Portfolio theory and Bitcoin. One of the fundamentals of portfolio… | by Titus | The Capital | Nov, 2020

Cryptocurrencies like Bitcoin belong in every portfolio. But what about their risk-return profile and how high is the correlation to traditional assets?

One of the fundamentals of portfolio theory is diversification, through which the risk — measured by the standard deviation — is to be minimized without reducing the expected return. Because every single asset class has its own risk-return profile, as can be seen in the graphic below.

The optimal investment would be located at the top left, i.e. a high expected return with a low standard deviation. Normally, a riskier investment also delivers a higher expected return.

Correlations are measured with the so-called correlation coefficient, which can be between +1 (perfectly positive) and -1 (perfectly negative). In terms of risk diversification, both values ​​are not desirable, as either the entire portfolio rises or falls with one event or half of the portfolio rises while the other half falls. Diversification is achieved above all by adding an asset that, ideally, does not show any correlation with other asset classes. The lower the correlation between the assets of a portfolio, the more risk that can be eliminated. A non-correlating asset is considered the holy grail of portfolio construction.

In the context of this article, the strategic asset allocation is assumed, not the tactical asset allocation. So it’s about a long-term breakdown into different asset classes and not about short-term earnings opportunities in certain industries or which asset manager is selected.

As can be seen in the top left quadrant, stocks correlate very positively with one another worldwide, so they are only suitable for risk diversification to a certain extent. Gold is very suitable for adding to an equity portfolio, but correlates relatively strongly with other commodities and real estate. Long-lived bonds in particular are ideal for diversifying into stocks, commodities and real estate.

What about other alternative asset classes?

It can be seen very clearly here that hedge funds, private equity and venture capital are excellently suited for diversification compared to all of the aforementioned asset classes with values ​​between 0.05 and 0.35.

From the results so far, we can conclude that stocks, commodities, real estate and bonds belong in a diversified portfolio just like hedge funds and private equity or venture capital. It is therefore less astonishing that the most successful investment concept of the last few decades is the so-called endowment model, which is rather aggressive. Unfortunately, not every investor has access to certain asset classes. Investing in private equity funds, for example, is only possible for professional (EU) or accredited (US) investors and the minimum investment amount is often more than 1 million euros.

If you look at the entire history of crypto assets, they have virtually nonexistent correlations with stocks, bonds and real estate as well as commodities, hedge funds and private equity, in the case of Bitcoin just 0.03 (Timber) to 0.10 (stocks ). So there is the holy grail: an asset class that has a very low correlation coefficient to all other traditional as well as alternative asset classes or whose correlation is not statistically significant.

But we don’t make it that easy for ourselves. Most crypto followers who travel around the world and tweet about zero correlations unfortunately neglect one thing: an asset can only correlate if it has a certain liquidity and this is measured in the trading volume. So we do the exercise again, but this time only from a daily trading volume of> 500 million USD.

The correlations are still very low, but at least noticeable. Ethereum , for example, now has a (still relatively low) correlation of 0.24 with private equity and infrastructure funds. For more details, read the original report here.

Even if you take a honest look at crypto, it is currently the only asset class that has a low correlation to all traditional and alternative assets, making it an excellent portfolio diversifier. While pension funds and endowments have long been investing in crypto assets, listed companies are now also using itto hedge in your own treasury management.

Demand is increasing and this time interest seems to have a lot more foundation than in the hype phase at the end of 2017. Most recently, not only because of the fact that more money is being printed around the world than ever before and “safe” investments in the low interest rate environment are virtually no longer any more exist.

Compared to other asset classes, the correlations of 0.17 to 0.63 of Bitcoin to other crypto assets are relatively high, but for the most part still low to moderate. It is particularly interesting that these correlations have decreased significantly in recent years. Bitcoin, Ethereum and Binance have completely different value drivers, which is now also reflected in independent value developments with increasing mass adoption. If these different value drivers continue to prove to be true, the individual cryptoassets should be further decoupled in the future.

  • Ideally, hedge funds and private equity are also allocated in order to achieve the highest possible diversification in the portfolio
  • Taking into account trading volume, which has been ignored so far, cryptos have at least a perceptible correlation to some other asset classes, but cryptoassets is the only asset class that has a very low correlation to all other portfolio components
  • Not only pension funds and endowments are now invested in cryptos, but also listed companies
  • Crypto assets have different value drivers and seem to decouple from each other in the long term, which makes sense within crypto diversification

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Disclaimer: These lines are not a substitute for investment advice, investments in the crypto market are made at your own risk. Invest only as much as you are willing to lose. I get commissions for purchases made through links in this post.

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Read Also:   Tokenization of classic cars: revival of a hidden gem for financial asset diversification? | by The Capital | The Capital | Oct, 2020

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