The cryptocurrency market reached an all-time high over the past few years with greatly increased trading volume and liquidity, led especially by bitcoin. Indeed, the market capitalisation is of the same order of magnitude as the distressed bond market.
Cryptos are digital money created by software programmers using encryption technology. Almost everyone in the conventional world agrees that the crypto mania will have staying power with the development of appropriate legal frameworks and proper regulatory oversight.
Legal challenges facing the future growth of crypto assets loom large although there has been substantial progress made in the past few months.
It has been argued that crypto is a speculative asset class and should be treated as a macro asset akin to gold. Gold is indeed a useful commodity and, like money, considered a store of value asset, but only in nominal terms. Gold also serves as a fallback safety asset in times of global adversity, when investors are unsure of the risk-adjusted performance of their other assets.
Gold’s trading volume is somewhat on par with major debt, equity and currency markets. Various market pundits have argued that gold is a good hedge against inflation. However, the academic evidence doesn’t seem to bear this out in a systematic manner as, say, the way Treasury Inflation Protected Securities, or TIPS, do.
One could consider crypto to be a reasonable store of value if it is secure, has a fixed supply, and is transferable. In the current day and age, where the majority of social interaction and commerce occurs online, it may also need to be digital. Hence crypto securities such as bitcoin and ethereum could serve as an alternative store of value.
But due to its volatility, bitcoin is neither a useful nor practical store of value. Crypto assets are still in their infancy; long-term funds and institutional investors are still speculating whether crypto will eventually achieve universal acceptance.
Making the investment case
Recent research demonstrates that cryptocurrency can be classified as a speculative asset class and serve as good alternative investment assets, especially in bringing diversification to traditional assets such as equities, fixed income, commodities, and real estate investment trusts.
In our definition, we consider an asset class as a pool of highly correlated and similarly behaving securities within that class. Hence, we will be looking at various traditional equity and fixed income asset classes, crypto indices BitScreener Token (BITX) and 21Shares Crypto Basket Index ETP (HODL), and the more familiar bitcoin and ethereum.
The data for these assets only go back to 2017. Due to the short time series, we use daily data from January 1, 2017 – December 21, 2021 in our analysis. Correlations are evaluated over an approximately five-year period. Table 1 lists the daily cross-correlations across the various asset classes.
As the table shows, BITX and HODL have low correlations with traditional asset classes as compared to bitcoin or ethereum, reinforcing the fact that crypto indices may be a reasonably good investment in terms of hedging or diversifying the risk of traditional assets. However, much remains to be said about their various other risks, including the extremely high volatility and the potential for large drawdowns.
We then examine the risk-adjusted performance from adding cryptos to a traditional, diversified portfolio. Cryptos, in general, exhibit large and volatile return swings and are riskier than most other assets in a typical traditional asset allocation portfolio. We hence include the central moments of the return distribution of cryptos through the following parameters: variance, skewness, and kurtosis.
Given the skew and kurtosis associated with cryptos, we use the ‘expected shortfall’ optimisation method in asset allocation, also known as conditional value-at-risk (CVAR), to determine the portfolio efficient frontier and to calculate the average loss associated with these portfolios at the 95% confidence level.
We also used copulas to model the joint distribution since the traditional approach, i.e., mean-variance, isn’t a good fit to model the joint distribution. This technique allows us to incorporate realistic marginal distributions that capture empirical risk features such as skewness and fat tails. In this exercise, we use the student t-copula method since it supports extreme co-movements between assets regardless of the behaviour of the individual assets.
Our asset allocation exercise shows that there are diversification benefits which arise from the introduction of crypto indices to the traditional portfolio.
The two efficient frontier graphs in Figure 1 are generated based on an unconstrained optimisation with and without BITX and HODL. The figure demonstrates that portfolio return, which include cryptos on an expected shortfall optimisation basis, dominate the corresponding no-crypto portfolio returns across the efficient frontier.
Table 2 further indicates that there are benefits to introducing BITX and HODL to a portfolio. The average daily loss at the 95% confidence interval is lower (-1.82%) when the indices are introduced on a marginal basis (at 5% maximum weighting to crypto indices). It thus helps improve the Sharpe ratio – or the return per unit of risk – of these portfolios. That being said, this conclusion is based on a rather small allocation to the crypto indices.
The million-dollar question is, how should long-term investors and institutional funds be thinking about this speculative asset class in the context of their portfolios?
As part of the exercise to include it in institutional portfolios, there is a need to establish the long-term asset class returns, volatility, skewness, kurtosis, and correlations. This is an arduous task given the limited data available for cryptos at this stage; it will be even harder to predict how it will fit into tactically managed portfolios over short time frames.
The idiosyncrasies associated with cryptos should also be considered when determining the appropriate allocation to this speculative asset class.
Crypto indices have had low correlations with mainstream or traditional asset classes over the last five years. The question is, given that the Federal Reserve is intent on increasing interest rates to ward off inflation, how would that impact crypto in terms of its documented diversification benefits?
Given that we are in a period where realised inflation has already started picking up, we calculated the correlations from October 2021 to November 2021 using the same daily data (Table 3). The correlations for the crypto funds are on average lower than for the entire period studied previously (Table 1), which may perhaps lead one to believe the anecdotal view that cryptos can serve as a good hedge against inflation.
For an asset class to add value to a portfolio, it has to offer either a low correlation or an attractive risk/reward payoff when it is added to the portfolio, preferably both.
As our study demonstrates, a small allocation to two crypto indices led to a reduction in the average loss (expected shortfall) and also improved diversification benefits from the low correlations.
According to our analysis, introducing crypto indices to a portfolio appears to add value. But due to its short and volatile history, it is our view that it’s premature to definitively conclude how much value cryptos can truly add to a traditional portfolio.
* Joseph Cherian is practice professor of finance at the National University of Singapore Business School. Yogi Thambiah is chief executive officer and founder of Princeton Analytics & Consulting in New York.