The Illusion of Risk Diversification through Cryptocurrency ETFs

Coins and Tokens 5 min, 27 sec READ

by Arnold Viatori

Current cryptocurrency ETFs do not offer risk diversification or reduce cryptocurrency correlation in cryptocurrency portfolio allocation.

In recent months there has been a surge of news of cryptocurrency exchanges seeking an Exchange Traded Fund (ETF). In June 2018, two of the largest cryptocurrency exchanges in the market, Huobi Pro and OKEx, unveiled their crypto ETF, while others, such as Bitwise, sought Securities and Exchange Commission (SEC) approval to launch the first SEC-regulated cryptocurrency ETF. Meanwhile, all eyes were on the U.S. SEC, which has postponed its decision on either the approval or disapproval of five Bitcoin-oriented ETFs until September.

An ETF is a financial security that tracks an index, or any other form of underlying security, such as a basket of assets. Creators of ETFs usually promote the advantages of those ETFs in risk diversification and lower transactional costs, garnering huge interest from cryptocurrency enthusiasts. But while in a traditional finance mindset this may ring true, such cause-and-effect has produced an almost radically different result in the world of cryptocurrencies.

Nevertheless, this has not stopped traditional finance exchanges from exploring the possibilities of a cryptocurrency ETF.

How Risk Diversification Is Achieved in Traditional Financing ETFs

Simply put, an ETF diversifies your risk by spreading out your eggs in different baskets; owning different securities through the purchase of only one financial product. Observers believe that cryptocurrency ETF becoming mainstream will lift the overall digital assets market. Fluctuating market conditions and movements in price for each corresponding market ensures that there is no concentration of risk in one market or sector.

In traditional finance, there are many geographies (North America, Asia ex Japan etc.), sectors (utilities, energy, tech etc.) and asset types (small cap growth, treasury bonds, precious metals) investors may choose to put their money in. It is not uncommon for ETF providers to include thousands of different securities in a single ETF to achieve diversification of risk.

The Illusion of Diversification in Cryptocurrency ETFs

Unfortunately, the same certainty offered by ETFs in traditional finance sectors is not easily replicated in the realm of cryptocurrency. The current offerings of cryptocurrency ETFs simply do not have enough components to provide for true risk diversification. For example, OKEx ETF known as OK06 Exchange-Traded Tracker (OK06ETT) has merely six cryptocurrencies, namely Bitcoin, Ethereum, Litecoin, Bitcoin cash, EOS and their native token OKB. The same can be said about Huobi Pro ETF, named HB10, that includes components of the Top 10 most traded tokens against USDT for the previous quarter on the Huobi Pro platform.

Firstly, both OK06ETT and HB10 with only 6 and 10 component securities does not sufficiently achieve risk diversification.

Secondly, the construction of the ETF ignores the correlation Bitcoin has with altcoins. Industry lore is that when Bitcoin dips, altcoins tank, and vice versa. This can be tracked using the Bitcoin Dominance Index.

Unlike traditional finance, cryptocurrency ETF providers cannot simply add more components into an ETF to make it more diversified. If someone were to recreate the Russell 1000 Index that has 1000 securities component in the cryptocurrency world, they would be adding in a lot of unknown altcoins - or as the community lovingly calls them – shitcoins (which may increase risk instead of diversify as intended). Small market cap altcoins move in tandem, with very high correlation between them. Adding more securities components into a cryptocurrency ETF will only make it riskier and achieve an undesired outcome.

Sorting Blockchain Projects by Use Cases for Cash Flow Variations

Use cases in the Blockchain world do not mirror sectors in traditional finance because of the different business models and markets that the altcoin works in.

Common use cases in the Blockchain world include payments, Internet-of-Things (IoT), content management, which mirror financial, technology and consumer cyclical sectors respectively. Separate use cases have distinct cash flows too. Payments sector typically earns from spreads, deposit and withdrawal fees. IoT business models earn from a subscription fee for the devices and unlocking value through data mining. Content management from a mixture of subscription and usage fees. The varied cash flow models would provide for diversification of returns.

Relying on Diversifying Geographies to Minimize Regulatory Risks

Regulatory risks are the ghostly specters hanging over Blockchain projects with a growing ominous presence. A project that is based in a single country or has most of its users based in a single country, will be subject to the different regulatory laws of each jurisdiction. Increasing regulatory intervention in the cryptocurrency economy which seek to protect investors may have a knock-on effect on the market and might affect business models positively or negatively. Diversification of portfolio through geographical means may provide some buffer against regulatory moves which may rock (or even capsize) the boat.

Diversify by Holding Different Market Capitalizations to Reduce Securities Correlations

As mentioned, small market capitalized altcoins usually move in correlated fashion. The best way to counter this is to have a healthy mix of large market cap coins such as Bitcoin, Ethereum and EOS, while holding some smaller market cap altcoins. This helps to reduce the correlation between securities in your portfolio as large market cap coins do not typically move in the same direction.

Investors Should Wait for Cryptocurrency ETFs to Mature

Cryptocurrency ETFs are at a nascent stage, with the number of new product offerings entering the market are few and far between. The way cryptocurrency ETFs are constructed, it is clear that the ETFs are not built for the purpose of risk diversification for the clients but set up in a way that the ETF providers can easily operate the ETFs with minimal liquidity issues. An understanding of the construction of the ETFs reveal that the components that make up the ETFs are often the most liquid coins that the cryptocurrency exchange has to offer. This is to minimize the price difference between the ETF and the component coins.

Touting risk diversification as a purpose to purchase cryptocurrency ETFs is a half-truth. True diversification cannot be achieved with the ETF offerings currently on the market. The simplest way to achieve diversification is to read up on Blockchain projects that catch your eye, do your due diligence, classify them according to their use case, geography and market capitalization and allocate accordingly.

The limitations of cryptocurrency ETF structures have not stopped the digital assets enthusiasts from demanding regulators to accept cryptocurrency ETFs. It remains to be seen if the momentum for cryptocurrency ETF will result in a useful financial product for everyday investors.

This article was written by Arnold Viatori.