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