Diversifying with Crypto:

By July 21, 2021DeFi
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TL;DR

  • Diversifying with cryptocurrencies is a controversial topic: on the one hand, the crypto asset class generates exceptional returns, on the other hand, the high volatility is rather destabilizing.
  • Crypto offers good diversification as long as it provides a hedge against downside risk in traditional assets by maintaining low correlations.
  • Cryptocurrencies generate high alpha vs equities. This is amplified by the recent rise of lending platforms offering high yields on crypto holdings.
  • A 5% allocation to Bitcoin does, in fact, allow to capture the crypto’s returns, while keeping the portfolio’s volatility practically unchanged.
  • A 5% allocation to ETH accounts for roughly 8% higher annual returns, with ETH running 7% of the portfolio’s volatility.
  • With a 20% allocation to the JKL Strategy, the annualized returns of a classic portfolio increase by 8%, while its volatility decreases.

In recent years, cryptocurrencies have enjoyed heightened attention coming from every possible direction: traditional financial institutions, corporates, governments, retail clients and many other. All these market participants have been looking at cryptos as the future internet/ gold/ payment method; as a disruption of governments and social order; as an instrument facilitating criminal activities and money laundering; as a new legal tender to fight inflation and grant the citizens their financial independence; as a reserve asset for their treasuries. Today’s potential applications of cryptocurrencies spread far and wide.

One of the most common research topics covered by financial institutions is whether cryptos are an ‘investable’ asset class and if so, what diversification benefits this asset class provides. The outcomes of such research have been impressively contrasting over the years and across researching institutions, often strangely coherent with the recent crypto market moves.

In February 2021, JP Morgan Global Research publishes its annual report on blockchain, digital and crypto currencies [3], in which “small (up to 2%) allocations to cryptocurrencies still improve portfolio efficiency due to high returns and moderate correlations”. At the same time, bank’s analysts are uncertain about cryptos’ diversification benefits since “crypto assets continue to rank as the poorest hedge for major drawdowns in equities”.

Such controversy does not allow for one single conclusion as to diversification benefits of crypto assets. There are many factors contributing to such lack of clear vision, in particular the volatility of crypto assets, which is multiple times higher than that of equities or gold. However, coupled with extraordinary returns, cryptocurrencies still generate a higher Sharpe ratio than many traditional assets.

Source: JKL Research

Besides, cryptocurrencies de-facto achieve remarkable alpha vs equities. For example, Bitcoin’s alpha vs S&P 500 between 2015 and 2020 was at 128%, which means that the cryptocurrency’s return exceeded the performance of the benchmark index by 128% over the 5 years timespan. The way cryptocurrencies generate excess returns is mainly through the dynamics of blockchain networks (such as bitcoin halving events or crypto ‘burning’) and the launch of new products. Alpha in crypto is also fueled by a combination of behavioral patterns and informational (in)efficiencies, whereby information and opinions from similar sources are shared by relatively small audience across a set of communication channels. Unfortunately, some of these sources happen to be unverified and biased, causing ill-famed ‘pump and dump’ schemes, intentional misrepresentation, etc.

Moreover, today cryptocurrencies have a possibility to generate alpha on Bitcoin and the crypto asset itself. With a growing variety of lending platforms which allow investors to earn high rewards on their cryptocurrency holdings, owning cryptos has never been more attractive. Yielding products relieve the selling pressure and reduce the liquidity on the market, as many users choose to hold on to their crypto assets to earn the high interest rates. Both — alpha on traditional assets and on cryptos themselves — set the digital asset class far apart from other investments.

Finally, cryptos’ beneficial role in diversification of a traditional portfolio stems from historically low correlations between digital and traditional assets. This feature has turned cryptocurrencies into a sort of defensive hedge against downside risk to a traditional portfolio.

To illustrate the diversification benefits of digital assets, we evaluated the change of various financial indicators when allocating cryptos to a classic 60/40 portfolio. We will use BTC as a proxy for cryptocurrencies in whole and ETH as a proxy for the DeFi space, since the latter is widely seen as decentralized application layer.

It is worth mentioning that up to this point, the market has been broadly treating crypto industry as monolith. However, as market participants become more educated on the blockchain space, we expect that correlations will decline, and crypto projects will be priced based on their intrinsic value.

Diversifying with BTC

We consider the following indicators to evaluate the performance of a portfolio diversified with BTC: returns, volatility, risk-adjusted returns and maximum drawdowns.

Even with its high volatility, Bitcoin still manages to generate outperforming risk-adjusted figures due to its excessive returns. However, bitcoin’s volatility being 3x that of equities, and its maximum drawdown more than twice as low, the cryptocurrency remains far out of the comfort zone for those investors who target a specific level of portfolio risk.

Source: JKL Research

A small allocation of investor’s assets to Bitcoin does, in fact, allow to capture the crypto’s returns, while keeping the volatility low. Between January 2019 and June 2021, a 5% allocation to BTC in a traditional 60/40 portfolio has a minimal impact on the portfolio’s volatility, while increasing annual returns by 6%. Larger allocations of 20%, however, already drive roughly 40% of the portfolio’s volatility.

Diversifying with ETH

By and large, diversifying a traditional 60/40 portfolio with ETH has some very similar pattens to Bitcoin. Same as BTC, ETH has generated an outstanding risk-adjusted return in the period between January 2019 and June 2021. A 5% allocation to ETH accounts for roughly 8% higher annual returns, with ETH running 7% of the portfolio’s volatility.

Source: JKL Research

Nevertheless, Ethereum is more volatile than Bitcoin. Between 01/2019 and 06/2021 Ethereum’s beta to Bitcoin is at 1.05, which indicates that throughout this period ETH was 5% riskier than BTC. Consequently, equal ETH allocations generate higher returns than BTC allocations, combined with higher risk levels.

This seems to be a fitting proxy for the DeFi space, given that most decentralized projects run much higher risks as compared to Bitcoin. Ether could have a bigger future upside potential with its decentralized applications, but the risk is higher. For example, while BTC was down 6% in the month of June, ETH decreased by roughly 16%.

It is important to highlight, that the above BTC and ETH diversification tables do not account for yield generation. Taking into account that various yielding apps offer an annual interest rate of up to 10% on one’s crypto holdings, performance of digital assets in a traditional portfolio would be even more impressive.

Diversifying with JKL Strategy

JKL Capital’s trading system utilizes over 200 statistical models that consistently optimize digital assets allocations to maximize return whilst minimizing risks of the portfolio. As opposed to long only strategies, JKL Capital trading system is aimed at predicting short- term price movements and capturing the attractive volatility of digital assets and cutting risks.

Our fund runs a consistently low correlation with the underlying digital assets: JKL Capital’s correlation to Bitcoin is a mere 0.0715 since the fund’s launch in September 2018. Diversifying a classic 60/40 portfolio with JKL Strategy not only provides the hedging benefits of the digital asset class, but also offers an additional hedge against downside risk in digital assets themselves.

Source: JKL Research

On this basis, allocating JKL Strategy to a traditional portfolio actually reduces the portfolio’s volatility(!) while improving annualized returns.And while the risk-adjusted returns are not as strong as when diversifying with BTC or ETH, improved volatility levels and maximum drawdowns are perfectly in line with the requirements of traditional investors who seek to minimize their risk exposure. For example, with a 20% allocation to JKL Strategy, the annualized returns of the classic portfolio increase by 8%, while the volatility decreases.

JKL Strategy enables investors to gain crypto exposure, diversify their portfolio, and benefit from the volatility associated with digital assets. At the same time, JKL Capital effectively manages the actual volatility of portfolios through a low correlation with price movements of the underlying digital assets while averting downside risks.

Conclusions

According to JP Morgan Perspectives [3], “small (up to 2%) allocations to cryptocurrencies still improve portfolio efficiency due to high returns and moderate correlations”. The bank’s Global Research agrees that Bitcoin improves long-term portfolio efficiency but is concerned that this contribution will probably decrease if cryptos grow their correlation with traditional assets.

Goldman Sachs’ “Top of Mind” research [2] endorses this conclusion, claiming that the drivers of bitcoin’s diversification benefits is its high risk-adjusted return paired with relatively low correlation with other assets.

Historical data suggests that small allocations to crypto assets have improved the portfolio’s risk-adjusted returns while maintaining low volatility. Main reasons for this beneficial impact are the cryptos’ ability to generate alpha vs traditional assets, as well as low historical correlations between cryptocurrencies and traditional assets.

Evaluating future diversification benefits requires understanding whether correlations between cryptos and traditional assets will remain low, or if they will grow with time as crypto asset class gains more mainstream exposure. The risk is that, as cryptos gain mainstream attention, their correlation with traditional markets will grow. On the one hand, higher adoption can improve the volatility of the digital asset class, maintaining current levels of risk-adjusted returns. On the other hand, losing the status of ‘defensive hedge’ may diminish the performance of crypto assets as a diversification tool.

[1] Goldman Sachs (2021). Top of Mind. Crypto: A New Asset Class?

[2] Goldman Sachs (2021). Digital Assets: Beauty Is Not in the Eye of the Beholder

[3] J.P. Morgan Perspectives (2021). Digital transformation and the rise of fintech: Blockchain, Bitcoin and digital finance

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