By looking at the risk/return structure of the cryptocurrency market, the authors explore the diversification role of cryptocurrencies. Further, a profitable trading strategy based on investor sentiment may be possible within cryptocurrencies.
How Is This Research Useful to Practitioners?
Research shows that the price of Bitcoin does not fluctuate in the same direction as the stock market. This low historical correlation with such conventional asset classes as stocks, bonds, and cash offers the possibility of an alternative asset class that could act as a source of diversification to mainstream assets.
The authors point out the differences between cryptocurrencies that are based on blockchain technology and other digital currencies that can be centrally issued, circulated within a community or geographic location, or tied to fiat currency. Blockchain solves the double-spending problem and does not require a trusted third party—twin features at the top of the list of shortcomings of traditional financial systems.
Overall, cryptocurrencies outperform traditional asset classes in terms of average daily returns. The very low correlations reinforce the assertion that cryptocurrencies may be a promising investment class in terms of hedging the risk of mainstream assets, but the existing evidence is scant. There is very little return history, and the high volatility coupled with negative skewness suggests exceptionally high tail risk in the cryptocurrency market.
An alpha component would potentially offset some of this risk. To consider what may generate alpha, the authors explore the hypothesis that cryptocurrencies with higher investor sentiment today tend to have lower future returns than those with lower investor sentiment, making investor sentiment the factor that controls alpha generation. The authors find a profitable trading strategy within cryptocurrencies based on investor sentiment.
How Did the Authors Conduct This Research?
The authors present empirical results on the diversification role of cryptocurrencies by examining the comovement characteristics between a cryptocurrency index (CRIX), the top 10 cryptocurrencies within the CRIX, and traditional asset classes. The authors evaluate static correlation coefficients as well as dynamic conditional correlations, and the results suggest a very low correlation between CRIX and traditional assets as well as between the top 10 CRIX component cryptocurrencies and traditional assets based on historical data. These observations suggest that cryptocurrency as an asset class is a good diversifier in a traditional portfolio, but the sample period of CRIX and individual cryptocurrencies is too short—and volatile—to fully explore the investment opportunity of cryptocurrencies. The sample period spans less than three calendar years, from 11 August 2014 to 27 March 2017. The traditional portfolio consists of such traditional assets as the S&P 500 Index, real estate investment trusts (REITs), and gold.
The high volatility of cryptocurrency, the authors conjecture, is driven by investor sentiment rather than a change in fundamentals, because there is no meaningful interpretation of fundamentals associated with alternative cryptocurrencies (i.e., altcoins). The intuition behind the conjecture emerges from previous research findings that marketwide sentiment has a greater effect on stocks that are difficult to value and hard to arbitrage.
The authors test strategies that trade cryptocurrencies based on investor sentiment. A strategy that buys low-sentiment cryptocurrencies and sells high-sentiment ones is profitable after assuming reasonable transaction costs. The strategy is not sensitive to the length of the formation period for determining investor sentiment.
Blockchain is a revolutionary ledger technology, with a broad array of potential applications from smart contracts to health care, but it did not catch the attention of speculators and the media until Bitcoin surged from $0.009 to more than $11,000 per coin. There are more than 869 cryptocurrencies, but without fundamentals, they are little more than “trust machines” and, as such, are nearly unanalyzable. They generate no cash flow, making discounted valuation approaches inapplicable, but this criticism applies to gold as well. Although it is cheaper to invest in the early stages, during a new cryptocurrency’s initial coin offering, doing so may overlook the network effect that favors older altcoins.