How to Portfolio-Manage the Risks of Surging Cryptocurrencies

By Irene Aldridge, co-author of “Big Data Science in Finance” (Wiley, 2020)

The NYPost reported on November 5, 2020, just two days after the still-inconclusive U.S. Presidential Election, that “Bitcoin rallies past $15,000 for the first time since January 2018”. Bitcoin is just one of now many cryptocurrencies, “crypto” for short. Other cryptocurrencies, like Ethereum, XRP, Chainlink, and many others are surging as well, offering investors an opportunity for unparalleled returns. The surge in  may seem random to some, but it also may have very strong fundamentals rooted in the current political landscape. This article makes a case for Crypto becoming a stronger performer in the coming months, and also shows the ground-breaking approaches for managing crypto portfolios for investors who are still concerned about the risks of the cryptocurrencies. 

The Democratic Presidential Candidate Joe Biden, the presumptive winner of the election, has pledged on several occasions to reverse the deregulations of the Trump administration. Proposals including a new financial transaction tax have been floated during the campaign year. With more regulation on the horizon under the Democratic administration, Crypto may offer a safe haven, and is thus surging in popularity with investors worldwide again. 

Crypto is still a Wild West to many finance professionals. Wild swings, hard to explain mechanics, security and, unfortunately, a prevalence of fraud, indicate that Crypto has a long way to go. Still, if the prospects of stricter financial regulation materialize, crypto may be interesting for those looking for an unbridled, and, yes, uncharted investment landscape. 

Still, stability and acceptance of crypto as an asset class is on the horizon. For example, JPMorgan announced in October 2020 that Blockchain, a technology that is the backbone of crypto, is morphing into a stable technology. JPMorgan further deemed blockchain worthy of institutional-grade investments that JPMorgan itself intends to undertake.  

As our latest research shows, Cryptocurrencies can also be successfully managed in a longer-term portfolio setting. As discussed in our new book, “Big Data Science in Finance” (Wiley, 2020) co-authored with Prof. Avellaneda of NYU Courant, forming crypto portfolios based on their correlation clusters helps significantly mitigate risks associated with crashes and other volatility in crypto securities, all while allowing to capture the upside. 

Figures 1 and 2, for example, are from Chapter 9 of our “Big Data Science in Finance” book. The figures show out-of-sample performance improvement from K-means and Spectral clustering of crypto portfolios a month in advance. The clustering results are compared to the equally-weighted (EW) crypto portfolio allocation, where each crypto currency is assigned equal initial capital. Figure 1 shows performance of the 3-cluster strategy, and Figure 2 shows how a 5-cluster allocation delivers even better results. The strategies shown re-clusters crypto currencies at the end of each month and then reports the strategy performance based on the clusters at the end of the following month. 

Figure 1. Out-of-sample crypto performance with 3 clusters, 2017-2020. The y-axis shows the cumulative return of the respective strategies. 

Figure 2. Out-of-sample crypto performance with 5 clusters, 2017-2020. The y-axis shows the cumulative return of the respective strategies. 

While crypto is becoming more widely accepted, research on it isn’t exactly new. Data on crypto has been available to researchers for several years now. As such, we are able to benefit from these data sets and make intelligent predictions about price behavior. While crypto can behave very differently from, say, U.S.-traded equities, it can also follow many of the same rules and laws. For example, many crypto practitioners report to me that the models in my 2nd edition of “High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems” (Wiley, 2013) work well for intraday crypto trading as well. 

Bottom line, scientifically managing crypto currency investments can help expand your investment set without sacrificing traditional portfolio management expertise and metrics. New data science techniques like clustering can further shore up portfolio performance and deliver strong results in good times and bad. As discussed in our another book, “Real-Time Risk: What Investors Need To Know about Fintech, High-Frequency Trading and Flash Crashes” (Wiley, 2017), co-authored with Steve Krawciw, crypto is here to stay and grow, and learning how to successfully manage it will bring significant portfolio rewards.

Irene Aldridge is a Managing Director, Research, AbleMarkets, a portfolio manager at AbleAlpha Trading, LTD., and an Adjunct Professor, Financial Data Science, at Cornell University.