- Insider spoke to Morningstar’s Amy Arnott, who leads the research firm’s coverage of ether.
- Arnott emphasized its extreme volatility, and how even a 2% weighting could “dramatically increase” a portfolio’s risk profile.
- However, that volatility appeals to a certain type of investor, due to ether’s low, or negative correlation with stocks and the US dollar.
Like many other cryptocurrencies, ether is an extremely volatile investment asset. Traders love it, regulators hate it and many longer-term investors are still on the fence about what role crypto might play in their portfolios.
Amy Arnott, a portfolio strategist at Morningstar, has crunched the numbers to come up with the ideal weighting for ether in a traditional portfolio. And it’s a lot lower than a lot of crypto investors might think.
“If you talk to crypto fans, a lot wouldn’t care about that day-to-day volatility because they’re holding for 20 years,” she told Insider. “Obviously, there have been huge rewards for people who got in early, say in 2015, but also it’s been subject to very large drawdowns like we saw in 2018 and over the past few months.”
“I think the difficult thing about ether is that the volatility is so high that it’s literally off the charts.”
Ether, the native token of the ethereum network, has fluctuated dramatically in 2021. It’s still up around 600% in the last 12 months, but the rollercoaster ride has seen it double from $1,313 in January to $2,773 in April, before crashing below $1,800 this week.
Ether is the second-largest cryptocurrency by market value behind bitcoin, worth around $206 billion, according to Coinmarketcap.com. It's got better environmental credentials than bitcoin, given its lower energy use and its network is almost the default option for developers of decentralized finance applications or even non-fungible tokens.
Even though it tends to swing less wildly than some of the smaller tokens, like "meme crypto" dogecoin, which has been prone to huge price swings, sometimes doubling in value in a day, ether's volatility is on a par with some of the most illiquid and risky equity indices, Arnott said.
"Over the past few years, ether's standard deviation level has been similar to MSCI Lebanon or MSCI Zimbabwe," Arnott said. "The volatility is so high that it is difficult to fit it into a traditional portfolio analysis framework."
In her research, Arnott tracked two separate hypothetical "80/20" portfolios from July 2016, one comprising a traditional mix of 80% equities and 20% bonds, and the other featuring a mix of 78% stocks, 20% bonds, and 2% ether.
The ether-weighted portfolio offered higher returns, but even including just 2% ether almost tripled its standard deviation - a metric to assess likely portfolio volatility - from 12.36 to 31.02.
"If someone is trying to maximize risk-adjusted returns, a very, very small weighting in ether - 0.5% - would do the best," Arnott said. "That's because the volatility has been so high that even if you had a 2% weighting, it would have dramatically increased the portfolio's risk profile."
Cryptocurrency bulls tend to shrug off ether's volatility and concentrate on making longer-term investments. But Arnott said that price uncertainty will alienate most traditional and institutional investors for the foreseeable future.
However, Arnott pointed to two reasons for less risk-averse investors to add ether to their portfolio.
First, the introduction of Ethereum Improvement Protocol 1559, an upgrade that will destroy some ether tokens to reduce overall supply, and "Ethereum 2.0", which will restructure and improve the network's algorithm, and could help to stabilize ether's price over the next few months.
"Once people see that protocol actually implemented, they will gain more confidence that the supply actually will decrease over time," Arnott said.
Secondly, ether has had a correlation coefficient of just 0.12 with the S&P 500 over the past five years, which means it would very rarely move in lockstep with the index, and a negative correlation with the US dollar, which means it would tend to move in the opposite direction.
That could make it an attractive hedging option.
"One really unique thing about ether, even more so than bitcoin, is that it has an extremely low correlation coefficient with other asset classes," Arnott said. "It's very hard to find correlations that low."
Those factors make ether an appealing asset to own in moderation. But research like Arnott's suggests investors should be careful not to overweight cryptocurrencies when building an 80/20 portfolio.
"Obviously we have seen the volatility level decrease somewhat as ether has become more mainstream, so it might become easier to make a case for ether from a portfolio perspective," Arnott said. "But people will still have to be really cautious about the volatility and potential for losses."