The Only Free Lunch

Diversification is often referred to as the “only free lunch” in capital markets and as such, sophisticated allocators spend considerable energy on portfolio allocation. This is one of the driving factors so many are convinced will cause institutional investors to enter the cryptocurrency space en masse — the lack of correlation to traditional assets provides a level of diversification along with extreme volatility not found in other asset classes.


Data is from Jan 2015 through April 2019 or from inception to April 2019 as some of the assets did not exist in 2015. Strix10 represents a notional unweighted index of the top 10 cryptocurrencies.

Data is from Jan 2015 through April 2019 or from inception to April 2019 as some of the assets did not exist in 2015. Strix10 represents a notional unweighted index of the top 10 cryptocurrencies.


While this has demonstrably been the case to date, a big question moving forward is whether the above conditions will persist. We believe the answer to be a resounding yes. To understand why volatility will persist, we need to understand why there is such extreme volatility in the first place. We see two root causes:

  • First is immaturity in market infrastructure where fractured global liquidity results in thin order books that cause rapid price movements when large orders are executed.

  • Second is uncertainty, defined as a perpetual condition of limited knowledge where it is impossible to accurately describe the factors driving the current and future state of the market.

The hard truth is that it is not possible to pinpoint a valuation for cryptocurrencies. The market doesn’t yet understand how the asset class will evolve, which cryptocurrencies will accrue the most value, or how many will persist over time. These factors result in a state of permanent uncertainty and it is that uncertainty that makes this asset class so well suited for algorithmic trading.

Cryptocurrencies as we know them today (excluding the emergence of security tokens) do not provide future cash flows, have limited historical basis for comparing valuations, and lack widely used or accepted methods of valuation. As such, price is nothing more than the aggregate of individual perceptions derived from personal convictions and biases. These perceptions are continually evolving and adjusting to market conditions, geopolitical events, and other arbitrary local pressures. George Soros makes the bulk of the effort in explaining this phenomenon through the Theory of Reflexivity outlined in the book, “The Alchemy of Finance.” In the simplest form, the Theory of Reflexivity states that individual perceptions influence market outcomes creating a positive (or negative) feedback loop preventing market equilibrium since perceptions are constantly changing. The effect is even more pronounced in the cryptocurrency markets as there is no anchoring mechanism for price. Many market participants are constantly forced to reevaluate positions on the fly with no basis for price discovery and those in the investment realm know too well how flawed quick, emotion-driven decision making often is. 

Let’s pose a question to drive the point about uncertainty home: how many individuals reading this update bought increasing amounts of Bitcoin as the price went from $1,000 to $2,000 and then from $2,000 to $5,000 and so on in 2017? I know many of us here did, but why? There is a natural inclination to formulate a narrative but the reality is no one had any idea how high price would climb and the allure of 100% returns only becomes more and more irresistible as the trend continues. As market conditions reversed, how many of those individuals doubled down at the same price points as bitcoin fell from $19,000 to 10,000, $10,000 to $6,000 and so on? Given the brutal drawdown of 2018, it is clear that a fraction of those who bought on the way up also bought on the way down. We argue this is largely because market participants understand there is no reliable method to determine the price. 

This market behavior will continue to persist because financial markets are a direct reflection of human nature and the state of uncertainty in cryptocurrency markets consistently brings out the flaws in cognitive reasoning and emotion-driven decision making. Litecoin serves as the most recent case in point. As of this writing, Litecoin is up 314% from its bottom despite the fact that some of the most influential and intelligent members of the crypto-institutional scene see the cryptocurrency as nothing more than a testnet for Bitcoin. Again, why? After a 100% gain, the market looked poised to continue its rapid ascent. Since market participants do not have a way to forecast a ceiling on price nor is there a definitive answer on Litecoin’s long-term prospects, you can either hop on the train or watch everyone around you bask in their 300% gains. The allure only becomes stronger as market behavior persists.


Global Equity Markets include S&P500, Nikkei 225, & FTSE 100. Jan 2015 to April 2019

Global Equity Markets include S&P500, Nikkei 225, & FTSE 100. Jan 2015 to April 2019


The second root cause is uncorrelated returns. We see this as not only continuing to persist but accelerating when it matters most. The rise or fall of cryptocurrencies will be driven by the success or failure of the financial and technological institutions of today. As such, we view cryptocurrencies as a hedge against a collapse in fiat currencies or a severe, sustained decline in traditional asset prices. Sure, the two can and will coexist as non-speculative demand varies around the globe. Clearly there is a strong case to be made that individuals located in places such as Venezuela or Syria represent legitimate demand for the advantages provided by cryptocurrencies. However, global wealth is incredibly concentrated in nations where the average individual does not need to worry about hedging their own currency. Therefore we see a global shift in financial and technological infrastructure to be highly unlikely without some form of catastrophic event. Most individuals don’t have the need or desire to contemplate how their financial system works, why money has value, the impact of monetary policies, or the implications of centralized technology solutions until an event forces them to.

Additionally, cryptocurrencies in their current form have limited advantages over centralized fiat and traditional technological solutions outside of the concerns that the current system is unstable or corrupt. Ask any Bitcoin maximalist why bitcoin’s USD price will be worth hundreds of thousands of dollars (if not millions) and nearly every single point will lead back to an overarching thesis that the current system is corrupt and unsustainable. Fortunately, whether an individual believes those arguments to be valid is irrelevant, if there is even the smallest probability that the global order of tomorrow looks a lot different than today then cryptocurrencies are a necessary inclusion in all investors’ portfolios.

Diversification In Crypto

The major problem allocators and investors face today in crypto markets is no longer ease of access or complexity. Rather, the difficulty is in allocating to the asset class in a sophisticated manner. Cryptocurrencies are strongly correlated with each other and the majority of cryptocurrencies have some form of cointegration with either bitcoin or another token due to technical relationships. While we believe the asset class will become more decorrelated as fiat on-ramps expand, the need for diversifying across assets and strategies will remain a relative importance.


Data is from Jan 2015 through April 2019 or from inception to April 2019 as some of the assets did not exist in 2015.

Data is from Jan 2015 through April 2019 or from inception to April 2019 as some of the assets did not exist in 2015.


For the time being, we suspect strong correlations will continue to persist until cryptocurrency wealth is less concentrated in early Bitcoin pioneers and bitcoin no longer serves as the market’s reserve currency. Avenues for investors who want exposure to cryptocurrencies to diversify remain limited. Not only are assets correlated, but the majority of institutional offerings are confined to passive indexes or long-term bets that will play out over the next five to ten years. Diversification and greater risk-adjusted returns in the market’s current form can only be achieved through active management.

In Closing

A well balanced portfolio requires exposure to this asset class given the decorrelated and asymmetric return profile. However, an investor is extremely limited once they take the plunge into the world of cryptocurrencies. Finding a decorrelated return stream can dramatically improve risk-adjusted returns through active management. A well-constructed portfolio of algorithms may provide benefit from continued volatility in either market direction.