Rebalancing Premium in Cryptocurrencies

The strategy utilizes the idea of a Rebalancing premium introduced by Willenbrock (2021). The paper argues that a simple buy-and-hold portfolio does not earn a diversification return. However, it generally has a lower variance than the weighted-average variance of its constituents. The cumulative return of a buy-and-hold portfolio is driven by the assets that perform the best and thus become a greater fraction of the portfolio. On the other hand, Willenbrock suggests the existence of a premium in a periodic rebalancing of uncorrelated assets. Additionally, the author emphasizes that reducing variance in a diversified portfolio is a necessary but not sufficient condition to earn a diversification return.

Novel research further analyzes the rebalancing premium on the cryptocurrency market. The study found a significant premium in the periodic rebalancing of cryptocurrencies. Moreover, the paper compares the daily-rebalanced long-only portfolio to the long-short portfolio with various weights on the short side. Additionally, the paper analyzes the ability of the rebalancing premium of cryptocurrencies to improve the performance of low volatile assets such as bonds.

 

Fundamental reason

Rebalancing premium is defined as the premium an investor gains from periodically rebalancing their portfolio. For example, imagine having two assets with zero return and high volatility. If we buy just one, we are not going to earn anything. However, buying both and periodically rebalancing forces the investor to buy the asset that has decreased in relative value and sell the asset that has appreciated (thus taking profit) in relative value (as measured by their weights in the portfolio). As a result, the investor earns a so-called “rebalancing premium” or “diversification return.”

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Markets Traded
cryptos

Backtest period from source paper
2018-2021

Confidence in anomaly's validity
Strong

Indicative Performance
7.65%

Notes to Confidence in Anomaly's Validity

Notes to Indicative Performance

Table on page 4, X = 70, assuming that only 1/10 of the portfolio is invested


Period of Rebalancing
Daily

Estimated Volatility
2.62%

Notes to Period of Rebalancing

Notes to Estimated Volatility

Table on page 4, X = 70, assuming that only 1/10 of the portfolio is invested


Number of Traded Instruments
27

Maximum Drawdown
-1.94%

Notes to Number of Traded Instruments

BAT (Basic Attention Token), BTC (Bitcoin), BTG (Bitcoin Gold), DAI (Dai), DATA (Data Coin), DGB (DigiByte), EOS (EIS.io), ETH (Ethereum), FUN (FUN Token), IOTA (Iota), LRC (Loopring token), LTC (Litecoin), MANA (Mana coin), NEO (Neo), OMG (OMG, Formally known as OmiseGo), REQ (Request), SAN (Santiment Network Token), SNT (Status), TRX (Tron), WAX (Wax), XLM (Stellar), XMR (Monero), XRP (Ripple), XVG (Verge), ZEC (Zcash), ZIL (Zilliqa) and ZRX (0x)


Notes to Maximum drawdown

Table on page 4, X = 70, assuming that only 1/10 of the portfolio is invested


Complexity Evaluation
Simple strategy

Sharpe Ratio
2.93

Notes to Complexity Evaluation

Region
Global

Financial instruments
cryptos

Simple trading strategy

The investment universe consists of 27 cryptocurrencies: BAT (Basic Attention Token), BTC (Bitcoin), BTG (Bitcoin Gold), DAI (Dai), DATA (Data Coin), DGB (DigiByte), EOS (EIS.io), ETH (Ethereum), FUN (FUN Token), IOTA (Iota), LRC (Loopring token), LTC (Litecoin), MANA (Mana coin), NEO (Neo), OMG (OMG, Formally known as OmiseGo), REQ (Request), SAN (Santiment Network Token), SNT (Status), TRX (Tron), WAX (Wax), XLM (Stellar), XMR (Monero), XRP (Ripple), XVG (Verge), ZEC (Zcash), ZIL (Zilliqa) and ZRX (0x). Two portfolios are created. The first portfolio is the daily rebalanced portfolio of all 27 cryptos to ensure that the assets have equal weights. The second portfolio is not rebalanced at all: an investor buys the equally-weighted crypto portfolio and lets the weights drift. Then the investor goes long the first portfolio and shorts the second portfolio with 70% weight. The ratio between first and second portfolio is daily rebalanced.

Hedge for stocks during bear markets

Not known - Usually, cryptos are not a great diversifier since these assets are sensitive to crises. However, the strategy also has a significant short position in cryptocurrencies. Therefore, the risks seem to be lower. Moreover, thanks to the unique structure and rebalancing (taking profit) from rising cryptos, there indeed might be potential.

Source paper
Out-of-sample strategy's implementation/validation in QuantConnect's framework (chart+statistics+code)
Other papers

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