How Are Cryptocurrencies Correlated?
Asset correlation is an established portfolio management tool used to measure how two or more assets perform in relation to each other. Correlation calculations are used to analyze, diversify, and maintain a balanced portfolio in both traditional and decentralized finance. Portfolio diversification is a hedging strategy that works best when assets are uncorrelated or are ‘negatively’ correlated. Diversification lowers the risk profile and overall volatility of a portfolio. It’s not a high-yield strategy, but instead, a strategy designed to protect investors during times of economic instability.
Correlations in Traditional Finance as a Portfolio Diversification Tool
Investment managers deploy correlation coefficients as a tool to compare asset performance within a portfolio. A positive correlation––a correlation coefficient greater than zero––indicates asset price fluctuations are in sync. Negative correlations indicate two or more assets are moving in opposition to one another.
Traditional investors rely upon correlation coefficients to balance and improve diversification within portfolios. An example of this practice in play is illustrated by the inverse correlation of stock prices and U.S. Treasury bonds (T-bonds). When there is economic contraction, stock returns tend to decline due to market uncertainty. This uncertainty then prompts investors to incorporate low-risk, lower-yielding government instruments like T-bonds into their portfolios.
Economic downturns also prompt investors to turn to assets that have almost no correlation with equity markets. The value of non-correlated assets––like gold, real estate, commodities––are not as susceptible to larger market fluctuations. These are not without risk, however. There can be less liquidity in non-correlated markets (as opposed to public equities) and investors may not find a buyer for these assets when it comes time to sell.
Establishing Correlations Between Cryptocurrencies
According to CoinMarketCap, there are more than 17,000 cryptocurrencies listed on over 400 exchanges as of February 2022. Of these assets, it’s estimated that 90 percent of the total market is comprised of the top 20 performing cryptocurrencies. Digital asset investors are working towards meaningful digital asset correlation by taking into account an asset’s economic use cases and publicly available accounting data. For example, bitcoin is a store of value and a means of exchange––the value is in the bitcoin itself. Ether (ETH), the asset, is a byproduct of transacting on the Ethereum blockchain. ETH gains value when the blockchain is successfully servicing network clients. A broader understanding of their unique valuations both off- and on-chain is integral to understanding all of the forces influencing their market price.
Correlation also requires time to establish useful patterns of behavior between digital and traditional asset classes. Digital asset leaders like bitcoin and Ethereum do have the benefit of an established market presence. Investors are beginning to note the correlation between these assets and traditional securities. In January, the IMF reported on the increasing interconnectedness of digital and traditional financial markets. The financial institution published a blog recognizing bitcoin’s maturation from an “obscure asset class with few users to an integral part of the digital asset revolution.” The report points to the pandemic and the central bank crisis responses of early 2020 as definitive correlation turning points, resulting in notable lockstep movement between digital asset prices and US stocks. Other factors such as regulation and mass, global digital asset adoption will additionally influence a digital asset’s ability to dependably correlate to other assets.
Asset correlation remains a reliable hedging strategy for balancing non-digital assets within a traditional portfolio. Correlation theory is applicable to established digital assets and is used to analyze assets and future-proof portfolios. It remains to be seen if and how emerging digital assets correlate without the benefit of time and without the same degree of financial transparency expected of traditional assets. There may also be a future in which a mature digital asset class stands alone and does not need to be correlated to traditional assets.