Integrating a new asset class into traditional investment portfolios

by Felix Fernandez, CEO OpenMetrics Solutions

Combining cryptocurrencies with traditional assets

Crypto assets are becoming more and more a recognized asset class and many investors consider cryptos as another alternative investment opportunity with significant performance and diversification potential. However, crypto assets are not necessarily easy to incorporate into traditional investment portfolios mainly due to extreme volatility, which renders many of the current risk management tools useless.

How can we use advanced risk management technologies to combine cryptos with traditional assets to build an attractive portfolio from a risk/return perspective?

Basically, we must work in two steps:

1. Reduction of Drawdowns
2. Volatility Downscaling

Reduction of Drawdowns

To incorporate the crypto assets properly into a portfolio, we must limit the drawdowns (as we do it for all risky assets) by applying a tactical risk management overlay. For this purpose, we use the stability signals for each individual asset: The stability levels between 0 and 1 are applied to every cryptocurrency. Whereby 0 = 0% exposure and 1 = 100% exposure within the given portfolio bandwidth.

The stability matrix above is an example of how stability is measured and thus exposure controlled in the range from 0%-100%. Due to the fast moves in cryptocurrencies, a weekly rebalancing is recommended.

Volatility Downscaling

Now, to incorporate cryptocurrencies in a portfolio context, the volatility of cryptocurrencies must be adjusted by downscaling (limiting the maximum exposure). By limiting the exposure to a maximum of 10% of the portfolio, we can reduce volatility to the levels of other assets (e.g. global equity).

Simulation Results

All simulation results have been generated based on the OpenMetrics framework and avoid the typical pitfalls and biases when performing back-tests (e.g. overfitting). The results are based on many years of practical experience in applying the underlying mathematical models to investable products.

Returns are gross returns, as implementation and operating costs depend on the assets under management (AuM), selected instruments, and investment vehicles.

The following results are intended to demonstrate the application mathematical risk management models and do not represent any type of investment advice. Please read the disclaimer at the end of this presentation!

Sample Multi-Asset Portfolio

The following simulation combines a global equity portfolio with bonds, precious metals and five cryptocurrencies. The green line represents this dynamic portfolio including cryptos in comparison to the MSCI World ACWI®, bond & precious metals and a passive 50/50 allocation of the two.

Conclusions

We can observe, that properly managed cryptocurrencies may enhance the risk-adjusted returns (Sharpe Ratio) of a multi-asset portfolio significantly, in combination with lower drawdowns than a pure equity exposure. By reducing the strategic weights of the cryptos, we could achieve equity market returns with even lower risks. You may find a more detailed version of this paper here.

About OpenMetrics Solutions

OpenMetrics Solutions LLC is a technology company founded in 2016 and recognized as an ETH spin-off. It focuses on advanced risk management methods and financial engineering. OpenMetrics Solutions focuses on the transfer of academic research into commercially viable products and services, advanced risk management solutions, and technology consulting for the financial industry.