MIT, State Street Paper Challenges Crypto's Ability to Diversify Portfolios

Cryptocurrencies have proved their worth as a way to speculate. But how well cryptocurrencies diversify investment portfolios remains to be seen, according to a working paper authored by a professor at MIT’s Sloan School of Management and three State Street employees.

Bitcoin, which was created in 2009, and the subsequent cryptocurrencies, simply have not existed long enough — throughout various market cycles — to establish a meaningful history of conflicting performance against other asset classes. “Full-sample correlations reveal little about an asset class’s diversification potential because they do not distinguish upside correlations from downside correlations, nor do they consider the magnitude of returns,” the paper published March 15 says.

“Although cryptocurrencies performed well when U.S. stocks performed well, they also moved in tandem with U.S. stocks when stocks performed poorly. This correlation profile suggests that cryptocurrencies do not offer protection for investors with short horizons.” 

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To be sure, the authors did not totally dismiss the new asset class. Cryptocurrencies have proven effective for speculation. It is just “less clear” if cryptocurrencies can be used to manage risk, according to the paper.

Though some “smart money” may be dabbling in cryptocurrencies to hedge, speculation and risk management are the only two reasons institutions might consider the new asset class, according to the paper. Cryptocurrencies are too volatile, aren’t backed by a sovereign entity, and their value is not tied to any fundamental source, such as a stream of cash flows, “therefore, their benefit to institutional investors, assuming speculation is not the primary motive, rests largely on their potential to diversify a portfolio.”

To determine how well cryptocurrencies can manage portfolio risk, the authors recommend a wait-and-see approach. Investors can only reasonably consider the direction and magnitude of crypto returns over the short term. Later, they can watch to see if the new asset class moves synchronously or drifts from other asset classes over time. Correlations from shorter-interval returns do not necessarily reflect the co-movement of longer-interval returns, the authors say.

“Diversification is a complex topic, even for traditional asset classes. It is not enough to calculate the correlation of daily or monthly returns, for example, and conclude that asset classes with low average correlations are good diversifiers while those with high correlations are not as good. It is important to focus on an asset class’s correlation with other asset classes when they are performing poorly separately from when they are performing favorably, as well as the magnitude of these directional returns.”

The paper’s authors include Mark Kritzman, the CEO of Windham Capital Management and a senior lecturer in Finance at the MIT Sloan School of Management, and from State Street, Megan Czasonis, managing director for the Portfolio and Risk Research team; David Turkington, Senior Managing Director and Head of Portfolio and Risk Research; and Baykan Pamir, an assistant vice president.

The vast majority of private wealth managers have not invested clients in cryptocurrencies. But more than a third of financial advisors say at least some clients have inquired about the asset class. Among the roughly 9% of advisors who are investing in cryptocurrencies, 51% say they are allocating to it in place of other alternative investments, 18% are allocating to it in place of equities, and 17% in place of cash, according to a survey by Bitwise Investments. 

Michael Thrasher (@Mike_Thrasher) is a reporter at RIA Intel based in New York City.

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