Investing with Cryptocurrencies -- evaluating their potential for portfolio allocation strategies

TL;DR

This paper evaluates the potential of cryptocurrencies to enhance portfolio performance by analyzing their impact on risk, return, and diversification across various investor types and portfolio strategies, considering liquidity constraints.

Contribution

It provides a comprehensive empirical analysis of cryptocurrencies' role in portfolio optimization, incorporating liquidity constraints and diverse investment strategies.

Findings

Cryptocurrencies can improve portfolios' risk-return profiles.

Maximum-diversification strategies benefit significantly from including CCs.

Liquidity issues may reverse the positive effects of CCs on portfolios.

Abstract

Cryptocurrencies (CCs) have risen rapidly in market capitalization over the last years. Despite striking price volatility, their high average returns have drawn attention to CCs as alternative investment assets for portfolio and risk management. We investigate the utility gains for different types of investors when they consider cryptocurrencies as an addition to their portfolio of traditional assets. We consider risk-averse, return-seeking as well as diversificationpreferring investors who trade along different allocation frequencies, namely daily, weekly or monthly. Out-of-sample performance and diversification benefits are studied for the most popular portfolio-construction rules, including mean-variance optimization, risk-parity, and maximum-diversification strategies, as well as combined strategies. To account for low liquidity in CC markets, we incorporate liquidity constraints via the LIBRO method. Our results show that CCs can improve the risk-return profile of portfolios. In particular, a maximum-diversification strategy (maximizing the Portfolio Diversification Index, PDI) draws appreciably on CCs, and spanning tests clearly indicate that CC returns are non-redundant additions to the investment universe. Though our analysis also shows that illiquidity of CCs potentially reverses the results.