Adaptive Risk Allocation in Crypto Markets: Evaluating Volatility-Scaled Portfolios

Abstract

This study applies volatility scaling, an established timing strategy that dynamically adjusts portfolio risk exposure, to the cryptocurrency market. We scale the market portfolio and seven cryptocurrency strategies by their recent volatility to improve risk-adjusted returns. Volatility scaling increases Sharpe ratios and generates abnormal returns in certain strategies, particularly momentum-based strategies and the overall market portfolio. The strategy remains effective even under tight leverage constraints and its advantages become more evident as we extend the investment horizon. Our results are robust after accounting for common risk factors and limits to arbitrage. We confirm that similar to the equity market, volatility scaling does not systematically benefit all strategies, and the strongest effects occur in momentum portfolios, suggesting a robust and potentially universal pattern.

Keywords: Cryptocurrency, Volatility, Portfolio, Momentum, Market Timing, Asset Pricing, Risk-return trade-off