Advisors have long extoled the virtues of diversification to clients. Diversification has long served as the bedrock of proper portfolio construction and while it’s not foolproof, as is on display this year, it’s usually a trait worth embracing and one that’s easy to implement.
Typically, the case for diversification across multiple asset classes is to reduce correlations. Indeed, advisors are up against it this year when it comes to diversification leading to lower correlations. As advisors know, one of the primary purposes of fixed income exposure is to reduce a portfolio’s correlations to stocks. It’s a big reason why the 60/40 portfolio structure was a gold standard for so many years.
However, the combination of rising interest rates and hot, persistent inflation is eroding some of the previously negative correlations of high-quality bonds to equities, meaning supposedly low risk fixed income instruments are reducing risk in client portfolios as those bonds have in years past.
Then there’s crypto. Using bitcoin as the barometer, cryto is a young asset class. BItcoin, the largest cryptocurrency by market capitalization, is about 14 years old. However, diversification here is imperative as it is with traditional assets.
Why Crypto Diversification Is Vital
Usually, advisors diversify client portfolios across assets and market cap spectrums to achieve diversification.
“Returns are typically driven by a relatively small number of strong performers, which pull the index’s return above that of most of its constituents,” notes Craig Lazzara, Managing Director and Global Head of Index Investment Strategy for S&P Dow Jones Indices.
There are lessons in there when it comes to crypto. Namely, index evaluation is worth the time and relying solely on bitcoin can weigh on returns.
“Looking at back-tested data, over the past five years (as of Sept. 30, 2022), the S&P Bitcoin Index and S&P Cryptocurrency MegaCap Index outperformed the broader cryptocurrency indices on an annualized risk-adjusted return basis. The S&P Cryptocurrency MegaCap Index, which combines Bitcoin and Ether into one index weighted by market capitalization, led the way in absolute returns, posting a 36.21% annualized five-year return,” write Tyronne Ross and Erik Smith of Turnqey Labs.
They note that while the comparable bitcoin index was a close second over those five years, more diverse crypto approaches beat bitcoin over the past three years. Some of that is attributable to ethereum’s rising dominance. Nonetheless, it underscores the point that crypto diversification is pertinent.
“Ethereum’s share of the total crypto-asset market cap has grown slightly since the beginning of 2017, now making up over 17% of the total digital asset market. Bitcoin’s market cap, which accounted for approximately 90% of the cryptocurrency market at the beginning of 2017, has fallen to around 39% dominance,” add Ross and Smith.
Risk Matters, Predictions Are Hard
Despite its youth, crypto share some similarities with more season asset classes. Namely, clients’ risk tolerances are crucial when discussing crypto and timing market bottoms and tops with digital assets is just as difficult as it is with equities.
Translation: Education matters.
“With limited historical data to base our analysis on, we are left pondering what the future holds for this new asset class that is growing exponentially,” conclude Ross and Smith. “The best way to make an informed decision on structuring a digital asset portfolio is to continuously learn about and evaluate this evolving market. Education comes first.”