Cryptocurrency Isn’t A Hedging Vehicle

Whatever else it may be

Kurt Winkelmann, Raghu Suryanarayanan, Ferenc Szalai

An important (maybe even key) feature of a market correction is that it gives investors an opportunity to revisit the logic behind both their investment strategy and individual investments. In this respect, this year’s market selloff should be no different than any other. As has happened after every other selloff, today’s trendy investments will be re-examined. Equally importantly, investors will re-learn two fundamental principles:

This note examines these points in the context of two widely followed (and trendy) investments: cryptocurrency (more specifically Bitcoin) and Tesla. Our analysis will build on the analysis of an earlier note. The discussion here suggests that the extraordinary gains associated with both of these are in part attributable to significant market exposure, and partly due to the usual hype that surrounds specific investments in asset pricing near-bubbles.

The Market (Still) Makes a Difference

Our previous note showed the average return, volatility (standard deviation of returns), and betas relative to the market for Tesla, Bitcoin, USD/EUR, and US government bonds. We reproduce these figures in Exhibit 1. The key takeaways from the exhibit are:

Exhibit 1 - Historical Return and Volatility

Historical Return and Volatility
Source: Navega Strategies LLC Research, Refinitiv, Vanguard, Blackrock iShares

The average annual return figures in Exhibit 1 are historical average returns over a common time period. Let’s look, though, at a different problem: how much of year-to-date performance can be accounted for by the market?

This point is addressed in Exhibit 2. The exhibit shows the year-to-date performance on each of the assets from Exhibit 1; the y-t-d performance relative to a riskless asset; the y-t-d excess return as predicted by the betas from Exhibit 1, and the difference between the actual and predicted performance.

Exhibit 2 - Year-To-Date Performance

Year-To-Date Performance
Source: Navega Strategies LLC Research, Refinitiv, Vanguard, Blackrock iShares

What can we infer from the figures in Exhibit 2? First, Bitcoin and Tesla’s year-to-date returns depended heavily on the market (as indicate by the high betas). Second, both Bitcoin and Tesla underperformed even the market-adjusted performance. Third, bitcoin underperformed (by a significant amount) the government bond market and the USD/EUR exchange rate. The moral of the story continues to be that investors should still ponder how every investment (actual and potential) will perform during market rallies and selloffs.

Diversification (Still) Helps Reduce Risk (as Does Simply Reducing Risk)

At this point in the history of applied portfolio theory, it is a mystery to us why some investors do not incorporate risk considerations in their portfolio design. This year’s market selloff and the knock-on effects illustrated in the previous section should hopefully help investors re-learn the (obvious) lessons that: (a) higher risk portfolios have a higher potential downside and (b) diversification can still pay.

We’ll examine these points in the context of the simple portfolios from our earlier note. These portfolios are shown in Exhibit 3. The portfolios in the exhibit were chosen to illustrate how risk budgets can be used in portfolio construction. The main point of the exhibits are: (a) risk allocations and capital allocations are not the same things, and (b) risk reduction only occurs when lower-risk assets are included in the portfolio.

Exhibit 3 - Alternative Portfolio Risk Budgets

Alternative Portfolio Risk Budgets
Source: Navega Strategies LLC Research, Refinitiv, Vanguard, Blackrock iShares

In the exhibit, the first portfolio has a 50/50 capital allocation between Tesla and Bitcoin; the second portfolio reallocates capital between these two assets to produce an equal contribution to portfolio risk; the third portfolio allocates capital to the US Equities and US government bonds, while the last portfolio reallocates capital so that all risk contributions are positive.

Exhibit 4 shows the year-to-date performance of each of these portfolios. Unsurprisingly the better-diversified (but still concentrated) portfolio underperformed less than the most concentrated portfolio. Finally, the lower risk portfolios did better than the concentrated portfolio.

Exhibit 4 - Portfolio Year-To-Date Performance

Portfolio Year-To-Date Performance
Source: Navega Strategies LLC Research, Refinitiv, Vanguard, Blackrock iShares

New Questions to Ponder

It continues to baffle us why investors have to relearn the same lessons about the relevance of the market for all assets, diversification, and that high non-market risk does not always pay off. With any luck, this market downturn will help these lessons sink in for a few more investors.

Every downturn also prompts questions that are unique to specific asset classes and that particular downturn. For our examples here, the questions that occur to us are the following: (1) what are the economic use cases for cryptocurrency, given that it demonstrably does not act as a currency? (2) Conditioned on an answer to (1), what role should cryptocurrency play in specific portfolios? (3) Can Tesla’s valuations be justified relative to other car manufacturers, both short and long-term?  We are sure that the next downturn (and there will be another at some point in the future) will prompt its own set of questions.

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