Portfolio Diversification | Digital Assets
Diversifying investment portfolios with digital assets and key considerations for investors
I) Types of Digital Asset Investment Vehicles
II) Fundamental Research in Digital Assets
III) Portfolio Theory and Management
Types of Digital Asset Investment Vehicles
An overview of gaining exposure to digital assets including: buying on exchange, ETFs, venture capital, and liquid hedge funds
Investing in digital assets provides a way to diversify a broader investment portfolio because the price movements of digital assets tend to be uncorrelated with other asset classes. Recognizing the benefits of having multiple uncorrelated assets in a broader portfolio, an investor should strive to build their collection of investments in a complementary and risk-adjusted manner, paying particular attention to how each asset moves against the other.
To achieve diversification from digital assets, investors can take a passive approach by buying and holding digital assets through an exchange or an ETF. Alternatively, they can adopt an active approach, either through personal investment decisions or by outsourcing to investment managers.
Purchasing on an Exchange
The simplest way to hold digital assets personally is by purchasing them on a centralized exchange like Coinbase or Kraken. These exchanges serve as the main bridges connecting traditional money with digital assets. The primary caveat of this method is that investors don’t actually hold the private key to their digital asset wallet, so they must trust these exchanges to store their assets safely. While exchanges such as Coinbase and Kraken have proven themselves to be trustworthy, the same cannot be said for FTX.
Investors can go one step further by moving their digital assets off of the centralized exchange to a personal wallet such as Metamask; however, investors will need to store their own private key, which acts as a password that unlocks access to all of their assets. This approach allows investors to directly interact with digital asset applications and explore different protocols but is also the most prone to risk and scams.
Investors simply looking to buy and hold popular digital assets should go to a trusted centralized exchange, as this route offers control and flexibility over investment decisions.
ETFs
The bitcoin ETF became a possibility for investors in January 2024 and has already earned the title of fastest-growing ETF in history. The bitcoin ETF achieved early success because it enabled investors to purchase spot bitcoin through traditional financial guardrails. Investors could hold the ETF share, which tracked bitcoin’s price, without the headache of setting up a bitcoin wallet and maintaining security.
Purchasing the bitcoin ETF requires investors to pay a management fee of around 0.25%; moreover, the ETF does not trade on nights and weekends, unlike actual bitcoin. Nevertheless, investors simply seeking exposure to bitcoin inside their brokerage account may find the ETF the perfect avenue. Additionally, these investors can purchase bitcoin shares through a tax-advantaged IRA account.
Importantly, the second digital asset spot ETF began trading on July 23rd with the launch of the Ethereum ETF. This enables pro-ETF investors to gain exposure to the second largest cryptocurrency and diversify outside of just bitcoin. Although, the Ethereum ETF does not allow holders to receive the benefit of staking Ethereum, which equates to a 3–4% yield and is currently only possible for holders of the actual digital asset.
Venture Capital (VC)
To date, venture capital, through investment managers, has been the typical path into the digital asset space for institutional and high-net worth investors. In part, because institutional allocators’ investment mandates only allowed for digital asset exposure through VC versus investing directly. Since 2017, over $70B has flowed into digital asset VCs. When VCs deploy this capital, they primarily receive future token distributions from projects or (SAFTs), although some investments are for equity.
Source: Galaxy
For background, early VC investors were rewarded appropriately for their risk-taking from 2013–2021 as digital asset projects could form quickly due to their capital-lite business models. The projects could then go-to-market (GTM) in under 12 months (3–6 if the founding team released product beta early) and then subsequently issue a token through a token generation event (TGE).
The TGE was often a quick financial windfall for the founding teams and VCs as retail investors were there to provide the necessary buying demand. Retail investors were eager to purchase the tokens as this was the first time they were able to access the value of a project that they had been researching (potentially). Unfortunately, this dynamic typically favored the founders and VCs with retail investors serving as exit liquidity.
This paradigm still exists today but has been undermined, in part, because retail investors no longer want to purchase new token sales from founders and VCs, especially if a significant portion of tokens will be continually unlocked via vesting schedules and then sold. Consequently, some founders are now pursuing a token distribution via fair launch that provides equal opportunity for both VC and retail investors, and better garners support from retail.
The digital asset VC industry has also been negatively affected by the saturation of capital in the market. This can be seen in the previous graphic as the 2021 bull market pulled forward fund creation, funding, deal activity, and valuations. It didn’t help that prominent VC’s were raising $1B+ funds with limited capacity to invest in promising companies unless they wanted to fund the entire round for projects, which some VCs did. Unfortunately, 2021 vintage VCs deployed capital into a frothy market that was hindered from the beginning with the impending collapse of FTX.
Another large-scale headwind for VC firms, especially highlighted this year by the emergence of the bitcoin ETF, is the relative outperformance of bitcoin. Only top performing VCs can consistently outperform bitcoin, which has become more noticeable this year as VC funding and bitcoin’s price have diverged, as shown below.
Source: Galaxy
Although, the worst appears to be behind for VC firms as capital invested increased for a second straight quarter in Q2 2024, growing to $3.2B from $2.5B in Q1. This positive trend should continue as regulatory headwinds in the U.S. decrease and founders begin building new project ideas, which can subsequently be funded by fresh VC capital and the dry powder that remains from 2021 and 2022.
Investors looking to gain exposure to digital asset VC vehicles should focus investment on funds that have access to promising founders and funds that provide utility to those founders.
Liquid Hedge Funds
The final investment category is liquid hedge funds. As the name implies, liquid hedge funds invest in liquid tokens. Liquid hedge funds revolve around three strategies: quantitative, market-neutral, and fundamental.
Quantitative liquid strategies rely heavily on mathematical models, algorithms, and statistical methods for trading decisions. These strategies can be fully automated with zero human involvement or can be used on a discretionary basis. Quantitative strategies can be directional and maintain varying levels of net long/short exposure to the market. Momentum, trend following, mean reversion, and sentiment fall under this group of strategies.
Market-neutral strategies involve the fund manager seeking to avoid some form of market risk entirely via hedging. Market-neutral funds must specify the type of risk that they are seeking to avoid, and truly market-neutral portfolios have zero correlation with this risk. This strategy aims to profit from both rising and falling digital asset prices, while minimizing exposure to the overall market movements. Beta-neutral, delta-neutral, and absolute return arbitrage fall under this umbrella. Compared to directional strategies, market-neutral strategies tend to have lower risk; however, this generally comes with lower returns.
Fundamental strategies will be explained further in the following section. At a high level, these strategies involve researching quantitative and qualitative aspects of digital asset projects. Specific digital assets are evaluated for value, growth, and potential appreciation or depreciation. These strategies could employ different processes for selecting an asset to include in the portfolio, including both long and short positions.
Overall, liquid hedge funds are smaller in terms of aggregate AUM compared to VCs with about $15B AUM; however, because of the saturation in the VC market and the regulatory acceptance caused by the ETFs, institutional allocators are likely to increase exposure to liquid funds in the future.
Liquid funds can offer significant returns but carry substantial risk too. Fundamental strategies vary by investment manager, so the investment opportunity should be evaluated on a case-by-case basis.
Fundamental Research in Digital Assets
The importance of fundamental research in digital asset investing
One of the defining characteristics of how venture capital funds and liquid hedge funds determine appropriate investments is through fundamental research. Venture capital looks at investments through the lens of potential market size, growth and the founding team’s ability to deliver on their stated vision.
Liquid hedge funds evaluate these factors too but will examine them later in a digital asset protocol’s growth. The protocol will already have issued a token through a token generation event (TGE) such as an initial token airdrop, so that the value of the protocol is freely trading. Furthermore, because the protocol has already grown from its early stages, hedge funds have a much wider array of metrics to analyze from such as network activity, adoption rates, and fees generated from paying users (to only name a few).
Successful digital asset VCs must envision a potential future, whereas fundamental hedge funds not only envision this future, but also analyze current data to assess whether it aligns with their projections.
Historically, fundamental research has always existed in some form or fashion — both inside and outside the world of investing — for the purpose of answering the question: “What is the price that you should be willing to pay for something if you didn’t know its price?” For example, you wouldn’t need to do a full discounted cash flow model to understand that ships in the 17th century were valuable. You’d likely be able to construct some mental framework for how much you would be willing to pay for that ship, perhaps by examining the intended voyage and payout, likelihood of achieving objective, and the operating crew.
This mental framework is fundamental research, and it was popularized by Benjamin Graham and David Dodd in the early 20th century. Their groundbreaking work fully laid out the qualitative and quantitative factors necessary to determine the intrinsic value of a company. They believed that you could value a company’s stock without looking at the price that it currently traded, but rather by analyzing the financial statements, industry conditions, business model, and management team. This led Graham and Dodd to find undervalued companies that intrinsically were worth more than their current market capitalization. This concept birthed value investing, and to this day remains a fundamental principle of investment research.
Source: Investopedia
So how does this relate to digital asset investing? While the time period and financial statements may have changed, the mental framework and goal of finding the intrinsic value remain. Just as value investors pore over 10-Ks to evaluate a company’s financial worth, fundamental digital asset investors can study the information present in blockchain networks to reveal a protocol’s intrinsic value.
Let’s illustrate how digital asset fundamental research might look with a high-level example. Imagine there are two digital asset lending and borrowing platforms: Protocol A and Protocol B. The protocols earn money whenever a user borrows or deposits tokens –equivalent to a bank business model that earns the difference between the borrowing interest rate and lending interest rate or net interest margin.
Protocol A is more established and currently has 100,000 monthly active users with total deposits of USD $20B (or USD equivalent) and total loans of USD $10B. Protocol A pays on average 3.2% interest to its depositors and earns on average 7% from its loans, thus making $60M a year in net interest income. Protocol A pays its developers $20M a year and $0 on marketing — ultimately, earning $40M a year in net income.
Protocol B is a younger startup looking to grow rapidly and currently has 20,000 monthly active users with total deposits of USD $5B and total loans of USD $4B. Protocol B pays on average 5% to its depositors and earns on average 7% from its loans, thus making $30M a year in net interest income. Protocol B pays developers $5M a year and spends $15M on marketing — ultimately, earning $10M a year in net income.
Both Protocol A and Protocol B have a maximum token supply of 100M and distribute annual net income to token holders.
How much would you pay for Protocol A and Protocol B’s token?
The answer is, of course, that it depends
These numbers and information alone don’t tell the full story so some follow-up questions worth considering are:
· How do the monthly active user growth rates compare?
· How many tokens are currently outstanding compared to the maximum supply?
· Are users likely to leave Protocol B if marketing spend stops?
· Are Protocol A and Protocol B direct competitors?
· How reliable are the developers behind Protocol A and Protocol B?
Certain sectors will warrant different questions. For instance, if you’re evaluating a layer 1 or layer 2 blockchain then you will want to track how much users are paying in transaction fees for blockspace and how much the blockchain network retains of those fees. However, if you’re evaluating a computation market, then you will want to understand the rate at which nodes/suppliers enter the blockchain ecosystem to provide their resources and the cost for end users. Each digital asset project has different value drivers and thus warrants different questions.
When attempting to value a token, these questions can help shine a light on whether a token is undervalued or overvalued. Ultimately, whether you are buying a share of the ships in the Dutch East India Company in 1602 or purchasing a token of a company that serves as a bank with no physical presence, the mental framework remains the same — this is just the next evolution of fundamental research.
Portfolio Theory and Management
How digital assets play a role in portfolio diversification
Let’s briefly move away from digital assets and focus on investing on a broader level. When you invest in any asset, the two important attributes to look at are expected return and volatility.
Investors will have different beliefs about the future returns of an asset. These beliefs can be represented as a probability distribution, such as a normal distribution. Using this distribution, you can determine what return you would expect “on average” or the expected return.
Once you have an idea of what return you should expect, the next aspect to consider is how “spread out” the distribution is. In other words, how much could the actual return deviate from the expected return. This can be measured using the standard deviation of the returns, also known as volatility. Volatility is a good measure for the risk of your investment — higher volatility means higher risk.
Investing in an asset involves two types of risks — idiosyncratic risk and common risk. If you were to invest in Tesla (NASDAQ: TSLA), for instance, it is exposed to risks within the firm, idiosyncratic risks, and risks outside of Tesla’s control, common risks. A product launch, for instance, is an idiosyncratic risk because its success or failure would only affect Tesla’s stock price. However, interest rates and inflation are risks that affect Tesla as well as every other company in the United States, making them common risks.
Suppose you can invest in two assets. Investment A has an expected return of 10% and volatility of 5%, and Investment B has an expected return of 12% and volatility of 10%. Which one should you choose?
It depends — the best investment depends on your individual preferences. If you are willing to sacrifice potentially higher returns for lower risk, Investment A makes more sense. However, if the higher expected return entices you, and you’re willing to stomach the extra volatility, Investment B would be the preferable choice.
Rather than simply choosing to invest in one asset, you will likely create a portfolio of multiple assets — as the saying goes, don’t put all your eggs in one basket.
For your portfolio basket, you should find an optimal combination that allows for a favored expected return while maintaining an acceptable level of risk. This is the art of diversification.
Diversification will help mitigate the effects of idiosyncratic risks, but not common risks. If you have Tesla and Amazon in your portfolio, and a Tesla product launch fails but an Amazon venture succeeds, your portfolio has smoothed out idiosyncratic risk. However, if the Fed raises interest rates, that will affect both Tesla and Amazon.
You can quantify diversification using correlation. Correlation scores range from -1 to 1:
· 1 means that the investments are perfectly correlated — when one goes up, the other goes up by the same proportion
· -1 means that the investments are perfectly negatively correlated — when one goes up, the other moves proportionally in the opposite direction
· 0 means that the investments are completely uncorrelated
Typically, the volatility of the portfolio decreases as the number of investments in the portfolio increases, although this depends on the correlation and covariance between the investments.
Once you know the assets you want to invest in, and you know the correlations between the different assets, you can assign weights to your investments and create different types of portfolios. One portfolio is the Minimum Variance Portfolio, which is the set of investments that minimizes your overall risk.
Another is the Tangency Portfolio, which maximizes your portfolio’s Sharpe Ratio. If Portfolio A has you taking 10% of risk for an expected return of 10%, but Portfolio B has you taking 10% risk for an expected return of 20%, which portfolio should you choose? Unlike earlier, this one has a clear answer — Portfolio B is the winner because it gives higher expected returns for a given level of risk. Put simply, the Sharpe Ratio measures risk-adjusted returns. The Tangency Portfolio maximizes the expected returns of your portfolio for a given unit of risk. The different portfolio types can be seen below:
Summary
Investors should include digital assets in a broader portfolio because they are uncorrelated with other major asset classes. When other asset classes trade down, gains in the digital asset sector could offset losses, and vice versa.
As an example, if all the players on a team end up playing poorly, that team is likely to lose the game. However, if even one of those players ends up performing well, such as a goalie in hockey or soccer, the team might still have a chance to win. The digital asset sector has the potential to be this “star player” in a portfolio team. Notably, it’s especially important for the coach to recognize the unique differences amongst the players, so that the appropriate players are utilized in optimal situations.
Furthermore, if over the last 18 months, your portfolio had held a significant position in Nvidia, regardless of how the other stocks in your portfolio performed, you would still likely be outperforming the S&P 500 and the NASDAQ. By that same token, if over the last decade you had allocated one percent of your total portfolio to digital assets, you would have outperformed most traditional investors with minimal downside risk to your overall portfolio, despite the volatility in digital assets.
If you would like to experiment with a portfolio tool to see how different weights of asset classes affect expected return and volatility, please email us here.
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