Bitcoin: Uncorrelated assets, the “holy grail” of portfolio allocation.

When it comes to investments of any kind, it’s important to understand how the assets in question are related to others on the market. The relationship between the price of different assets,  or “correlation” as it’s called in investment terms, is crucial to determining the overall risk your portfolio may have. You could think of your portfolio as heavily diversified, but if the sectors you’re invested in are highly correlated (when assets move in the same direction at the same time), the overall risk could much higher than you initially thought.

In the cryptocurrency world, Bitcoin and altcoins (other cryptocurrencies) have always had an interesting relationship, shifting from highly correlated to negatively correlated (when asset prices move in the opposite direction at the same time). This is to be expected since most investors first enter the crypto rabbit hole through Bitcoin and eventually have the curiosity to start branching out into altcoins. Once in crypto most investors just alter the weight of their Bitcoin,  altcoin and USD exposure depending on market conditions, hence the correlation. For the majority of 2017, all Cryptocurrencies were highly correlated, moving in unison, until the last few weeks when news of a potential Bitcoin ETF started to gain momentum which helped push the BTC price to all time highs.

That said, while cryptocurrencies have a high degree of correlation with each other most of the time, they haven’t shown to be affected by the trading price of other traditional asset classes like gold, stocks, real estate or commodities, etc. As an uncorrelated asset class with more and more onramps for retail and institutional investors, cryptocurrencies and Bitcoin in particular, offer interesting opportunities for savvy investors. When correlated markets due for a broad decline impact each other and set off a domino effect, the price of Bitcoin is not necessarily affected at all, allowing traders to offset risk by allocating a small amount of their total investment portfolio to the top cryptocurrencies. This can reduce the overall risk of a portfolio while increasing expected returns…the “holy grail” of investing.

By having a basket of uncorrelated, or negatively correlated investments, it is less likely that your investments will suffer a catastrophic loss in the event of a major downturn or a financial crisis.

Burton Malkiel, the author of “A Random Walk Down Wall Street” and investment guru Ray Dalio, founder of hedge fund Bridgewater, both credit uncorrelated investment strategies for some of their success in investing.

Bitcoin as an uncorrelated asset

Bitcoin offers traders a lifeboat when things turn rough by being uncorrelated to the stock market – largely. Fundstrat’s Thomas Lee is one analyst to point out that the VIX, AKA the stock market’s ‘fear gauge’ is arguably correlated with Bitcoin’s price movement.

However, while Lee acknowledges that it’s possible Bitcoin may be ‘predicting’ the stock market to an extent by mirroring the VIX before it happens, the connection to the actual price movement in the stock market is “really, really limited.”

“In the past 12 months, not only did we have a strong rally in equities, we had a strong rally in cryptocurrencies. I wouldn’t be surprised if those investors who saw risk-on assets everywhere outperforming globally were also buying cryptocurrencies.”

“Cryptocurrencies have their own economy based on activity on that Blockchain. Equities have their own economy based on earnings per share multiples. The institutional overlap is essentially zero.”

Lee has also produced findings showing that Bitcoin is not only uncorrelated to many asset classes, but actually negatively correlated to others like gold due to the “cannibalization of the demand for gold”.

Datatrek analysts agreed with Lee, stating:

“Since investors have only one brain to process risk, they will make similar decisions about cryptocurrencies and stocks when they see price volatility in the latter.”

Meanwhile, Morgan Stanley analysts have voiced the opinion that the correlation is due to traders escaping stock market dips by converting their holdings in and out of Bitcoin, leading to a mild connection between both markets without Bitcoin actually impacting mainstream stock prices.

However, it’s exactly that kind of behavior that could lead to the two markets being more strongly connected in future. An Octagon Trading trainee stated:

“As for it being indirectly related, I would say that BTC is considered to many as a hedge against currencies, similar to that of gold. Therefore, if the demand, recognition and acceptance of BTC becomes much larger, there is a chance it would be in a similar position to that of gold and the stock market.”

So how does this help your portfolio?

Thomas Lee didn’t just make a passing comment about the interaction between the stock and cryptocurrency markets – in his presentation entitled ‘Economics of Cryptocurrencies’ at Upfront conference he dug a lot deeper, producing some very interesting information.

The Fundstrat analyst found that while a 60:40 stock/bond equity portfolio allocation tended to gain 6.42% over three years, a portfolio split 58:60:2 between stock/bond/Bitcoin led to an 8.73% increase, over 2% more with the addition of Bitcoin.  Pushing the Bitcoin split to 5% led to even greater gains over three years, almost doubling the returns on a stock/bond blend and actually reducing profit volatility despite the volatile reputation of Bitcoin.

While Bitcoin also gained negative press over the years from people going ‘all in’ on what many viewed as a fad with some even mortgaging their homes to invest in Bitcoin, Lee states that “you don’t have to bet your firm on crypto to see uncorrelated alpha”.

Uncorrelated Alpha

Alpha is the portion of a portfolio’s return that cannot be attributed to market returns, and is thus independent from them. Exposure to alpha is equivalent to exposure to idiosyncratic risk.

Beta, on the other hand, is the return generated from a portfolio that can be attributed to overall market returns. Exposure to beta is equivalent to exposure to systematic risk. Systematic risk refers to the risk of a collapse of the entire financial system, the type of risk that most assets can’t avoid. As in, if the US government collapses tomorrow, you can bet your ass that everything and I mean everything from stocks, bonds, commodities and and real estate will collapse right alongside it.

So while beta is essentially exposure to more predictable and interconnected market risks, uncorrelated alpha is earnings gained from returns generated outside the normal boundaries of the risks associated with the traditional market, a very rare thing indeed. Traders are now looking to Bitcoin to generate these returns due to its loose connection with other financial asset classes.

Grayscale investor Michael Sonnenshein said in 2017:

“Bitcoin is uncorrelated alpha. This is the holy grail of investing.”

Grayscale puts out the GBTC Bitcoin fund which trades $400 million over the counter, an amount equivalent to that of McDonalds.

Uncorrelation a Buy Signal?

As always, it’s important to do your own research before making an investment in cryptocurrency or anything else for that matter. What I will say is that crypto has currently no correlation to either stocks, bonds, gold and hedge funds, which may be a a serious buy signal for investors that have not yet entered the market.

Many investors and portfolio managers are agnostic to the actual assets that they allocate in their portfolio, that is to say they aren’t so focused on the micro/industry specific factors pertaining to the asset class they are investing in but the returns and how they integrate with the rest of their portfolio. As a consequence of this, as long as crypto continues to be uncorrelated we are likely to see a growing interest from portfolio managers and investors.

For almost a decade now the cryptocurrency boom has been a retail investor phenomenon led by individual investors flocking to this new and emerging technology. While many flocked to cryptocurrency as a means of making their first investment, an investment in something relatively unconnected from the world of traditional finance, those invested in stocks and bonds may do well to consider the inclusion of Bitcoin or other cryptocurrencies for a more diverse portfolio that will offset the beta risk associated with those asset classes. As the industry matures by creating more investment vehicles from fiat currencies to cryptocurrencies, like the previously mentioned Bitcoin ETF, and reduces the risk of custody for institutional investors, well…what does the crypto community call it “moon lambo”…or something like that.

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Interested in other cool crypto posts….check out Mining Wars: Bitmain vs Dragonmintand The Price of Bitcoin vs Cost of Mining.

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