Unlocking the Power of Diversification in the World of Cryptocurrencies
Long-standing and generally accepted financial theory shows that diversification is not only beneficial, but also improves expected returns per unit of risk. However, it seems that the crypto space is currently ignoring this principle.
In a timely post from the quantitative asset management firm AQR, co-founder and CIO Cliff Asness challenges a recent paper that poses the question, “Why not 100% equities?” This line of thinking tends to resurface during bull markets, but Asness firmly rebukes it.
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The blog draws attention to various foundational financial principles, essentially stating that “holding one asset is suboptimal”:
“In finance 101 we learn that we should separate the choice of 1) what is the best return-for-risk portfolio, and 2) what risk we should take. This new paper and others like it confuse the two. If the best return-for-risk portfolio doesn’t have enough expected return for an investor, they can leverage it (within reason). If it has too much risk, an investor can reduce their exposure with cash. This has been proven to be effective.”
Asness refers back to the fundamentals of modern portfolio theory to show that while it is possible to hold a single asset, it should not be expected to outperform a portfolio of diversified (i.e. not perfectly correlated) assets adjusted for risk.
Does Diversification Matter for Crypto?
Crypto investors should ask themselves a similar question: why not 100% Bitcoin?
Given Bitcoin’s dominating media attention, market commentators often still equate “crypto” with “Bitcoin.” While the approval of spot Bitcoin ETFs may be a significant first step towards widespread investor adoption, it has also brought to light a departure from the golden rule of diversification.
Let’s examine four hypothetical crypto portfolios dating back to 2018: Bitcoin Only and Ethereum Only (no diversification), an equal-weighted allocation to Bitcoin and Ethereum (some diversification), and a passively-weighted portfolio of the top 10 non-stablecoin assets each month (better diversification).
The bottom line: diversification matters for crypto.
The Bitcoin Only and Ethereum Only portfolios had very similar annualized returns of around 30%. However, Ethereum Only exhibited higher volatility, resulting in inferior risk-adjusted performance compared to Bitcoin. While annualized returns of this magnitude may satisfy “Bitcoin Bulls” and “Ethereum Maximalists,” could investors construct more efficient portfolios? Absolutely.
By combining Bitcoin and Ethereum in a simple equal-weighted basket, we can observe significantly improved risk-adjusted returns. Compared to Bitcoin Only, the annualized risk slightly increased, but the increase in return was greater, resulting in superior risk-adjusted performance. For investors who aren’t comfortable with the slight increase in risk, they could hold some cash alongside the portfolio to dampen volatility while still achieving better returns.
Adding more assets to the portfolio further improved risk-adjusted returns. By passively weighting and rebalancing each month, the top 10 assets based on circulating market capitalization, we see that annualized volatility remains relatively consistent compared to the equal-weighted BTC-ETH portfolio, while annualized returns increase significantly.
Broadening the universe of digital assets to better capture the value proposition of different blockchain technologies ultimately improved the portfolio’s risk-adjusted returns.
Despite crypto’s brief and volatile history, recent evidence suggests that, similar to traditional markets, holding a single asset may result in inferior risk-adjusted returns compared to a portfolio of diversified assets.
