We are going to explore a simple solution to increasing returns for investing in cryptocurrencies, through modifying the cryptocurrency index that we made in the previous post.
Note that I have not included new data since the previous post. This is so that it can easily be compared to the previous post for those that are interested.
In the post before this one, we explored what a basic index could look like and how it is generally better than simply investing in a single asset such as Bitcoin. It offers diversification that is not prone to human bias, limiting the risk factors.
But what if someone would like to increase the risk/return of an index without involving 24/7 active management? Usually, this is done by applying some extra rules for the index to follow.
One way to increase returns is by increasing the exposure of an index to the smaller market capitalization assets. Which means moving money from assets that own a large portion of the cryptocurrency market total value to assets that own less of the market’s total value.
For instance, Bitcoin holds about 50% of the market’s value on 2019–03–22. Meaning it will hold about 50% of the index that reflects the market.
What happens if we limit the maximum percentage per asset and then redistribute the difference to the other assets? Let’s start with limiting at 10% and see what happens.
This bar graph shows that more money is going towards smaller market capitalization assets in comparison to Bitcoin. And as shown in the backtest at the beginning, this increases the returns due to that smaller market cap assets tend to have higher returns.*
But nothing is free, including higher returns. You might have noticed the max drawdown is higher than the market. Depending on how you measure risk this might be an increase in risk for you. But we get a higher return for that risk.
So risk and return go hand in hand in this case. To further explore this let’s take a look at the average drawdown for the day and month. On top of that, we will check out the average gain in a month that is up and the average loss in a month that is down.
Now let’s see if this hold up when we try the same idea but instead of a 10% limit we are going to try out a 50% limit and see what happens. Ideally, it’s performance is somewhere between the normal index and the 10% limited index, meaning its risk/return is adjusted as we expect.
Now let’s check the 50% limit and what the diversification of this index looks like. Will the difference be rather extreme compared to the 10% index?
Bitcoin is taking the lead here but the smaller coins have their share as well. Exactly 50/50, 50% in Bitcoin and 50% in the following 19 biggest projects. That level diversification is what we are aiming for and in this case, Bitcoin’s portfolio share is 5 times larger compared to the 10% cap index.
But that 50% limit looks a lot different is we go back in time. The above bar graph shows the 50% limit index at 2019–03–22. Let’s go back two years in time and see what it looks like.
Here we see Ethereum taking the lead of the altcoins with about 30% of the portfolio and Bitcoin still holding 50%. The index is behaving as we wish and we can proceed to check it’s performance statistics.
So in conclusion, changing the max percentage the positions in an index can have an effect on the risk and returns. By adjusting the level of diversification you could make an index more defensive or aggressive as you wish.
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* The small-firm effect is based on the following research (pdf): source . There is more recent research but almost all of them are based on this one.
In the next post, I am going to include new data. A lot has happened in the last 2 months and I’m curious about what that will look like in the backtest. If you want to suggest some topics for backtesting that is index related, shoot me a DM on telegram: @FinanceFox
This post is not investment advice. You should choose to invest on your own terms, and within assets and projects you understand. Markets are very volatile, which offers opportunities for both short and long-term investment, but under no circumastances are return or results guaranteed. If you do decide to invest, make sure you have researched thoroughly and you’re confident in what you are doing.