The Role of Cryptocurrencies in Investor Portfolios

LAGOS (Capital Markets in Africa) – Cryptocurrencies have attracted widespread interest among private investors and even some hedge funds as a vehicle for speculation. However, institutional investors such as endowment funds, pension funds, and sovereign wealth funds have allocated only small amounts to cryptocurrencies. Their reluctance to invest meaningfully in cryptocurrencies can be traced to a variety of concerns. Cryptocurrencies have displayed significant volatility, they are not backed by a sovereign entity, and their value is not tied to any fundamental source, such as a stream of cash flows. Therefore, their benefit to institutional investors, assuming speculation is not the primary motive, rests largely on their potential to diversify a portfolio.

But diversification is a complex topic, even for traditional asset classes. It is not enough to calculate the correlation of daily or monthly returns, for example, and conclude that asset classes with low average correlations are good diversifiers while those with high correlations are not as good. It is important to focus on an asset class’s correlation with other asset classes when they are performing poorly separately from when they are performing favorably, as well as the magnitude of these directional returns.

But even if an asset class displays a favorable correlation profile based on short-term returns, most investors care as much, if not more, about how asset classes interact over long horizons. An asset class that moves independently or even inversely with a portfolio’s main growth engine on a daily or monthly basis, but which also drifts in the same direction over the course of the investor’s investment horizon, does little to mitigate adverse long-term performance.

But what’s their role in a portfolio — growth engine or diversifier? The paper explores the potential role of bitcoin in multi-asset portfolios based on their track record for diversifying stocks (or not) over the last nine years. It considers the various features of diversification: monthly versus multi-year horizons, during up versus down markets, and on average versus specific periods in time. The case has yet to be made for bitcoin as an equity hedge, though it may be heading in that direction. The key for investors is to combine their preferences for risk mitigation and upside potential with bitcoin’s expected diversification and return properties to determine their optimal allocation.

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