Bitcoin entering into the mainstream could erode its diversification value over time, JPMorgan says

• JPMorgan said bitcoin’s acceptance into the mainstream could hurt its diversification value.
• The bank found that as bitcoin becomes more mainstream, it becomes more correlated to other assets. 
• JPMorgan also found bitcoin has been less successful than other hedges during stock market drawdowns.
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Bitcoin promoters have long touted the cryptocurrency’s role as a diversification tool. A bit reason why is because the token is seen as uncorrelated to other assets and can therefore rally during major stock market drawdowns.

However, a team of JPMorgan strategists said on Thursday that as bitcoin and other cryptos become more mainstream, their correlation with other assets increases, and this decreases their diversification benefits.

“Bitcoin improves long-term portfolio efficiency, but its contribution will probably diminish as its mainstreaming increases its correlation with cyclical assets. And crypto continues to rank as the least reliable hedge during periods of acute market stress,” the strategists led by John Normund said.

JPMorgan found that allocating up to 2% of a portfolio to crypto can improve portfolio efficiency due to the various cryptocurrencies’ sky high returns, but investors may need to reassess that allocation as cryptos become more mainstream. 

“In a portfolio context, the mainstreaming of cryptocurrencies – particularly with retail investors – appears to be raising its correlation with all cyclical assets (Equities, Credit, Commodities, the EM complex),” said JPMorgan.

Their models show that bitcoin’s cross-asset correlation appears to be rising, and has coincided with its mainstreaming through products like the Grayscale BTC fund. 

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After examining the largest global stock market drawdowns since 2008 and comparing bitcoin’s performance versus other portfolio hedges, the strategists found that bitcoin was one of the least profitable hedges. In the February and March 2020 stock market crash, for example, bitcoin lost 33%, while US treasuries, a more traditional hedge, gained 6%, according to JPMorgan data. 

Overall, the strategists found that bitcoin ranks the worst in terms of medium returns (-5%), compared to fiat currencies like the USD vs EM FX (3%). It also doesn’t have a high success rate of turning positive during stock market declines. In all of the drawdowns studied, bitcoin turned positive 42% of the time, compared to the USD vs EM FX hedge, which has a 100% success rate of offering positive returns during equity drawdowns.

“Perhaps market dynamics will be different during an equity market correction driven by much higher US inflation and a more durable loss of confidence in the dollar,” the strategists added. “But until and unless those macro concerns materialize, crypto’s ownership structure inclines it to underperform in a macro crisis those very currencies it aspires to replace.”

In a more positive outlook for bitcoin, the strategists also said that cryptocurrencies could serve as “insurance against dystopia” like high inflation or a breakdown of the payments system.

“Relative to any other asset class or portfolio hedge, cryptocurrencies would uniquely protect portfolios against a simultaneous loss of faith in a country’s currency and its payments system, because they are produced and they circulate outside conventional and regulated channels…” said JPMorgan.

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