The benefits of diversifying cryptocurrency exposure

Diversification means not having all your eggs in one basket

The benefits of diversifying cryptocurrency exposure

The benefits of diversifying cryptocurrency exposure 800 600

Do investors even need exposure to more than just bitcoin and ether? Today we will address the benefits of a diversified portfolio of cryptocurrencies. 

While it is true that bitcoin and ether have historically experienced high correlations, the same can’t be said for bitcoin or ether versus the largest alt coins. This can be seen in the historical daily correlation table below. Note that the May 2020 analysis period was selected as the start date because it represents the common inception for all cryptocurrencies included in the analysis. 

Cryptocurrency correlations across various market environments:

Cryptocurrency correlations are usually close to or below the 0.60 threshold

Source: Coingecko May 1, 2020 through July 20, 2022

Diversification benefits typically accrue to an investor’s portfolio when correlation coefficients are less than 0.60.  As you can see the correlation coefficients are generally close to or below the 0.60 threshold, with the median correlation of 0.52.  

As with any market based statistics, these correlations are dynamic and have changed over time and in different market environments. Historically, correlations of traditional asset classes have tended to fall in rising markets while securities have tended to become more correlated in falling markets. As the cryptocurrency market has matured, it too has tended to follow a similar pattern. This can be seen by looking at the correlations during the market rise between May 2020 and the all-time high in November 2021. The median correlation during this rising market was 0.47. 

Cryptocurrency correlations during bull market period:

Cryptocurrency correlation values tend to trend down in a bull market

Source: Coingecko May 1, 2020 through November 1, 2021

By comparison the median correlation during the crypto winter from November 1, 2021 through July 20, 2022 jumped significantly to 0.75.

Cryptocurrency correlations during bear market period:

Cryptocurrency correlations in a bear market tend upwards to 0.75

Source: Coingecko November 1, 2021 through July 20, 2022

The lower correlations in a rising market illustrates the idiosyncratic risks that exist between the largest cryptocurrencies. Small differences in governance structure, consensus mechanism, cryptography, fees, or transaction times between the different cryptocurrency blockchains can have a material impact on how they perform and contribute or detract from a diversified portfolio.

A diversified portfolio of cryptocurrencies including both core positions in bitcoin and ether complimented by a basket of altcoins can add diversification benefits in rising markets and across multiple market cycles.

Check back tomorrow where we will explore how smart index construction can be used to reduce the concentration risk inherent in building a market capitalization weighted index that includes bitcoin and ether.

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