Is Bitcoin an Effective Hedge Against the Stock Market?

In previous posts, we’ve highlighted the exemplary performance of software stocks after evaluating the risk-adjusted returns of a software portfolio and the best performing individual stocks. Recently, we’ve noticed investors are paying more attention to crypto as the stock market outlook remains uncertain following a head-scratching rally and bitcoin recently underwent its third halving. Crypto is often touted for its ability to serve as a hedge against the stock market. Here, we explore the merit of that claim.

For some initial perspective, let’s compare the returns of Bitcoin and Ethereum to market indices. Bitcoin has returned an unfathomable 3880% since May 2015, even better than Shopify, the best performing software stock.

Next, let’s compare the betas of Bitcoin and Ethereum to these assets. Recall that beta is a risk metric used to gauge how an asset moves relative to a market benchmark. An asset can be a valuable hedge if it has a beta close to -1 (the asset moves inversely with the market, protecting against downward moves) or a beta close to 0 (the asset does not move with the market at all).

Using the Nasdaq as the market benchmark to calculate beta, we see that Bitcoin has a beta of 0.43, the lowest of the set (and lower than any other software company except Zoom). This implies that Bitcoin, while far from the perfect hedge, doesn’t move closely with the market and is a valuable hedge, especially as part of a high-beta software portfolio. Note that Bitcoin’s low beta does not come at the expense of high historical returns, again disproving the belief that low beta = low return potential. Interestingly, Ethereum has a beta of 0.88 — it isn’t an effective hedge against the overall stock market.

However, don’t fall into the trap of assuming that low beta necessarily means low risk. Despite their low betas, Bitcoin and Ethereum have been highly volatile assets. If we examine the variance of the daily returns (i.e. how much each asset moves on a day-to-day basis), we see that Bitcoin and Ethereum lead the pack, with variances an order of magnitude above that of the software average, Nasdaq, and S&P 500.

Again, Ethereum is an ineffective hedge due to its volatility — unsurprisingly, it is more volatile than any software stock. Bitcoin actually has a lower variance than 7 software stocks (Bill.com, Sprout Social, Medallia, Domo, CrowdStrike, Datadog, and PluralSight).

In short, Bitcoin is clearly the more effective hedge — its low beta and high but not extreme volatility make it a unique asset. Stay away from Ethereum as a hedge, which moves in sync with the market and has extreme volatility.