Cryptocurrencies
in multi-asset portfolio?

What cryptocurrencies have and haven't done for multi-asset portfolios: Mainstreaming is reducing diversification benefits and leading to failure during a crisis

Whether cryptocurrencies are judged eventually as a financial innovation or a speculative bubble, Bitcoin has already achieved the fastest-ever price appreciation of any must-have asset.
Each of these predecessors began with a compelling narrative and a tagline.
And each delivered extraordinary price momentum that challenged standard valuation models at that time.
Figure 1: The hype cycle - Bitcoin ascent has been steeper than any other financial innovation or assset bubbles of the past 50 years
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Why considerCryptocurrenciesan unconventional and high-volatility hedge, in a portfolio?

3reasons:

One is that extraordinary monetary and fiscal stimulus over the past year has created one of the broadest and earliest valuation problems of the past 25 years.
Figure 2: Proportion of Equity & FICC markets trading rich to long-term valuation metrics is unusually high for a young expansion
Equity and Credit valuations look record-rich for a very young business cycle.
Conventional hedges like DM Bonds barely serve as insurance when US 10Y rates are near 1%.

Improvement in long-term portfolio efficiency

Do small allocationraise a multi-asset portfolio’s risk adjustedreturns

As a stand-alone asset, cryptocurrencies remain several times more volatile than core asset markets, with 3M realized volatility of 90% compared to about 20% on US Equities and Gold.
But coupled with extraordinary returns in some years, crypto has often generated a much higher Sharpe ratio on average than core markets like Equities or hedge assets like Commodities in general and Gold specifically.
Figure 3: Cryptocurrencies' risk-adjusted returns have usually beaten Gold, except for 2019-20

In a portfolio context, measured over a five year sample (top half of table), cryptocurrencies co‑movement with all markets remains low and seems to highlight their potential diversification value.

Indeed, Bitcoin's correlation coefficients range from 0 to 0.2 and would seem to position it better than the Yen or Gold for hedging purposes.

However, the mainstreaming of cryptocurrencies - particularly with retail investors - appears to be raising its correlation with all cyclical assets (Equities, Credit, Commodities, the EM complex). If sustained, this development could erode diversification value over time.

While many pairwise correlations remain moderate (around 0.4) even after their rise, this trend bears watch.

Table 1: Correlation of weekly returns over past five years and past year

Migration of short-term drawdowns

For tactical investors focused on risks that could crystallize over the next year, the better test of hedge effectiveness is whether a defensive or quasi-defensive asset rallies when Equities experience a material drawdown of perhaps 10% on Global Equities.

During the 20 largest Global Equity corrections of the past decade, Bitcoin ranks as the worst in terms of median returns (-5%) and the third worst in terms of success rate (42%).

Gold is slightly better on both metrics (52% success rate, 2.5% returns), but inferior to fiat currencies like USD vs EM FX (100% success rate, 3% returns) and JPY vs USD (86% success, 2% returns).

Drawdown calculated as maximum peak-to-trough move during episode. Returns on other asset classes calculated as total return over same window. Green indicates positive return on hedge during equity decline.

Table 2: Returns on traditional and non-traditional defensive assets during largest global equity drawdown since 2009

Perhaps market dynamics will be different during an equility market correction driven by much higher US inflation and a more durable loss of confidence in the dollar (none of the episodes in table2 were driven primarily by the upside surprises on inflation).

But until and unless those macro concerns materialize, crypto's ownership structure inclines it to underperform in a macro crisis those very currencies it aspires to replace.

Our conclusions
haven't changed much in the three years we have been tracking this diversification issue.

Bitcoin improves long-term portfolio efficiency, but its contribution will probably diminish as its mainstreaming increases its correlation with cyclical assets. And crypto continues to rank as the least reliable hedge during periods of acute market stress.