Why diversification is also important for cryptocurrencies
Longstanding and widely accepted financial theory suggests that diversification is not only good but also improves expected returns per unit of risk. Unfortunately, the current crypto space seems to be ignoring this principle.
Equivalent to “TradFi”
A timely post from quantitative asset management firm AQR offers a direct "TradFi" equivalent to the undiversified issue. In the post, AQR co-founder and CIO Cliff Asness rebutted a recent article that effectively asked the question, "Why not 100% equity?" - a style of thinking that tends to reappear during bull markets.
The blog recounts certain tenets of basic financial theory, mostly "owning an asset is suboptimal":
“In finance 101, we are taught that we should generally separate the choice of 1) what is the best risk-return portfolio? and 2) what risks should we take? This new article and many similar articles confuse the two. If the portfolio with the best risk-reward ratio isn't delivering your expected return, take advantage of it (within reason). If it's too much risk for you, you'll reduce your cash leverage. It is worth noting that this has been proven to be effective.”
Asness goes back to the basics of modern portfolio theory to show that you can own a single asset, but don't expect that one asset to outperform a portfolio of assets. diversified (i.e., not perfectly correlated) assets on a risk-adjusted basis.
Is diversification important for cryptocurrency?
Cryptocurrency investors should ask themselves a similar question: why not 100% Bitcoin?
With the overwhelming media attention on Bitcoin, market commentators often equate “cryptocurrency” with “Bitcoin.” The approval of spot bitcoin ETFs could be an important first step toward widespread investor adoption, but a clear departure from the golden rule of diversification has emerged.
Let's look at four hypothetical crypto portfolios from 2018: Bitcoin Only and Ethereum Only (undiversified), equally weighted to Bitcoin and Ethereum (slightly diversified), and passively weighted investment of the top 10 non-stablecoin assets in any given month (better diversification).
Bottom line: diversification matters for cryptocurrencies.
The Bitcoin Only and Ethereum Only portfolios generate very similar annual returns, around ~30%, but Ethereum Only has higher volatility, resulting in poorer risk-adjusted performance compared to Bitcoin. Annual returns of this magnitude could satisfy “Bitcoin bulls” and “Ethereum maximalists,” but can investors build portfolios? Is investing more effective?
By combining Bitcoin and Ethereum in a simple equally weighted basket of the two assets, we see significantly improved risk-adjusted returns. Compared to Bitcoin Only, annualized risk is slightly increased but the increase in returns is larger than the increase in volatility, resulting in superior risk-adjusted performance. If the slight increase in risk compared to Bitcoin Only is not acceptable to the investor, then the investor can keep some cash with the portfolio to reduce volatility while still achieving better returns.
Adding more assets to the portfolio further improved risk-adjusted returns. With a passively weighted, monthly rebalanced portfolio of the top 10 assets by circulating market capitalization, year-over-year volatility remained practically flat compared to the weighted BTC-ETH portfolio equivalent, while annual profits increased meaningfully.
Expanding the digital asset universe to better capture the value proposition of differentiated blockchain technologies has improved the risk-adjusted return characteristics of the portfolio.
Conclusion
Despite the short and volatile history of cryptocurrencies, recent evidence shows what traditional markets have repeatedly demonstrated: owning a single asset delivers risk-adjusted returns underperform over the long term compared to a diversified asset portfolio.
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