Why Diversification Matters for Crypto, Too

Long-standing and generally accepted financial theory shows that diversification is not only good, but improves expected returns per unit of risk.Unfortunately, the crypto space currently seems to be overlooking this principle.

A “TradFi” Equivalent

A timely post from the quantitative asset management firm AQR provides a direct "TradFi" equivalent to the problem of under-diversification. In the post, AQR co-founder and CIO Cliff Asness rebuffs a recent paper that effectively poses the question, "Why not 100% equities?" — a style of thinking that tends to resurface during bull markets.

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The blog recounts certain tenets of introductory financial theory, largely amounting to "owning one asset is suboptimal":

“In finance 101 we are taught that in general 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 many like it, confuse the two. If the best return-for-risk portfolio doesn’t have enough expected return for you, then you lever it (within reason). If it has too much risk for you, you de-lever it with cash. Remarkably this has been shown to work.”

Asness harkens back to the basics of modern portfolio theory to show that you can own a single asset, but don't expect that one asset to outperform a portfolio of diversified (i.e., not perfectly correlated) assets on a risk-adjusted basis.

Does Diversification Matter for Crypto?

Crypto investors should ask themselves a similar question: why not 100% Bitcoin?

Given Bitcoin's outsized media attention, market commentators often still equate "crypto" with "Bitcoin." The approval of spot bitcoin ETFs may be an important first step toward broad-based investor adoption, but a conspicuous departure from the golden rule of diversification has emerged.

Let's examine four hypothetical crypto portfolios going back to 2018: Bitcoin Only and Ethereum Only (no diversification), an equal-weighted allocation to Bitcoin and Ethereum (a little diversification), and a passively weighted portfolio of the top 10 non-stablecoin assets in any given month (better diversification).

The bottom line: diversification matters for crypto.

The Bitcoin Only and Ethereum Only portfolios produced highly similar annualized returns of about ~30%, but Ethereum Only exhibited higher volatility, resulting in worse risk-adjusted performance compared to Bitcoin. Annualized returns of this magnitude may satisfy "Bitcoin Bulls" and "Ethereum Maximalists,” but could investors construct more efficient portfolios? Yes.

By combining Bitcoin and Ethereum in a simple equal-weighted basket of the two assets, we observe notably improved risk-adjusted returns. Compared to Bitcoin Only, the annualized risk increases somewhat but the increase in return is greater than the increase in volatility, resulting in superior risk-adjusted performance. If the slight increase in risk vs. Bitcoin Only wasn't acceptable to an investor, the investor could hold some cash alongside the portfolio to dampen volatility while still achieving better returns.

Adding more assets to the portfolio improved risk-adjusted returns even further. With a passively weighted, monthly rebalanced portfolio of the top-10 assets by circulating market capitalization, annualized volatility effectively remained constant compared to the equal-weighted BTC-ETH portfolio, while annualized returns increased meaningfully.

Broadening the digital asset universe to better capture the value proposition of differentiated blockchain technologies improved the portfolio's risk-adjusted return characteristics.

Conclusion

Despite crypto's brief and volatile history, recent evidence suggests what traditional markets have repeatedly demonstrated: owning a single asset delivers worse risk-adjusted returns over the long-term compared to a portfolio of diversified assets.