Why and how BTC is decorrelated from equity and debt investments
By: Erik Roussel
Tags: Investing

Traditional financial markets looking at investing in cryptocurrencies both directly and through funds. Impressive profitability of long-term investments is one of the main reasons. However, an extremely low correlation of bitcoin with other asset classes is another important factor. This opens up wide opportunities for diversification of investment portfolios.

So, legendary investor William Miller’s portfolio increased by 46% in the first half of 2019 by including the bitcoin. In addition to the first cryptocurrency, the MVP 1 hedge Fund includes shares of Amazon, ADT and Avon Products.

Researchers of the Binance platform found that even a small proportion of digital gold in portfolios with traditional financial assets can significantly increase the profitability of investments with relatively low risks.

Correlation between BTC and the stock market

The dynamics of the bitcoin exchange rate may affect the state of the US stock market, according to a new study by the American consulting company Nautilus Investment Research, released in early August. The company’s experts came to this conclusion after analyzing 18 cases of a surge in the cryptocurrency exchange rate above the average monthly historical levels and comparing them with the daily change in the s&P 500 index (it includes 500 American companies with the largest capitalization). The period from 2010 was taken for analysis.

The authors of the study found that in most cases, when the bitcoin rate showed a yield of 30% month to month, the s&P 500 quotes reacted with similar movements up relative to their average daily values. However, this happened with a time lag-exactly the same numbers, but two and three months after each case of bitcoin growth.

The coincidence of the dynamics of the cryptocurrency and the index with a time interval of two months was recorded in 15 cases out of 18, with an interval of three months-in 17 cases out of 18. That is, in most of the studied cases, there was a double reaction of the index to bitcoin jumps: first in two months, and then in another month. The average increase in the index on each of these days, according to the study, was 3.61 and 4.66%, which is higher than the historical average daily growth of 2–3%.

The authors of the study do not answer the question about the possible causes of the revealed correlation in detail. The only guess from the experts of Nautilus Investment Research is that bitcoin can be a kind of” barometer “ of the atmosphere in the market. When traders are willing to take risks and actively speculate with volatile assets, this is first reflected in bitcoin, and then in the stock market, according to the authors of the study.

The connection between the stock market and the bitcoin exchange rate can really be explained by the behavior of traders, says the Director of the social network for investors eToro Paul Salas. According to him, when investors decide to actively trade, they invest in different classes of risky assets with increased volatility compared to conservative instruments. Such assets include American stocks, and, to a greater extent, various cryptocurrencies. Accordingly, by increasing investments in bitcoin, investors could simultaneously increase their positions in The s&P 500 index, which eventually led to its growth.

According to data collected by the American asset management company Blockforce Capital, the correlation is very weak in the long term. In its research, Blockforce compared bitcoin and the Standard & Poor’s 500 index (S&P 500) between January 2015 and October 11, 2018. The correlation was insignificant.

Why is bitcoin suitable for portfolios with different assets?

For 10 years, bitcoin has been an extremely volatile asset, showing significant drawdowns after several of the largest rallies in the history of this cryptocurrency.

Despite its volatility, BTC has not shown a significant correlation with other classes of traditional assets such as commodities, stocks or fixed income products since its inception in 2009.

In the context of trading, bitcoin is one of the most liquid instruments with consistently low spreads (the median value of which is less than 2–3 basis points), large volumes and price efficiency, since trading platforms constantly resort to arbitration.

Binance Research has modeled various bitcoin distribution techniques in diversified portfolios with multiple assets. All BTC-inclusive portfolios showed a generally better risk-return ratio than portfolios with multiple traditional assets. The results show that diversification through bitcoin does provide benefits for investors using strategies with different financial instruments.

With the development of institutional-oriented custodial solutions and other investment tools, bitcoin has become an important alternative asset that can be included in a variety of portfolios in order to diversify them.

Low correlation with other classes of assets

Correlation analysis is an important tool for investors seeking to create a diversified portfolio.

If the returns of two assets show a positive correlation, it means that both of these assets tend to move in the same direction. Therefore, these assets have comparable risks. On the other hand, a negative correlation between the returns of two assets indicates that their prices are moving in opposite directions. Thus, one asset can be used to hedge another.

Overview of the major commodity, equity and fixed-income indices

As a result, assets with low correlation, as a rule, are a good diversification in profile. At the same time, assets with negative correlation can serve as a means of hedging the portfolio.

Bitcoin does not demonstrate any significant statistical relationship with other asset classes. Thus, the median correlation coefficient with other financial instruments is below 0.10.

It can be concluded that bitcoin has become an extremely liquid asset with high trading volumes, effective pricing mechanisms among trading platforms and extremely narrow spreads, which makes it attractive to large investors.

With the development of institutional-oriented custodial solutions, bitcoin has become an important alternative asset, which is advisable to include in diversified portfolios.

Portfolio management: theory and modeling

One of the key concepts is related to the correlation between financial assets. If two financial instruments are not statistically interdependent (that is, their correlation coefficients are close to 0), then these assets may be suitable for creating a diversified portfolio.

Since bitcoin does not correlate with all other non-cryptocurrency instruments, in theory, it can complement a portfolio with various assets quite well. Diversified portfolios typically cover a wide range of asset classes, including stocks, bonds, currencies, and alternative investments such as real estate and infrastructure. A wide range of investment instruments usually provides a greater degree of diversification.

With the exception of 2018, all monthly rebalanced portfolios with bitcoin have shown much better results than those where the first cryptocurrency is not represented. In 2018, losses were increased by monthly rebalancing (-6.54% compared to -5.65% and -5.69% instead of -4.78%). Less frequent reallocations (such as quarterly reallocations) could reduce potential losses.

Summary

Bitcoin is a unique asset class, showing almost zero correlation with all other traditional financial instruments, including stocks, bonds or commodities.

As a component of a portfolio with various financial instruments, bitcoin provides the benefits of diversification, regardless of the asset classes preferred by investors. Despite high (but decreasing volatility over time), simply including BTC in a diversified portfolio leads to an improved risk/return profile.

The popularity of OTC platforms and futures contracts as alternative ways to trade large volumes of bitcoin has increased. This allowed institutions to quickly open large positions in cryptocurrency. Significant volumes on large crypto-exchanges, effective pricing, and low spreads are also attractive for potential investors.

Moreover, new products based on bitcoin are being introduced:

- supply futures (e.g. LedgerX, Bakkt);

- ETF providers seeking approval for their products from the U.S. securities and exchange Commission (Bitwise);

- specialized custodial solutions (e.g. Fidelity Digital Assets).

These new products will help to resolve any issues of concern to traditional investors, for example, related to technological and custodial risks. As a result, these initiatives can raise the status of bitcoin from an intriguingly risky asset to an investment tool acceptable to most traditional managers due, in particular, to its unique diversification properties.

Despite the low correlation between cryptocurrencies and other asset classes, it should be remembered that, like stocks, cryptocurrencies can be overvalued. However, excessive noise around some digital assets (and here we mean, for example, ICO) does not mean that they should be considered too risky or volatile from an investment point of view.

The new class of digital assets has many real applications and advantages that are valuable to investors, and a low correlation with other markets is one of the most important advantages.

So although, as always when investing, there are no perfect solutions and the risk is always there. Nevertheless, it can be stated that today cryptocurrencies are a good solution for diversifying investments.

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