Hedging uncertainty: Bitcoin's asymmetric diversification benefits in factor-based portfolios

This paper examines the benefits of adding Bitcoin in a portfolio framework that also includes the five Fama-French risk factor portfolios in periods of low versus high US economic policy uncertainty (EPU). The empirical investigation utilizes data spanning from 2015 to 2023 and follows a two-step methodological approach. First, the US EPU monthly time series is segmented in sub-periods characterized by high and low EPU, determined using the Bai-Perron structural breaks test. Secondly, we employ the mean-CVaR portfolio optimization approach that seeks to maximize risk-adjusted expected returns on portfolios that are formed with and without Bitcoin. We find that the optimal weight of Bitcoin asset increases and subsequently the risk-adjusted performance of the Bitcoin portfolio improves in periods of high EPU, as opposed to periods of low EPU. Our results are robust to rolling estimation windows, different rebalance frequencies and alternative portfolio construction techniques. This asymmetric impact is critical and should be incorporated in portfolio decisions, as it shows that Bitcoin is most useful as a diversifier in periods where the economic uncertainty is relatively high. The obtained results also reinforce the idea that crypto assets are independent from the existing financial system. • Objective assessment of periods characterized by low and high economic uncertainty using the Bai-Perron structural breaks test. • Portfolio analysis conducted in both periods using mean-CVaR optimization approach and adding bitcoin to a portfolio framework that includes the five Fama-French risk factors (FF5). • Bitcoin is not useful as a diversifier in low EPU periods as the out-of-sample risk-adjusted performance of optimal portfolio is inferior to the FF5 portfolio. • On the other hand, adding bitcoin in optimal portfolios improves out-of-sample risk adjusted returns during periods characterized by high economic policy uncertainty (EPU). • Investors decisions regarding allocation of crypto assets in their portfolios should depend on the prevailing level of economic uncertainty.