Even in Crisis, Most Cryptocurrencies Offer Diversification Benefits

During times of global turbulence, like the kind induced by the Covid-19 pandemic, cryptocurrencies may provide much-needed diversification to investment portfolios, according to a paper from researchers at the University of Bath. 

The researchers came to this conclusion after aggregating popular cryptocurrencies into nine equally-weighted portfolios based on the type of algorithm used in the blockchain of each currency, a methodology that gave them room to consider 553 cryptocurrencies in total. These categories included proof-of-work coins — popular mineable coins like Bitcoin and Ethereum — and proof-of-stake coins, a more energy-efficient alternative to PoW coins. 

Seven of the nine categories of cryptocurrencies offered diversification benefits to investors, including PoW and PoS coins, according to co-authors Xinyu Huang, Weihao Han, David Newton, Emmanouil Platanakis, Dimitrios Stafylas, and Charles Sutcliffe.

For the study, they measured the diversification capabilities of cryptocurrencies during the pre-pandemic and post-pandemic periods. The researchers compared the cryptocurrencies’ performance to the performance of equity and bond portfolios and found that, during uncertain economic periods like the aftermath of the pandemic, most cryptocurrencies provided strong diversification for investors. 

For the observed cryptocurrencies, the pre- and post-pandemic periods didn’t look all that different. In fact, during the post-pandemic period, the cryptocurrencies provided generally similar diversification benefits as they did during “normal” economic conditions, according to the study.

“It is very common, during periods of crisis, for most asset classes to decrease in price,” Platanakis told Institutional Investor. “But, in our case, because cryptocurrencies did not have the same exposure to the same variables — like equities, bonds, and other asset classes — our prices were consistent pre- and post-Covid.” 

Platanakis said investors began to want more diverse portfolios after the 2008 financial crisis: At the time, many long-term institutional investors were only investing in equities and bonds, but, after the crash, they began to seek more diversity in their portfolios. 

For investors in crypto, diversification benefits may be contingent on their level of risk aversion: Only four out of the nine categories of cryptocurrencies were found to be beneficial regardless of investors’ risk tolerance, including PoS and PoW coins. Three other categories were only beneficial when investors were risk averse.

Across cryptocurrencies, however, the authors said that coins provided more diversification benefits to “aggressive“ investors than to “conservative” investors. In short, the lower the risk aversion of the investor, the more beneficial it was to invest in cryptocurrencies.

“Those cryptocurrencies are riskier asset classes,” Plantanakis said. “But, at the same time, the correlation between those portfolios or cryptocurrencies, in relation to our equities, bonds, and other major asset classes, including real estate and commodities, is low.”