By Daniele Bianchi, PhD
With the rising prices of Bitcoin and public awareness on blockchain, investors have drawn their attention to cryptocurrency markets, driven by the promise of significant returns compared to the flat or negative yields in more traditional asset classes. But how should investors examine cryptocurrencies in the context of a multi-asset portfolio? Reaching high returns has often proved to be a bumpy ride, as cryptocurrency markets are often plagued by an unprecedented level of volatility. Do cryptocurrencies offer diversification benefits? I seek to answer these questions in my paper, “Cyptocurrencies As An Asset Class? An Empirical Assessment,” in The Journal of Alternative Investments.
Despite such a high volatility, both retail and institutional investor interest in cryptocurrency markets has grown over the past few years. Above and beyond the promise of large returns, one key aspect of interest for investors was the idea that cryptocurrencies represent a novel, innovative asset class which is potentially segmented away–i.e., driven by alternative economic forces and factors–from other, traditional asset classes.
While segmentation from traditional asset classes may ultimately indicate that we still do not fully understand the pricing mechanisms behind cryptocurrencies, practically, cryptocurrency markets still may offer large and persistent diversification opportunities.
Empirically, at least in reduced-form, such segmentation can be investigated by looking at the cross-correlations between cryptocurrencies and more conventional investment vehicles, and between crypto and macroeconomic variables. The rationale is simple, if cryptocurrency exhibits uncorrelated returns to either standard asset classes or macroeconomic variables, they may represent significant diversification instruments against typical financial and/or economic risk factors.
This research, which studies the returns and market activity of the top 300 cryptocurrencies, shows that, except for a mild correlation with the returns on precious metals, there is no significant relationship between returns on cryptocurrencies and global proxies of traditional asset classes. The absence of cross-assets correlation holds true for both returns and volatility, with the latter indicating that there are no significant spill-over effects in terms of risk between cryptos and more traditional investments.
Similarly, empirical evidence suggests little evidence of prices and volumes being driven by macroeconomic activity on a global scale. More specifically, delving further into the dynamics of market activity provides evidence that trading volume is primarily influenced by past returns and volatility. Additionally, macroeconomic variables such as shocks to inflation expectations, interest rates, and aggregate market risk aversion (proxied by the VIX index) do not influence short-term trading activity in cryptocurrency markets. As a whole, macroeconomic activity on a global scale does not seem to influence the short-term dynamics of cryptocurrency prices and volume. However, long-term dynamics may differ whereby macroeconomic fundamentals, aggregate risk attitudes, and global imbalances may well influence trading activity in cryptocurrency markets.
As a whole, the results in this research advocate caution in giving a naïve interpretation of the dynamics of returns and trading activity in cryptocurrency markets based on the returns on other more traditional asset classes and/or changes in aggregate macroeconomic conditions. The fact that the return dynamics in traditional markets and cryptocurrencies does not share many commonalities represents a source of difficulty that should warn investors to be cautious if cryptocurrency enters their portfolios.
There is still a considerable debate as to whether and how cryptocurrencies may be segmented from traditional asset classes, and how this possibly translate in economic gains for the average investor. This paper solidly contributes to the empirics of this debate, but there is still much to be answered.
The original paper, “Cyptocurrencies As An Asset Class? An Empirical Assessment,” is featured in the Fall 2020 edition of The Journal of Alternative Investments and is freely available to all readers.
Daniele Bianchi, PhD is Associate Professor of Finance at the School of Economics and Finance, Queen Mary University of London
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