How a diversified crypto portfolio looked like in 2019

Written by Eric Choy

In the traditional sense, portfolio management and investment managers have always sung the same tune when it came to asset allocation: DIVERSIFICATION. If you look at any investment portfolio or retirement account, regardless of age, diversification is always prevalent. It is what our investment managers always stress to us on a daily basis. Turn on CNBC or Bloomberg, and watch the segments when guest investment managers come on the show to talk about what they foresee coming in the markets, they always, ALWAYS reside to repeating the lame old diversification line.

DON’T PUT ALL YOUR EGGS IN ONE BASKET!

In my opinion, diversification is analogous to the phrase “Jack of all trades, master of none”. Or someone trying to have many friends but actually not having any real friends.

It is well quoted:

“Diversification is for idiots, volatility is great” -Mark Cuban

If you had a diversified portfolio going into the great recession of 2008–2009, yes it is true that your portfolio wouldn’t have taken as much of a hit if you were to be in all equity, but if you kept it in all equity through the storm and up until now, you would’ve been up by a large margin thanks to the longest bull run of the past 10 years. Diversification does have its merits though. It is safe and it does keep the average investor able to sleep at night.

But do we need it in crypto yet? In a space where volatility is king with limited historical price action to reflect on, does it matter if we are diversified with many cryptos besides being solely invested in the Bitcoin king?

Let’s take a look at some existing crypto funds that offer such a diversified approach to crypto investing.

Crescent Crypto has made a name for itself in the space with their Crescent Crypto Market Index Fund, which tracks their CCMIX market index with a breakdown of components shown below:

(Figure 1) Constituents of CCMIX

And then there’s the Bitwise 10 Private Index Fund, which as its name suggests, tracks the 10 largest cryptos in one fund charging a 2.5% fee (which is quite high compared to your usual ETF or mutual fund).

(Figure 2) Constituents of Bitwise 10 Private Index Fund

It’s interesting to see how Bitcoin just dominates both of these funds with basically an 80% majority. Then again, historically BTC’s dominance, as a % of the total market capitalization has been above at least 50% for 90% of the time. If BTC is considered the equity portion and the ALTs are considered the safe or fixed income portion, then such an allocation can be considered Very Aggressive, in standard asset allocation speak.

Traditionally, private bankers and investment managers have utilized the standard asset allocations presented below depending on a client’s risk profile:

(Figure 3) Traditional Asset Allocation Models

The most common is a Moderate asset allocation as many would view this as being the most “optimal” in terms of risk and diversification falling somewhere in the middle of the efficient frontier. But since crypto investors are young and crypto probably takes up a small portion of any investor’s entire wealth portfolio, I would like to use a Moderately Aggressive portfolio allocation to demonstrate the effects of crypto diversification this past year of 2019.

Before I show what a diversified crypto portfolio would have done in 2019, let’s first see how a 100% BTC portfolio would have unfolded.

(Figure 4) What a hypothetical 100% BTC portfolio would have returned in 2019

Being indexed to 100, a 100% BTC portfolio would have produced a 94% return. Not bad considering many in the crypto space thinks we are still in a bear market.

For a diversified crypto portfolio, let’s use a synthetic portfolio composed of the largest cryptos in the space right now, arbitrarily chosen as a portfolio composed of the following:

· ETH

· XRP

· BNB

· XLM

· LTC

· BCH

· EOS

· ADA

· TRX

· DASH

And of course, BTC. Reasonings for choosing the above constituents comes down to the same reasonings other funds have chosen these large crypto for diversification: liquidity. One can make the debate of selecting other cryptos that have a moonshot opportunity, but liquidity outside of the top cryptos based on market cap are always suspect to fake liquidity.

If we were to use the above constituents with an equal weighting of 1/11, the YTD portfolio growth would have produced only a 6% return.

(Figure 5) What a hypothetical equal weighted portfolio would have returned in 2019

To be more reflective of current real life institutional crypto funds (ex-hedging, derivative trading strats), let’s say for example we placed a 50% weighting on BTC with the rest of the listed alts holding a 5% weighting each. Such a portfolio would have done reasonably better than the Equal Weighted Portfolio, but still underperforming BTC, alone.

(Figure 6) What a hypothetical 50% BTC/50% ALTs portfolio would have returned in 2019

To put this in a real-life scenario of an actual investment portfolio, let’s take the above fore mentioned Moderately Aggressive portfolio and have an allocation of 70/20/10 which corresponds to equity/fixed income/crypto respectively. I will use the S&P 500 and the iShares Core US Aggregate Bond ETF as proxies for equity and fixed income, respectively. And within that designated 10% crypto allocation, I’ll compare a 100% BTC position versus holding an equal weighted position of the cryptos listed above.

(Figure 7) Comparing two traditional portfolios with different crypto allocations

You are looking at an 872 basis point difference in returns. To give you some perspective, say we placed the wealth of Bytedance’s founder, Zhang Yiming, into both of these portfolios to illustrate the magnitude 872 basis points can have on a portfolio.

(Figure 8) Comparing two crypto portfolio allocations and the absolute difference in monetary returns

Another aspect of crypto diversification I would like to point out is the rationale for diversifying in the first place. In the traditional sense, equity and fixed income should have an inverse relationship. Fixed income is viewed as the buffer — protecting one during equity corrections and acting as a hedge during irrational bull runs. In addition, the “fixed income”, aka the coupon/interest payments of these fixed income instruments divvy out is meant to provide a means of steady income. Are any of these altcoins dishing out a stream of income? Have they been a hedge against violent BTC price swings to the downside?

Depicted below is a clear example of how alts have been the exact opposite of the purpose of diversification this year:

(Figure 9) Comparing price action between BTC and ALTs during daily market corrections

To pivot to my last point, I would like to make note of one of my favorite investment ratios: The Sharpe Ratio (The Sortino Ratio is also a ratio that I am a fan of but for simplicity purposes, I’ll just show the Sharpe). Here is a link to a Stanford paper dissecting the ratio as well as providing variations such as the ex-ante and ex-post Sharpe ratios.

(Figure 10) Formula for the Sharpe Ratio

The Sharpe ratio essentially measures how much excess return your portfolio generates per unit of risk. Now to compare the three portfolios shown before — 100% BTC, Equal Weighted, 50%BTC/50%ALTs — the 100% BTC’s Sharpe ratios flat out dominates by a margin of more than 10 for the year of 2019.

(Figure 11) Sharpe Ratio comparison amongst different crypto portfolios

Conclusion

This analysis is not to completely rule out using diversification in one’s investment strategy. There are obvious reasons to do so, as there are reasons to not, with arguments on both sides. And this is by no means a shot at those crypto funds mentioned above for implementing such a diversified portfolio allocation for their investors. For a highly risk averse investor with minimal crypto knowledge, diversification is the way to go to limit any loss aversion bias. And as most investment managers are held to the fiduciary standards, being conservative in this asset class (which sounds like an oxymoron) is what they are limited to, which is one of the key characteristics the SEC is looking for before approving a crypto ETF catered to retail investors.

But it is still too early to apply these traditional fundamental investing strategies to crypto. Obviously BTC has been the clear winner this year, outperforming any “diverse” crypto portfolio out there (excluding derivative/leverage strategies). So the question can continue, is there a real need for diversification? How to chase alpha besides the main alpha in BTC?

Diversification is meant for the sole purpose of reducing volatility. But since a crypto investment, on average, probably only accounts for a small portion of one’s already diversified portfolio, why bother diversifying within this new asset class? For now, from the point of view of a passive investor, the rationale of having a diversified crypto portfolio to “gain exposure” in alts is still albeit weak. And I propose that when BTC’s market dominance, as a % of total market capitalization goes below 40%, is when the relationship between BTC and ALTs reflect that of the traditional relationship between equity and fixed income. But then again, in any market panic selloffs, most asset classes converge to a Beta of 1.

Bitcoin at least has a few years, maybe even a few decades, before its price stabilizes. Until then, I’d rather have all my crypto eggs in one BTC basket if I want to chase moonshot returns. And perhaps by that time, we can start using BTC and the other ALTs in the same way Smart Beta is constructed.

Investing in cryptocurrencies and Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by the writer to invest in cryptocurrencies or ICOs. Since each individual’s situation is unique, a qualified professional should always be consulted before making any financial decisions.