Applying a risk-based approach and optimizing multi-asset portfolios through Cryptocurrencies

Applying a risk-based approach and  optimizing multi-asset portfolios through  Cryptocurrencies
Exploring “alternatives” in a multi-asset portfolio

Investors continue to worry about the lasting impacts of the worsening pandemic, unprecedented quantitative easing and historical low interest rates therefore have identified alternative sources of return a top priority. The search for returns has been a challenge due to less favorable valuations in global equities and nearly negative yields in bonds. That has left alternatives as an asset class worth exploring. They have often been additive to portfolios due to their uncorrelated asymmetric returns and it would be useful to understand why. Investors should explore how alternatives can benefit a multi-asset portfolio to meet their contractual obligations and funding expectations.

Applying a risk-based approach to optimize ones’ portfolio and understanding what risks drives returns

Constructing a portfolio that efficiently diversifies away idiosyncratic risks and drives asymmetric returns would not be an easy task but one that is possible with the addition of alternatives. Using a risk factor-based approach to portfolio construction, investors can optimize their portfolio to harness such potential. But before discussing the risk-factor approach we should briefly review the driving theory behind such approach. The capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return that compensate for well-diversified unsystematic risks or the lack thereof. Total portfolio risk is known to be comprised of two types of risk 1) systematic risk (undiversifiable) and 2) unsystematic risk (diversifiable). Furthermore, systematic risk refers to the risk common to all assets while unsystematic refers to individual assets. Some of the factors that lead to unsystematic risks may include credit, business, financing, product, legal, liquidity, political and operational risks. Whereas systematic risk may include changes to laws, tax reforms, interest rate hikes and economic recessions. According to the CAPM model, investors should not take on any unsystematic risks since they can be diversified away by holding different types of assets and are only compensated for systematic (non-diversifiable) risks. The chart below shows unsystematic risk diminishing as the number of stocks or assets increase in one’s portfolio (diversification effect); ultimately the total portfolio risk is reduced to systematic risk or beta.

Risks can be further decomposed into three broad systematic risk factors (equity, credit and rates) along with unsystematic risk factor (idiosyncratic risk) across asset classes as shown below. Decomposing and understanding the different risk factors that contribute to the total risk is the first step in knowing what risks drive returns.

Applying a risk-based approach by leveraging an emerging alternative asset

Cryptocurrencies are emerging alternative assets and predominately contain unsystematic risks as they are not inherent to market impacts (e.g. interest rate). Therefore, including an uncorrelated asset such as Bitcoin that predominately contains unsystematic risk (which has been diminishing overtime as the industry matures) may reduce the overall risk-return profile of the portfolio by enhancing its return and diversifying away concentrated systematic risks (i.e. equity risk).

Unsystematic risks relative to cryptocurrencies may include:

-Regulation: The total market cap for cryptocurrencies has exponentially grown without much regulation and oversight.

-Custody: Growth of the industry relies on improved custody for both “hot” (online) and “cold” (offline) storage, including security.

-Cyber Security: Cryptocurrencies are digital in nature therefore susceptible to cyber hacks. Security expertise is not keeping up with the growing pace of the cryptocurrency market.

-Illiquidity: The level of volatility for cryptocurrencies greatly decrease their usefulness as a currency, contributing to liquidity issues.

-Reputation: Institutions engaging in cryptocurrency related activities may attract new revenue streams however they risk losing current clients if negative or adverse regulatory event occurs prompting a loss in confidence.

A study conducted by Nuveen on a hypothetical endowments’ average asset allocation along with the actual risk allocations is shown below. Even though more than 50% of the portfolio is allocated to alternatives, equity risk accounted for 94% of the total risk while unsystematic or idiosyncratic risk accounted for just 4%. Therefore, diversifying alternatives with cryptocurrencies may reduce equity risk and better balance the risk factors of the portfolio.

Allocating to risk factors not asset classes better aligns portfolio’s objectives and constraints

Investors seeking long-term risk adjusted returns should allocate to risk factors allowing asset classes to be a byproduct of the portfolio construction process; investors should be compensated for owning risks rather asset classes. Investors should decompose the risk factors that contribute to the performance for each asset class and seek opportunities to diversify away unsystematic risk and enhance the risk-return profile of their portfolio. The traditional asset allocation approach can hide overlapping market risk exposures and undermine the diversification benefits of alternatives. Allocating to risk factors will help lower total portfolio risk and better align with the portfolio’s objectives and constraints.

Risk first approach to multi-asset portfolio construction
Leveraging the expanded CAPM model (Fama and French 3- factor model) to better understand the cross-section of cryptocurrency returns

There are two contrasting views on the cryptocurrency market. We have heard from well-respected billionaire, Warren Buffett claiming cryptocurrencies to be a bubble and a fraud to another well-known venture capital investor, Tim Draper claiming Bitcoin is good for humanity. If you are in the same camp as Tim Draper, analyzing the cryptocurrency market from the empirical asset pricing point of view should be important for two reasons. The first reason is to see If there are similarities with other asset classes and the second reason is to establish empirical regularities for inputs into theoretical models for cryptocurrencies. The Fama and French 3-factor model expands on the CAPM model by adding size and value risk factors to the market risk factors. Certain factors like size and value have historically earned a long-term risk premium in traditional markets. A study conducted by Liu, Tsyvinski and Wu, examined whether such fundamental systematic risk factors that capture the characteristics deemed important in the cross section of equity returns are also present in the cryptocurrency market. They considered a comprehensive list of price and market related factors in the stock market and constructed their cryptocurrency counterparts. They ultimately developed a cryptocurrency 3-factor model using standard asset pricing tools and identified the following risk premia factors to capture most of the expected returns: 1) cryptocurrency market 2) size and 3) momentum. The combined effect of size and momentum largely explained the cross-sectional variation in cryptocurrency returns; small cryptocurrencies having more significant momentum effect.

CMKT: Cryptocurrency excess market returns CSMB: Cryptocurrency size factor CMOM: Cryptocurrency momentum factor

Diversifying risk factor returns in multi-asset portfolios by leveraging factor cyclicality and cryptocurrency factor returns

Historically factor returns have been highly cyclical and have responded differently to macroeconomic and macro market forces. They have not all reacted to the same drivers and, hence, any one of them may have low correlations relative to other factors. Combining multiple factors in a multi-asset portfolio can yield a smoother ride and diversify across multi-year cycles. Therefore, the addition of cryptocurrency factor returns should further diversify and contribute to reducing the length of these periods of underperformance. When diversified risk factor exposures are combined in a multi-asset portfolio, it has historically led to:

-Lower volatility and higher Sharpe Ratio

-Higher information ratios and lower tracking errors

-Less regime dependency over business cycles

If holding cryptocurrency can optimize the risk-return profile of a multi-asset portfolio then how do investors narrow down the vast universe of cryptocurrencies? Understanding the factors (size and momentum) that drive cryptocurrency returns, investors should decide which cryptocurrencies represent those factors and will persist in the future. It will depend on the investor’s return, risk or Sharpe Ratio objectives.


According to the consulting firm Accenture, the Silent Generation and baby boomers will gift their heirs up to $30 trillion by 2030, and up to $75 trillion by 2060. Investors face an “adapt or miss-out” moment, particularly when it comes to engaging the next generation. Millennials have very different investment and technology preferences than previous generations, and will require major investors and asset owners to reassess their investment strategy for the largest wealth transfer in history. Institutions that focus on long-term investment strategies and effectively implement them will be in the position to capture significant portion of these assets. Cryptocurrencies are in a position to capture its share of investment as wealth passes to generations whose preference, experience and expectation align more with its fundamental characteristics. Understanding the risks factors that drive cryptocurrency returns and how they may play a role in a multi-asset portfolio is the first step in planning for the significant wealth transfer and investment trend.