector, it does so by tracking the top 30 largest cryptocurrencies by market capitalization. The Top20 crypto portfolio previously used as the index will be evaluated like any other portfolio and will no longer be referenced as the cryptocurrency market index.
All CryptoCurious portfolio except the StableCoin are beating the CCI30 Index (Chart 3). I believe the CCI30 Index is losing a share of its return because of management fees (charge levied by an investment manager for managing an investment fund) but I need to crunch more data to verify my assumption.
All CryptoCurious portfolio except the StableCoin are beating the regular stocks market (Histogram 1). The list is a bit random as I mixed tech stocks, the S&P 500 market index, a Financial ETF, and a Gold ETF but it stills give an idea on the current market situation. It had been a long time since the crypto market did better than the stock market. In the coming months we expect positive news with the launch of the Bakkt platform and the development of Nasdaq’s Bitcoin futures market.
The Interoperability portfolio is still the best performer with 20% return since November 24th 2018, it beats the CCI30 Index by 18%. 75% of its cryptocurrencies have made 20%+.
The SmartContract portfolio has made an impressive comeback, with Ethereum and Cardano gaining more than 60% since I last wrote.
The Top20 portfolio is the 2nd best performer, pulled up by TRON, MakerDao and IOTA(Hist 3), all of which are in the Top 4 of the coins I am watching.
Best performer TRON is the 10th biggest crypto by market capitalization, it has increased by 86%. The company is known to have acquired the famous file sharing platform BitTorrent last summer, at that time the coin was worth 2x today’s price.
Second Best Performer in our selection, MKR, from MakerDAO which is a very interesting San Francisco based project working on a platform for decentralized finance applications (ex: allows cryptocurrency loans triggered by smart contracts). It has build its own Maker’s Dai stablecoin (not backed by USD or any FIAT) that lives completely on the blockchain chain with its stability unmediated by the legal system or trusted counterparties.
The DigitalCash portfolio used to closely follow the Top20 but has lost some ground, because TRON, MKR, and IOTA do not belong to the DigitalCash portfolio which is why it could not keep up.
The PrivacyCoins portfolio ranks in 3rd position but has the highest volatility and the worst drawdown of all (-37%). As I mentioned in the previous series, it has the highest 𝛽 (beta coefficient) among the CryptoCurious portfolios (ref Histogram 4).
The 𝛽eta coefficient measures a coins volatility in relation to that of the market. The 𝛽eta of a portfolio is an important measure of risk, a value above 1 means the investment is more volatile than the market, a value lower than 1 is less volatile (in our study, the CCI30 is the reference market index with a beta of 1).
Both the Interoperability and Top20 portfolios have very good returns and 𝛽etas close to 1, they seem to be more efficient than the CCI30 Index (same beta but lower returns).
The Hybrid portfolio is interesting because it has around the same return as the DigitalCash and SmartContract portfolios but with lower risk/volatility (beta=0.40), this comes from its 50% allocation to the S&P 500 which diversifies very well.
Did rebalancing the CryptoCurious portfolios help?
As previously stated, I rebalance every month all CryptoCurious portfolios. For the purpose of the study, I have compared the returns of each portfolio with what would have happened if I did not rebalance. The results are shown in the below Histogram 5.
2 are better after rebalancing, 2 are the same and 3 are better with no rebalancing. It is too close and too early to make any conclusions. But for the past month, I have seen that most of the time no rebalancing was a better option especially for the Interoperability portfolio.
If this assumption holds true with time, it would suggest that cryptocurrencies are mostly trend following than mean reverting. For those unfamiliar with these concepts:
- Mean reversion is financial theory suggesting that asset prices and returns eventually return back to the long-run mean or average of the entire dataset.
- Trend following assumes that a security will continue to move along its current trend.
Conclusion and takeaways:
1. Stock markets and cryptocurrency markets diversify very well.
2. Rebalancing lowers portfolio volatility and increases diversification which in return results in lower drawdowns.
3. Cryptocurrencies seem to have a tendency to be trend following rather than mean reverting
Remember, the goal of diversification is not necessarily to boost performance — it won’t ensure gains or guarantee against losses. But once you target a level of risk — based on your goals, time horizon, and tolerance for volatility — diversification may provide the potential to improve returns for that level of risk.
I hope you enjoyed this publication, and wish all of you a Happy New Year!