A Systematic Review of Cryptocurrency's Role in Portfolio Diversification and Hedging

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Introduction

Cryptocurrencies have revolutionized the financial landscape since the introduction of Bitcoin in 2008. As decentralized digital currencies, they represent a significant disruption to traditional financial systems. The market has experienced rapid development, capturing the attention of individual investors, institutional players, regulators, and media outlets alike. This growing interest has made cryptocurrency investments an important topic of academic research across numerous fields.

For investors seeking to properly manage their portfolios, understanding cryptocurrencies' relationships with other assets and their volatility characteristics is crucial. Information about diversification benefits, hedging capabilities, and safe-haven properties becomes especially valuable when considering investments in this relatively new and evolving market.

Methodology and Research Approach

This analysis employs a systematic literature review process to aggregate and synthesize quality knowledge about cryptocurrency investment properties. The research draws from 146 studies published in journals ranked in the Association of Business Schools 2021 list, considering all fields of knowledge without restrictions.

The methodology involved searching the Web of Science database from January 2009 through November 2021, using comprehensive keywords related to cryptocurrency investments, portfolio diversification, and hedging strategies. Only English-written journal articles were considered to ensure research quality, with all articles addressing cryptocurrencies through the perspective of investors and investment methodologies.

Bibliometric analysis was conducted using VOSviewer software, organizing articles into clusters based on shared references. This approach helped identify relationships between studies and revealed a distinct cluster dedicated to portfolio diversification, hedge, and safe-haven properties in cryptocurrency investments.

Key Findings on Hedging Properties

Research indicates that cryptocurrencies demonstrate hedging abilities against various assets and risks, though these properties are often time-varying. Studies show cryptocurrencies can hedge against:

Bitcoin specifically shows hedging effectiveness similar to gold, particularly against developed markets. It can serve as a hedge in both normal and stressed market conditions, responding to underlying macroeconomic factors. Evidence suggests Bitcoin may hedge against increased asset volatility during high uncertainty periods in numerous countries including the USA, Germany, France, China, Canada, Russia, the UK, and Japan.

However, these hedging properties aren't consistent across all market conditions. Bitcoin's ability to hedge against partisan conflict and economic policy uncertainty varies over time, with these abilities typically present during high political and economic uncertainty but disappearing when the impact of these factors turns negative.

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Some studies present contradictory evidence, suggesting cryptocurrencies don't provide reliable hedging for stock markets due to positive correlations between stock/cryptocurrency pairs in most cases. Bitcoin's high volatility also makes it less effective as a hedging tool for stocks according to some research.

Diversification Benefits of Cryptocurrencies

Adding cryptocurrencies to traditional portfolios (containing stocks, currencies, and commodities) appears to increase diversification benefits and returns while reducing portfolio volatility. The cross-correlation between cryptocurrencies and traditional assets is typically time-changing and weak, supporting the hypothesis that cryptocurrencies can serve as good financial diversifiers.

Specific benefits include:

The diversification benefits vary across regional and country-specific assets, as well as across different asset classes. Different cryptocurrencies offer varying diversification advantages: Ethereum appears most effective for short-term diversification, while Bitcoin, Ripple, Litecoin, Stellar, Monero, and Dash show better long-term diversification properties.

However, these benefits can be undermined during periods of instability and market shocks. The co-movements between cryptocurrencies and stock indices are mostly positive and increased during the COVID-19 pandemic, reducing diversification benefits. Close integration across major cryptocurrencies and the tendency for jumps in one cryptocurrency to increase jump probability in others also reduces diversification potential.

Safe-Haven Properties Examined

Research presents mixed evidence regarding cryptocurrencies' safe-haven properties. Some studies indicate that certain cryptocurrencies can serve as safe havens for specific assets:

Bitcoin specifically shows strong safe-haven properties for crude oil but weaker safe-haven characteristics for major stock indices. It may also serve as a safe haven during extreme Economic Policy Uncertainty shocks.

However, other evidence contradicts these findings, suggesting cryptocurrencies generally cannot be considered safe havens against stock markets or gold. Bitcoin showed no safe-haven properties during the COVID-19 pandemic, particularly for energy assets like crude oil and gas.

The safe-haven ability of cryptocurrencies varies across time and market conditions, though they tend to perform better as safe-haven instruments during periods of high uncertainty. During the COVID-19 period, Bitcoin and Ethereum functioned as short-term safe havens against stock market turbulence.

Impact of Uncertainty on Cryptocurrency Investments

Uncertainty plays a significant role in cryptocurrency returns and market behavior. Research reveals a strong causal relationship between social media uncertainty measures (Twitter-Based Economic Uncertainty and Twitter-Based Market Uncertainty) and cryptocurrency returns.

Key findings include:

The effect of uncertainty varies across different cryptocurrencies and geographical regions. China's Economic Policy Uncertainty significantly impacts cryptocurrencies like Litecoin and Bitcoin, while the effect of United Kingdom EPU on cryptocurrency pairs is lesser than that of US EPU.

Frequently Asked Questions

Can cryptocurrencies effectively hedge against stock market downturns?

Research shows mixed results. Some studies indicate cryptocurrencies can hedge against stocks, particularly during normal market conditions, while others show positive correlations between cryptocurrency/stock pairs that reduce hedging effectiveness. Bitcoin's hedging ability appears strongest during periods of high uncertainty but varies across time and market conditions.

Which cryptocurrencies offer the best diversification benefits?

Evidence suggests Ethereum provides the most effective short-term diversification, while Bitcoin, Ripple, Litecoin, Stellar, Monero, and Dash show better long-term diversification properties. The optimal approach involves combining digital and traditional assets in carefully weighted portfolios.

Are stablecoins reliable safe-haven assets?

Stablecoins can act as safe havens and diversifiers, contributing to market efficiency. However, they demonstrate an unstable peg with the US dollar, and their safe-haven properties are not consistent over time. Tether has shown safe-haven characteristics during bad market conditions due to its negative co-movement with stock indices.

How does economic policy uncertainty affect cryptocurrency prices?

Economic Policy Uncertainty influences cryptocurrency attractiveness and returns. Increases in EPU typically lead to higher Bitcoin returns and increased trading volume and volatility. However, this effect varies by country, with US EPU having greater impact than UK EPU on respective currency pairs.

What role does investor sentiment play in cryptocurrency markets?

Investor attention is influenced by cryptocurrency performance, and emotions affect Bitcoin's return volatility and trading volume. Negative sentiment can predict Bitcoin returns, volatility, jumps, and trading volumes. Social media sentiment, particularly from influential figures, can significantly impact cryptocurrency prices.

Should investors consider gold alongside cryptocurrencies?

Research suggests investors should consider gold, along with the European carbon market, CBOE Bitcoin futures, and crude oil to hedge against unexpected movements in cryptocurrency markets. Gold shows stable and reliable safe-haven properties against cryptocurrency uncertainty.

Conclusion

This systematic review reveals several important findings about cryptocurrency investments. First, cryptocurrencies can hedge against various assets and risks, though these properties are time-varying. Second, they present diversification and safe-haven properties that fluctuate across time and market conditions. Third, investors should consider complementary assets like gold, European carbon markets, Bitcoin futures, and crude oil for hedging against cryptocurrency market movements.

The research also confirms that uncertainty is a significant determinant of cryptocurrency returns, and stablecoins can act as safe havens and diversifiers despite their unstable peg with the US dollar. For individual investors, evidence suggests considering investment in coins' market cap portfolios rather than tokens due to their higher Omega ratio.

These findings provide valuable insights for researchers, investors, analysts, and regulators. They offer structured networking for research outlets and literature strands, practical guidance for investment strategy development, and important information for effective market regulation. As the cryptocurrency market continues to evolve, further research will be essential to understand these dynamic relationships and their implications for portfolio management.