Do cryptocurrencies offer diversification benefits?
The observed high returns of Cryptocurrencies has attracted new investors and some argue that despite the high price volatility, this new asset class may offer diversification benefits. Under Modern Portfolio Theory, it is possible for an asset to offer diversification to a portfolio even if the return to risk ratio is less efficient because of low correlation between the asset and the market portfolio. Assuming one believes this theory to be true, can cryptocurrencies such as Bitcoin (BTC) or Ethereum (ETH) offer diversification benefits to a market portfolio of mostly equities?
In this first post, I will simply compare the price trends and returns of BTC and ETH versus the NASDAQ 100 stock index. I only look at BTC and ETH because I am looking at the broader digital currency asset class and not at the specific protocol and its idiosyncratic risk factors as I am only trying to answer the question if cryptocurrencies as an asset class offer much diversification benefit over technology stocks?
The analysis will look at monthly price and return trends since November 2013, which is when BTC breaks $1,000. As the history of cryptocurrencies is short, one must be careful when drawing conclusions.
First, I plot the price and natural log price of each on a single chart. All three experienced a bull market run during the highlighted period. In general, one can see that the natural log price on the right hand axis normalizes the growth trend so as to not overstate the most recent period price observations.
Second, I plot the monthly log returns and annual log returns of each series. The log return is simply a continuous compounded return of the observed period and is taken from the natural log price transformation.
As you can see below, the returns for BTC and ETH are much higher than NDX but in general they follow a similar trend as there was a decline in 2018–2019 and then a bull market that started in 2020. The trends are a bit more obvious if we look at the yearly log return transformation.
Next, I plot the monthly and yearly log returns of BTC, ETH, and NDX on the same chart. This helps to better visualize and compare the much larger returns and return volatilities of cryptocurrencies over the same period.
A simple 12 month rolling correlation for each of the above monthly and annual log return pairs is presented below.
Although the historical data is relatively short, one can observe that the correlation between cryptocurrencies and technology stocks increased in 2020 as prices dramatically increased. This higher correlation is expected as we start to see broader acceptance and belief in cryptocurrencies and the blockchain technology.
This isn’t to say that there are no diversification benefits to investing in cryptocurrencies but one needs to be careful to identify the unique idiosyncratic factors that maybe unique to a protocol and token versus the broader macroeconomic factors driving technology stocks and risk assets. For example, one can see that the correlation of ETH and NDX has increased as the price of ETH has increased relatively more than BTC since 2020. The question here is if the ETH merge is bringing in additional investors and making it more accepted as a Risk Asset as it becomes the DeFi highway or will it continue to offer risk diversification benefits as an alternative asset class? That is, will ETH behave more like the next Amazon or will it be something completely different? If it is more like the next Amazon, then I would expect a large draw down in price if the economy falters, but if it is something different than ETH and other cryptocurrencies may be viewed as a hedge such as Gold and Silver did during periods of inflation and risk aversion. It is also worth noting that historically, all risk assets become more highly correlated during bear markets; i.e. risk assets are more highly correlated on the way down than up.
