Passive Investing in Cryptos

Setting The Benchmark

There has been a lot of hype about bitcoin and cryptocurrencies lately. Most of the general public is in shock and awe for missing out on astronomical returns. Some early adopters, however, have made a hefty chunk of money. Should we look at them as the next generation of (crypto) hedge fund managers? or they have been simply lucky? let me ask this question differently, how much return (and volatility) is good for a strategy in cryptos?

Cryptos
Figure 1. Are cryptocurrencies the future?

So it is becoming a little more obvious where I am going with this post (which is also my first). Like any other market, we need a benchmark in this market. This would allow us to assess the performance of active strategies. An index that is serving as a benchmark, by construction, helps to quantitatively assess extra return and volatility of superior manager with impressive “alpha”.

So let’s get to it. I am going to look at the equity curve of a market capitalization-weighted passive strategy. But first, a few technicalities.

  1. Yes, I understand there would be limitations going back in time and the index would mostly consist of bitcoin, but let’s say for a moment we have accepted these practical issues. Particularly, we just want to know how much one would have earned if he had made a cap-weighted portfolio of top ten largest currencies (by market capitalization) and rebalanced every day.
  2. I also understand that companies follow a certain methodology to construct widely-followed indices (you can look at S&P US Indices Methodology for S&P methodology on their indices), but here we are going to accept the fact that we did not have a big universe of cryptos back in 2013. So I am going to take the top ten currencies today, go as far back as I can and build the portfolio.
  3. Yes! there is forward-looking bias! You could argue that in 2014 I could have not known that ETH (Ethereum) would be a big cryptocurrency. Just bear with me here, I think the bias is actually not material and the performance would not suffer dramatically. Remember that this is a passive strategy, we are not trying to actively beat the market.

I used the data from Coin Market Cap which goes back to 2013. The strategy simply holds the coin that has higher market value and rebalances the portfolio daily. For example, if BTC has twice the market capitalization of ETH, and we have only these two coins, the weights in our portfolio would be 2/3 and 1/3 respectively. For this exercise we have only looked the top 10 coins with the highest market cap. The results should be more or less robust if someone looks at a portfolio that holds all 1000 or so coins. This is due to the enormous market cap of BTC and ETH compared to the rest.

Figure below shows the equity curve for a passive cap-weighted strategy.

 

pnl_capweighted.png
Figure 2. The equity curve of a $1 invested in a market-cap weighted portfolio. The universe consists of top 10 coins by market capitalization.

 

In the next post, we will look at a few statistics for this basic strategy. It would also be interesting to look at diversification benefits of holding this portfolio and its relative performance compared S&P500.

Happy trading,

HD