JP Morgan explains how to use cryptocurrency as part of a diversified investment strategy

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  • JP Morgan considered how Bitcoin’s price volatility correlates to other asset classes.
  • Found that despite Bitcoin’s huge value increase over past five years, its use as a portfolio-hedge is limited due to low volatility correlation.
  • Bitcoin’s price appreciation would have contributed to improved diversified returns over the past five years, but other limitations remain.

JP Morgan has run some numbers on the pros and cons of including cryptocurrency as part of a diversified investment portfolio.

The verdict? Bitcoin would have improved performance over the past five years — simply by virtue of its huge price appreciation — but cryptos still have some serious limitations in providing an effective portfolio hedge.

The analysis was carried out by John Normand, JP Morgan’s Head of Cross-Asset Fundamental Strategy.

Normand began by looking at Bitcoin’s price action, which has risen dramatically through huge boom and bust cycles.

To illustrate, he included this chart which neatly demonstrates how Bitcoin’s volatility compares to traditional asset classes:

On a 12-month basis, Bitcoin’s volatility was about 10 times that of stocks and commodities.

Such uncertainty is reason enough for many investors to stay away all together, but Normand notes that cryptocurrencies shouldn’t be ruled out of a diversified portfolio strategy just because they are volatile.

Of more importance is how that volatility correlates to other asset classes, particularly during periods of market stress.

For example, if strong evidence exists that Bitcoin goes up or holds its value when stocks are falling, then including Bitcoin could improve the portfolio’s risk-return characteristics.

And on that measure, Bitcoin has shown some limitations.

Here’s Normand on how it’s played out to date (our emphasis added):

Including Bitcoin in a multi-asset portfolio did not prevent portfolio drawdown from mid-2015 to early 2016 when US stocks and emerging market were falling, since Bitcoin itself
was mostly range-bound over this period.

Nor did cryptocurrencies offset portfolio losses during periods of acute market stress like the equity flash crashes of August 2015 (S&P500 -11% in a week, Bitcoin -12%) and February 2018 (S&P500 -8% in a week, Bitcoin -45%).

So based on the price action in recent years, there’s no strong evidence indicating Bitcoin will act as a safe portfolio hedge if, say, a sharp rise in inflation causes a more systemic selloff in global equities.

“Cryptocurrency markets have demonstrated a near-zero average correlation with other asset classes over the past five years, compared to the mildly positive average correlation that some other traditional hedges like inflation-linked bonds, commodity indices, gold and the yen often exhibit with other capital market assets,” Normand said.

Normand added that despite Bitcoin’s huge volatility, its value has rocketed higher over the past five years.

And on that basis alone, “a modest allocation to bitcoin over the past several years would have improved portfolio efficiency on average for a hypothetical multi-asset portfolio”.

However, Bitcoin’s boom and bust cycles and lack of correlation with other asset classes limits its effectiveness.

Normand added that cryptocurrencies haven’t been tested as an effective asset hedge through multiple business cycles, given that Bitcoin has only been around since 2009.

In connection with that, the relative youth of cryptos as an asset class — which are traded on unregulated exchanges — reduces their liquidity compared to traditional hedges such as the Japanese yen.

Looking longer-term, Normand said even if cryptocurrencies evolve to play a bigger role in the financial system, the returns of the previous five years are unlikely to be repeated.

“So even if cryptocurrencies represent as much the future of finance as they could represent a financial market bubble (like technology stocks 20 years ago), the possibility of mean reversion in coming years could detract from portfolio efficiency through the return angle.

“Thus, based on the above, investors are probably best served by hedging their bets — we believe that any allocation to cryptocurrencies as insurance should not be a portfolio’s only hedge.”

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