Can crypto still help investors diversify their portfolios?

Lily Zhang

Huobi Group CFO

The recent market downturn has drawn crypto investors’ attention not just to digital assets’ returns over the years, but also how they performed relative to other asset classes – in other words, crypto’s correlation with other key components of a typical investment portfolio such as stocks, bonds and gold.

There has been a long-held perception that crypto serves to diversify risk and hedge against volatility in other asset classes. This explains in part why so many investors jumped on the crypto bandwagon and bought popular tokens such as Bitcoin, as its price surged in recent years.  

However, does this diversification tenet still hold based on the market volatility we’ve seen since the onset of the pandemic?

IMF: Growing correlation between crypto and stocks

In its January 2022 report titled “Cryptic Connections: Spillovers between Crypto and Equity Markets”, the IMF highlighted a growing correlation between the crypto and stock markets across the United States and emerging markets. It noted that popular crypto assets such as Bitcoin and Ether showed little correlation with major stock indices before the pandemic, but crypto prices and US stocks surged after central banks eased monetary policy in early 2020.

Using daily data on price volatility and returns, the IMF found that spillovers from Bitcoin’s price volatility to the S&P 500 and MSCI emerging markets indices have increased by about 12-16 percentage points since the start of COVID-19, while those from its returns are up by about 8-10 percentage points. Spillovers from Tether to global stock indices have also increased by about 4-6 percentage points.

In absolute terms, the IMF’s analysis shows that spillovers from Bitcoin to global equity markets are significant – accounting for about 14-18% of the variation in equity price volatility, and 8-10% of the variation in equity returns.

Morningstar: Crypto correlation relatively low, but watch out for volatility

From a longer-term perspective, Morningstar offers an alternative view in its recent 2022 Diversification Landscape Report. It found that while crypto’s correlation with traditional assets tends to spike in market crises, it remains “relatively low” with most other major asset classes. Morningstar’s data shows that for the three-year period preceding end-2021, Bitcoin had a correlation coefficient of 0.32 with stocks, 0.14 with bonds, and just 0.08 with gold.

Morningstar however cautions that crypto’s correlation with the stock market has been slowly increasing in recent years, limited not just to Bitcoin but also Ether and other major cryptocurrencies. It expects this trend to continue as more institutional investors and individuals embrace crypto.

Morningstar also warns of crypto’s volatility which it believes makes it tough to use in a diversified portfolio: “Diversification value is one potential reason to add cryptocurrency to a portfolio, but investors should also consider other factors, such as their ability to hold on through crypto’s periodic downdrafts, which have been unusually swift and severe.”

Beyond Asset Correlation: What Investors Should Focus on

What are the key takeaways for investors from these findings? First, the shift in trends highlighted by the IMF and Morningstar reflect the frenetic pace of the crypto market’s development over the years. As crypto matures as an asset class with its growing adoption across the world, it is not inconceivable that its correlation with other asset classes would change over time, and across market cycles as we have seen.

While it is not wrong for investors looking to build a diversified portfolio to focus on the correlation of their assets, they should not lose sight of the bigger picture. Specifically, this concerns their investment objectives and horizon, which will determine the risk level they can tolerate and consequently the asset mix of their portfolios.

Accordingly, they should do their research by staying across key developments in the crypto market, instead of blindly following the latest trends. This will help them make more informed and prudent decisions that are compatible with their risk tolerance and objectives – just as important, if not more – as having a well-diversified investment portfolio with low correlation across assets.

Photo by Anne Nygård on Unsplash