Bitcoin is not the equities hedge that some investors want it to be, but that doesn’t mean it’s not worth including in a portfolio, new research shows.
A paper published in mid-September reveals that while Bitcoin doesn’t hedge against equity portfolio risk, it can act as a hedge against assets with a similar or higher risk profile than its own.
The cryptocurrency’s introduction into the market in the early 2010s was marked by the promise of its low correlation to other assets — and thus, high potential to act as a hedge against asset classes like equities.
Since then, a growing body of work — including at least 19 scholarly articles — has explored whether Bitcoin is a hedge or can reduce portfolio risk. The latest piece, entitled Is Bitcoin A Hedge? was published on September 18 by a trio from the University of Western Australia: Dirk Baur, Lai Hoang, and Md Zakir Hossain.
“The question [of] how excess volatility of Bitcoin affects its hedge and diversifier properties is generally not analyzed,” they wrote in the paper’s introduction.
So they attempted to analyze which weight of Bitcoin in a portfolio alongside the S&P 500 index could reduce portfolio risk — in other words, act as a hedge. Their work suggests that Bitcoin is a “rather poor risk diversifier and hedge for the S&P 500,” the paper said.
The authors created model portfolios using monthly and daily return data from 2011 through 2021 for both the S&P 500 and Bitcoin. The model portfolios included zero, low, and high Bitcoin weights, then analyzed whether the inclusion of Bitcoin reduced the risk relative to a standalone S&P 500 portfolio.
They found that the inclusion of Bitcoin increased portfolio risk, even for allocations as low as 1 percent, the paper said. According to the research, Bitcoin’s risk-diversifying or risk-hedging capabilities are undermined by its extreme volatility.
“Since Bitcoin is very volatile, it hardly reduces any risk,” Baur said via email. “However, this does not imply that it cannot improve the risk-return relationship or Sharpe ratio of a portfolio; Bitcoin often improves the Sharpe ratio of a portfolio because the (historical) returns are much higher than the risk relative to other assets such as the S&P 500.”
According to Baur, the findings also apply to other asset classes.
“The higher the volatility of an asset relative to Bitcoin, the better the risk hedging potential of Bitcoin,” he said via email. He added that because the volatility of the S&P 500 is much lower than that of Bitcoin, adding the cryptocurrency to a simple public equities portfolio is less effective at reducing risk than it may be for other, riskier assets.
And that’s not the only benefit of including Bitcoin in a portfolio. According to research published in August, including certain cryptocurrencies in a portfolio can offer diversification benefits to investors, Institutional Investor previously reported.
In other words, while Bitcoin isn’t a hedge, it still can be a tool for investors — as long as they know how to use it.