Chain Hill Capital: Crypto Index Research: Volatility Weighted

Original title: "Chain Hill Capital: Cryptocurrency Index Research: Volatility Weighted"

Original source: Chain Hill Capital Qianfeng Capital

Author: Chain Hill Capital (千Peak Capital) Managing Partner Carrie

Volatility weighting is an index construction method to achieve risk diversification, which can improve the risk-adjusted performance of cryptocurrency portfolios and gain Actively reciprocate.

Weighting method and risk diversification

Indices weighted by market capitalization It has always been a barometer for monitoring the stock market, such as the S&P 500 Index and the Shanghai Composite Index.

While market capitalization weighting is the most common index construction method, it has also received some skepticism in recent years. For example, while an ETF or mutual fund that tracks a market-cap-weighted index holds hundreds of stocks, it's often only a handful that make the biggest impact. In other words, these funds have not achieved true risk diversification.

The reason for this suspicion is that market capitalization weighted indices tend to be heavily skewed towards the largest stocks, underestimating the performance and contribution of smaller constituents. This mega-cap dominance doesn't appear to be a problem in current market conditions, as the largest companies have consistently grown faster than the average stock in recent years. But when these giants run out of steam and fall out of favor with the market, the capitalization-weighted index, which focuses on megacaps, could suffer.

For this reason, the industry has proposed some different solutions to explore how to better realize risk diversification. Of these, the simplest alternative is equal-weight weighting, ie, assigning weights equally to all components. For example, fixing each company's share of the S&P 500 at 0.20%. This approach appears to be more decentralized, as it resolves the problem of over-concentration of weights in a few industries and large companies in a cap-weighted index. But in reality, the overall risk of the portfolio is elevated because the approach "overweights" smaller companies, which are more volatile over the long run.

Another approach is to limit the scope of the index sample to low-volatility stocks, which can certainly achieve a low-volatility portfolio, but it is not the most A good risk diversification strategy. Because low-volatility stocks tend to be concentrated in defensive sectors like consumer staples and utilities, such a portfolio is clearly not an ideal stock allocation.

Therefore, the above two alternatives cannot solve the problem of risk diversification very well. In contrast, volatility weighting provides a more reasonable solution. It is unique in that it better balances the volatility contribution of each component to the entire portfolio, thereby balancing the risk contribution of the components, making the exposure of each component more reasonable. Research and practice in the stock market has also shown that this approach helps to create a portfolio that consistently performs well through different market cycles.

Table 1: Comparison of common index weighting methods in the stock market

Generally speaking, the volatility corresponding to the weighting method in the table decreases from top to bottom

Understanding volatility weighting

1. The relationship between volatility and risk The relationship between

For stocks, volatility describes the degree of stock price fluctuations. Risk refers to factors that can cause a stock to lose value.

There are many types of risk that can affect the price behavior of a stock, including macro risk, interest rate risk, firm-specific risk, currency risk, geopolitical risk, liquidity risk etc. The price change of the stock is affected by the comprehensive influence of these risk factors in different proportions and degrees. Because these risks change and interact over time, it is difficult to develop a comprehensive and forward-looking risk calculation that accurately measures the impact of these factors on individual stocks and the broader market.

In practice, price volatility is a reliable indicator of stock risk. On the one hand, historical price volatility is often persistent: stocks with low historical volatility are more likely to remain relatively low in the short term, while stocks with high historical volatility are more likely to remain highly volatile in the short term. On the other hand, stocks with greater exposure tend to have larger historical price swings than stocks with less exposure. Therefore, it can be considered that volatility is an expression of the relative risk of holding a certain stock, and it is also a comprehensive measure of the risk of the stock. Standard deviation is the metric most commonly used to quantify risk.

The above relationship between volatility and risk applies equally to cryptocurrencies.

2. How does volatility weighting improve portfolio risk diversification

The basic principle of volatility weighting is to Index components with higher volatility are given less weight and those with lower volatility are given higher weight, with the goal of having each component contribute an equal amount of expected risk to the portfolio. This risk equalization is an intuitive way to enhance risk diversification, and ideally, it can reduce the overall volatility of the portfolio to a lower level than market-cap weighting.

The example in Table 2 compares portfolio risk contributions under three different weighting schemes: market capitalization weighted, equal weighted, and volatility weighted. In this case, the volatility-weighted portfolio is the most risk-diversified of the three weighting methods, and the portfolio's expected risk is the lowest.

Table 2: The impact of different weighting methods on portfolio risk

January 1, 2020 to December 31, 2020

Application in the crypto market Volatility Weighting

Based on our research on cryptocurrency volatility indices we found the following results.

1. Volatility weighting cannot reduce the volatility of the portfolio

In the stock market, the volatility weighted index can usually Reduce the overall volatility of the portfolio. However, our study finds that risk equalization through volatility weighting does not reduce the volatility of cryptocurrency portfolios. On the contrary, the volatility of the volatility-weighted index is significantly higher than that of the market capitalization-weighted index.

Table 3: Chain Hill Capital Volatility Weighted Study Summary

Note: The table shows the market capitalization weighted index and 11 volatility based on data of different frequencies (daily, weekly, monthly) and periods (30, 90, 180, 360 days) Weighted index;

d, w and m represent data of three different frequencies, which are daily, weekly and monthly; 30, 90, 180, 360 represents the volatility calculated based on 30, 90, 180, and 360-day cycles respectively;

The backtest time is from November 31, 2014 to November 2020 31st;

The data in the table is for the top 10 cryptocurrencies by market capitalization, which are the most representative in terms of market capitalization and liquidity .

One of the reasons for this phenomenon is the unique structure of the cryptocurrency market itself: the market value is very polarized. As we pointed out in the "Cryptocurrency Index Investment Research Report", "The market value distribution of the current encryption market has obvious head utility. The market value of the top 10 projects accounts for 85% of the market value of the entire market, and the market value of projects ranked 11-30 accounts for The market value of projects ranked 31-100 accounted for 4%. In contrast, the top 10 stocks in the U.S. stock market by market capitalization account for about 20% of the total market.

What's more special is that Bitcoin's market value accounted for more than 50% for a long time, especially before 2017, when it accounted for more than 90%. At the same time, the volatility of Bitcoin is significantly lower than that of other currencies. Therefore, when weighting the volatility of a portfolio containing Bitcoin, the weight of Bitcoin will inevitably be greatly reduced, and the weight of currencies with high volatility will be increased, resulting in an increase in the volatility of the portfolio. As can be seen in Table 4, Bitcoin’s volatility is much lower than other components in the portfolio, and volatility weighting reduces Bitcoin’s share by about 55%.

Table 4: Comparison of different weighting methods for the top ten cryptocurrencies by market capitalization

Note: Using the market data in November 2020

Table 5 shows the portfolios other than the top ten in market capitalization, this part is encrypted Using volatility weighting for currencies can reduce the expected risk of the portfolio, possibly because cryptocurrencies ranked 11 to 100 by market capitalization are less divergent in market capitalization and volatility.

Table 5: Comparison of expected risks of different weighting methods

**## 2. Volatility weighting can Improve risk-adjusted performance

It can be found from Table 3 that the volatility-weighted combination with higher frequency and shorter cycle parameters has a higher performance than Sharpe ratio and Sortino ratio. The most pronounced improvement was seen in the metric, which may be due to the fact that the crypto market is changing more quickly and thus requires more "instant" volatility to capture information. Based on our findings, the last 90-day daily return volatility is the optimal parameter setting.

Figure 3 illustrates the risk and return profile of three major cryptocurrency portfolios. It can be seen that volatility weighting improves returns more than volatility increases. Consequently, risk-adjusted performance, as measured by the Sharpe ratio, improves in all three portfolios. The increase in the Sortino ratio is more pronounced, suggesting that volatility-weighted portfolios can achieve higher excess returns when bearing the same unit of downside risk.

Figure 3: Risk-adjusted performance comparison

3. Performance in different market cycles

Finally, let's look at the performance of the volatility-weighted index in the up market and the down market. In Table 7, we use two indicators to measure the performance of the volatility-weighted index under different market conditions, namely the average monthly return capture rate and win rate. The takeaway from the table is that volatility weighting overcaptures market upside while limiting its downside to some extent. On average, the volatility-weighted index gained 116% of its benchmark in positive months and lost only 84% of its benchmark in negative months. Also, volatility weighted has a slightly higher chance of outperforming the benchmark in up markets, as seen by outperformed odds. On average, volatility weighting outperformed the benchmark 52% of the time in up markets but only 48% of the time in down markets. The winning rate of large market capitalization and market indexes in the down market is significantly lower, especially the large market capitalization index. The reason is that Bitcoin has an overwhelming market capitalization ratio and the lowest volatility in the whole market, which distorts the effect of the volatility weighted index. . From this we can also see that the volatility-weighted index can well protect the small and medium-cap index in the down market, and it has the highest probability of outperforming the benchmark index in the down market.

Table 7: Capture and Win Rates for Up and Down Markets

Note: Up and down markets are defined by positive and negative benchmark monthly returns. The backtest period was from November 30, 2014 to November 30, 2020.

The top half of the table shows the average monthly returns of the volatility-weighted index and its benchmark (market-cap-weighted). The capture rate is calculated as the ratio of the volatility-weighted index to the return of the benchmark index.

The bottom half of the table shows the total number of months in which the VIX or benchmark index outperformed. Winning percentage calculates the ratio of the number of months in which the VIX has outperformed to the total number of months.

Summary

The research and practice of the stock market show that volatility Weighting can provide a more reasonable risk diversification plan, making the risk exposure of the portfolio more balanced.

Our research on the cryptocurrency volatility-weighted index concluded the following:

1 . Due to the unique structure of the cryptocurrency market itself, the volatility of the volatility-weighted index is significantly higher than that of the market capitalization-weighted index. However, the increase in its volatility came more from upside volatility. That is, the positive volatility brought about by volatility weighting is higher than the negative volatility.

2. Volatility weighting can significantly improve risk-adjusted performance. Risk-adjusted performance, as measured by the Sharpe and Sortino ratios, has improved across major cryptocurrency indices, especially the Sortino ratio. This suggests that volatility-weighted portfolios can achieve higher excess returns when bearing the same unit of downside risk. Furthermore, information ratios and alpha return metrics, which measure active risk-reward, illustrate that the volatility-weighted approach achieves significant active returns.

3. Volatility weighting can overcapture the market's upward returns, while limiting the downward returns to a certain extent. But this downside risk management role is currently most effective for small and mid-cap indices, which outperform the benchmark 71% of the time in a downmarket. However, the volatility-weighted large market capitalization index lags significantly behind in the downward market. The reason is that Bitcoin has an overwhelming market capitalization ratio and the lowest volatility in the entire market, which distorts the effect of the volatility-weighted index. It is expected that as the crypto market matures, the volatility-weighted index can better play the role of risk management.

In addition, it should be noted that the volatility-weighted index for small and medium market capitalization may have certain liquidity restrictions. This is because volatility weighting increases the weight of small-cap coins compared to market-cap weighting, and small-cap coins in cryptocurrencies are often notoriously illiquid. Therefore, the volatility-weighted index of small and medium-sized market capitalization may not be suitable for large-scale capital allocation at this stage.

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