- We summarise two papers in the journal of Finance Research Letters on market correlations in good and bad times.
- In the first, authors show how correlations among cryptocurrencies increase in the tails of daily returns, with smaller cryptos driving much of the price action.
- For the second, we turn to global equity markets, where international diversification remains an option despite rising global financial interconnectedness.
The Importance of Diversification Strategies for Crypto and Stocks
Portfolios that outperform in bad times are as (if not more) valuable than ones that do well in good times. For investors, the adage ‘you need to be in it to win it’ means avoiding financial ruin, and diversified trading strategies reduce this risk. Indeed, knowing how diversification can affect your portfolio gives you an edge. That is why keeping an eye on how asset price correlations evolve is important, as two new papers in the journal of Finance Research Letters show.
In the first, the authors examine the correlations among the top 50 cryptocurrencies during good, bad and normal times. Its USP is being one of the first to examine correlations in the tail. The second paper tests whether cross-country diversification is becoming less effective as global equity markets become more interconnected. Combined, they find:
- The connection between cryptocurrencies increases in the tails, especially the right tail, which captures extreme bull market periods.
- Smaller cryptocurrencies have intense pricing behaviour. This makes them the largest drivers of crypto market risk, influencing the price movements of larger cryptocurrencies.
- Meanwhile, cross-country diversification remains effective at reducing risk in normal times. But correlations rise in bad ones, making it worse at eliminating large downside risks.
Crypto Investment: Correlations in Good and Bad Times
Crypto investment is taking off. Recently, we covered an IMF paper revealing that cryptocurrencies like bitcoin and ethereum are now highly influential in global equity markets. Equally as important for investors, though, is the impact of cryptocurrencies on each other.
Academics from several universities, including Montpellier Business School, use daily price data from CoinMarketCap between 1 January 2015 and 30 September 2020 to study the interdependence of the 50 largest and most liquid capitalised cryptocurrencies.
They use a LASSO regression alongside a quantile regression to calculate the total return connectedness and clustering during good, bad and normal times. The authors determine these times by the total daily returns of the crypto market at the top fifth percentile, bottom fifth percentile and 50th percentile, respectively.
They find that the connectedness between cryptos is lowest on ‘normal’ days, when daily returns align with the average (Chart 1). Each grey line represents a strong interconnection in the pricing behaviour between two cryptocurrencies – there are few. Bitcoin price behaviour has a surprisingly small influence on other cryptos during these days. This connectedness has also fallen as the market has matured.
Meanwhile, on days where total returns are in the top fifth percentile, interconnectedness increases (Chart 2). The same holds only slightly less true when returns are in the bottom fifth percentile. In other words, the crypto network becomes much denser during periods of boom and bust.
During boom and bust days, the pricing behaviours of MintCoin, Digitalcoin and GlobalBoost-Y influence the market most. Meanwhile, Litecoin, XRP and Dogecoin prices are most likely to be susceptible to the pricing behaviour of other cryptocurrencies. In the words of the authors, they are the greatest ‘receivers of risk’ from other cryptos.
While it is informative that the spillovers (or bi-directional correlations) between cryptocurrencies strengthen significantly during extreme price movements, the diversification potential is limited. The authors find that cryptos typically move in the same direction. That means if you invest in crypto and only crypto as an investment strategy, financial ruin could strike! Therefore, crypto investing strategies should be combined with suitable alternative assets.
International Diversification for Global Equities
Next, we turn to portfolio diversification for global equity markets. The paper’s authors explore whether the liberalisation and integration of financial markets have limited investors’ opportunities to diversify risk across countries. In short, they have not: portfolio diversification is still possible and critical.
For the analysis, the authors collect daily equity index returns for 63 countries between January 1973 and October 2018 at a country and industry level. They aim to learn how these correlate on a monthly basis with other countries (pair-wise correlation) and a global market portfolio – the DS World Market Index.
Chart 3 shows the time-series behaviour of average correlations between countries. On average across the 63 countries, global equity price correlation has not increased significantly over the last 40 years. Instead, correlation jumps during crises but drops after. Over the last 10 years, global interconnectedness appears to have fallen.
On an industry level, the correlations are even smaller. That is, the equity prices of different industries within the same country are less correlated than the same industries across countries. Correlations between industries across countries are even lower (so, for example, banks are highly uncorrelated with healthcare in different countries).
The findings imply the best diversification strategy for equity investors is to choose equities across different countries and different industries. Even more diversification benefit comes from investing in EM countries. The average EM industry (e.g., tech in India) has a correlation of only 0.16 to the same global industry (e.g., a global tech index) versus 0.34 in developed markets.
Portfolio Diversification Strategy
While not ground-breaking, the papers remind us to remain aware of how correlations change under different market conditions. When building a longer-term portfolio, we should account for correlations in ‘normal’ times, but also how these change during extreme events.
Here, simple diversification strategies are to include equities across industries and countries. But beware that these correlations typically increase during tail events. In crypto, it means not over-allocating funds within the asset class. Correlations may seem low, but right when you need them to be low (during bad times), they jump up!
Sam van de Schootbrugge is a Macro Research Analyst at Macro Hive, currently completing his PhD in international finance. He has a master’s degree in economic research from the University of Cambridge and has worked in research roles for over 3 years in both the public and private sector.