Suitability of the equal-weighted diversification strategy to the cryptocurrency investment environment

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Volume Title

School of Business | Master's thesis

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Date

2015

Department

Tieto- ja palvelutalouden laitos
Department of Information and Service Economy

Major/Subject

MSc program in Information and Service Management
MSc program in Information and Service Management

Mcode

Degree programme

Language

en

Pages

102

Series

Abstract

ABSTRACT: Objectives of the Study: The objective of this study is to analyze the suitability of the equal-weighted (a.k.a. 1/N) diversification strategy to the cryptocurrency market space. We first study the characteristics of the cryptocurrency market space both qualitatively and quantitatively. Based on this analysis we analyze the suitability of the equal-weighted diversification strategy to the cryptocurrency market space from a theoretical point of view and also in practice using real trading data. Academic background and methodology: The naive equal-weighted diversification strategy, where 1/N fraction of investable wealth is allocated to each of the N assets available, recently received plenty of attention when De Miguel et al. (2009b) showed that it performs quite well in comparison against the mean- variance optimization and its extensions. The work done by De Miguel et al. (2009b) within the US equity market has been later complemented with others within equity, bond and commodities markets with similar results. In light of these recent findings it is appropriate to investigate the suitability of the equal-weighted diversification strategy to the cryptocurrency market space; a unique investment environment, consisting of individual and distinct platform-mediated multisided networks, that, according to a common belief, represents a winner- takes-all -scenario where losers, by definition, take nothing. Due to factors, such as the nature of the market space, we ex-ante condemn the mean-variance optimization inapplicable, and instead compare the performance of the equal-weighted portfolio of cryptocurrencies to the first established cryptocurrency bitcoin and also to the general market on which we use the CRSP index as a proxy. In our comparison we use real trading data covering hundreds of cryptocurrencies that, to the best of our knowledge, is unique and not currently available from any public source. Findings and conclusions: We find that the cryptocurrency market space is likely to contract in terms of number of mar- ket entities, but not necessarily into only one, as there seems to be room for some differentiation. Based on this analysis we theoretically derive that the expected return of the equal-weighted diversification strategy with rebalancing in a perfect market, based on e.g. the investor's assumptions, equals the change in the total market capitalization of the whole market space. In practice we find that the equal-weighted diversification strategy provides statistically higher mean return, and seemingly also a higher Sharpe ratio despite possessing much higher volatility, than a comparable investment made into bitcoin both before and net of transaction costs. Our results, supported by qualitative and quantitative findings, are surprising in regard to the common belief that the cryptocurrency market space possesses a high likelihood of a WTA-scenario with bitcoin being the dominant force and a pre-seen winner. However, due to factors such as illiquidity, the additional gains of diversification could be gains only on paper.

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Keywords

Equal-weighted also known as 1/N diversification strategy, platform-mediated networks, cryptocurrencies, bitcoin

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Permanent link to this item

https://urn.fi/URN:NBN:fi:aalto-201512165800

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[gradu] Kauppakorkeakoulu / BIZ