Crypto as an asset class: What investors need to know
Crypto as an asset class: What investors need to know | Image by Nigel Tadyanehondo
Cryptocurrencies, initially perceived as speculative instruments suited only for tech enthusiasts and high-risk investors, have evolved into legitimate contenders within global asset allocation strategies. Today, major financial institutions, hedge funds, governments, and family offices actively engage with digital assets, underscoring a significant paradigm shift in the investment landscape.
As cryptocurrencies continue to gain broader acceptance, investors increasingly question their long-term role in the financial ecosystem. Is cryptocurrency merely a fleeting trend, or does it represent a genuinely viable and enduring asset class comparable to stocks, bonds, or commodities?
While proponents highlight substantial benefits such as diversification opportunities and the potential for significant returns, skeptics remain cautious due to inherent volatility and evolving regulatory environments.
Consequently, discerning the precise positioning of cryptocurrencies within portfolio allocation strategies and appropriately quantifying exposure levels have become pivotal considerations for institutional and private investors alike.
What Is an Asset Class?
To assess cryptocurrencies as a distinct asset class, it is crucial to define an asset class first. In traditional finance, an asset class is a group of investments that behave similarly in the market and have similar risks and returns. Conventional asset classes include, among others:
- Public equities: Ownership in publicly traded companies, offering capital appreciation and income through dividends. Public equities are highly liquid and are traded on exchanges like NYSE or NASDAQ.
- Fixed income: Includes government and corporate bonds. These instruments provide regular interest payments, lower volatility, and usually lower returns.
- Commodities: Physical goods such as gold or oil or agricultural products. Commodities are often used as a hedge against inflation and currency devaluation. They are more volatile assets, influenced by supply/demand dynamics, geopolitical events, and market speculation.
- Real estate: Ownership or investment in residential or commercial property. Real estate is valued for its potential to generate rental income and appreciate over time.
Crypto assets exhibit some traditional asset characteristics, including speculative value and market volatility. Yet, their foundational technology and decentralized nature set them distinctly apart. Unlike conventional instruments, cryptocurrencies leverage blockchain technology, providing decentralized, secure, and transparent platforms that fundamentally transform ownership and transaction processes.
Crypto as a New Asset Class: Key Arguments
As digital assets transition from speculative instruments to essential components of financial strategies, several compelling arguments highlight their emergence as a distinct and credible asset class:
- Decentralization and market independence: Digital assets operate independently from traditional financial systems and central banks, potentially providing a hedge against conventional economic risks.
- Volatility and speculative opportunities: High volatility presents significant opportunities for substantial returns, although accompanied by heightened risk.
- Technological growth drivers: The valuation of cryptocurrencies largely depends on technological advancements, adoption rates, and innovation, rather than corporate earnings or economic cycles.
- Institutional integration: Prominent institutions, such as BlackRock, Fidelity, Tesla, and MicroStrategy, increasingly integrate cryptocurrencies into their financial strategies, affirming their growing legitimacy.
- Evolving regulatory frameworks: Progressive regulatory clarity from global governments is gradually providing structure, enhancing investor confidence, and facilitating broader institutional participation.
Crypto portfolio diversification | Image by Kier in Sight Archives
Crypto Portfolio Diversification: Benefits & Risks
Cryptocurrencies offer distinctive diversification benefits due to their relatively low correlation with traditional assets like equities and bonds. Their potential for outsized returns further reinforces their attractiveness within institutional portfolios, although risk management remains essential:
- Diversification and low correlation: Cryptocurrencies often display market behaviors distinct from traditional assets, beneficially impacting portfolio diversification.
- Inflation hedge potential: Cryptocurrencies like Bitcoin, with capped supply mechanisms, serve as potential inflation hedges akin to "digital gold."
- Growth opportunities: The explosive growth trajectory of crypto assets presents significant potential for portfolio enhancement.
- Volatility and price instability: Significant short-term price fluctuations necessitate careful risk management.
- Regulatory ambiguity: Ongoing regulatory developments can significantly impact valuation and market participation.
- Security risks: Digital assets require sophisticated custody solutions to protect against cyber threats.
Crypto Asset Allocation: How Much to Invest?
Digital assets are characterized by their high return potential and low correlation with traditional assets, making them attractive from a diversification standpoint. In theory, adding an asset class that behaves differently from the existing components of a portfolio can reduce overall risk without sacrificing returns. This is particularly relevant for digital assets, which have shown both high volatility and high returns.
The low correlation between digital assets and traditional investments such as stocks and bonds implies that digital assets can move independently of broader market trends. This independence can help in mitigating risk during market downturns, potentially cushioning the portfolio from significant losses.
However, the inclusion of digital assets in a portfolio must be approached with caution. Their high volatility means that while they can enhance returns, they can also introduce significant risk. A small allocation to digital assets can have a disproportionate impact on portfolio performance, amplifying both gains and losses. For instance, a typical 60/40 portfolio (60% equities, 40% bonds) might benefit from a modest allocation to digital assets, with even a 1-5% exposure potentially enhancing returns without substantially increasing overall volatility.
A structured approach to crypto allocation considers risk tolerance, investment objectives, and market dynamics:
- Conservative allocation (1-5%): Suitable for risk-averse investors seeking minimal exposure.
- Moderate allocation (5-10%): For balanced risk-taking investors diversifying across leading cryptocurrencies and stablecoins.
- Aggressive allocation (10%+): Designed for investors confident in cryptocurrencies’ long-term prospects, diversifying across Bitcoin, Ethereum, and innovative assets within decentralized finance (DeFi), meme coins, and NFTs.
Small Allocation, Significant Impact: Incorporating even a modest digital asset exposure into a traditional 60/40 portfolio can enhance returns and improve diversification, leveraging Impatheir low correlation and high return potential.Period of analysis 31-Dec-2019 - 31-Dec-2024. Performance metrics based on monthly returns. *) Portfolio assumes 60% S&P 500 TR and 40% S&P U.S. Aggregate Bond TR, proportionally scaled to include BTC allocation (e.g., 60/40 + 10% BTC = 54% equities, 36% bonds, 10% BTC). Source: Google Finance, S&P
How to Include Crypto in Your Portfolio
Institutional investors have multiple pathways to crypto asset exposure:
- Direct investments: Utilizing established cryptocurrency exchanges and secure custody providers.
- Crypto ETFs and funds: Gaining indirect exposure through regulated investment products.
- Active managers: Leveraging specialized crypto-focused investment managers who actively select, trade, and manage digital asset portfolios to optimize returns and manage risk.
- Derivative instruments: Engaging in advanced financial strategies through futures and options markets.
- Passive income strategies: Capitalizing on blockchain networks via staking and yield farming for income generation.
The Future of Crypto as an Asset Class
As digital assets continue to transition from speculative instruments to integral financial tools, key developments shaping their institutional adoption include:
- Deepening institutional involvement: Accelerated adoption by major financial firms, embedding cryptocurrencies within mainstream investment portfolios.
- Regulatory maturation: Increasingly clear regulatory frameworks enhancing market stability and investor protection.
- Technological innovation: Continued advancements in blockchain technology and decentralized financial ecosystems, expanding crypto’s utility and market significance.
Conclusion
The institutionalization of cryptocurrencies marks a pivotal moment in financial history, reflecting the broader evolution of money itself. Digital assets offer innovative solutions to traditional finance’s limitations—transparency, efficiency, and decentralization—positioning themselves as integral components of contemporary and future financial systems.
For institutions and family offices, the primary consideration now lies not in whether to incorporate crypto into portfolios but in how to strategically manage exposure to optimize risk-adjusted returns within this emergent asset class.
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The full breakdown
In our first article, "Navigating Crypto Volatility: The Advantages of Active Management," we explored how the high volatility and low correlation of digital assets with traditional asset classes create unique opportunities for active managers. We discussed how these characteristics enable active managers to execute tactical trading strategies, capitalizing on short-term price movements and market inefficiencies. Building on that foundation, we now turn our attention to the unique market microstructure of digital assets.
Conducive market microstructure of digital assets
The market microstructure of digital assets - a framework that defines how crypto trades are conducted, including order execution, price formation, and market interactions - sets the stage for active management to thrive. This unique ecosystem, characterized by its continuous trading hours, diverse trading venues, and substantial market liquidity, offers several advantages for active management, providing a fertile ground for sophisticated investment strategies.
24/7/365 market access
One of the defining characteristics of digital asset markets is their continuous, round-the-clock operation.
Unlike traditional financial markets that operate within specific hours, cryptocurrency markets are open 24 hours a day, seven days a week, all year round. This continuous trading capability is particularly advantageous for active managers for several reasons:
- Immediate response to market events: Unlike traditional markets that close after regular trading hours, digital asset markets allow managers to react immediately to breaking news or events that could impact asset prices. For instance, if a significant economic policy change occurs over the weekend, managers can adjust their positions in real-time without waiting for markets to open.
- Managing volatility: Continuous trading provides more opportunities to capitalize on price movements and volatility. Active managers can take advantage of this by implementing strategies such as short-term trading or hedging to mitigate risks and lock in gains whenever market conditions change. For instance, if there’s a sudden drop in the price of Bitcoin, managers can quickly sell their holdings to minimize losses or buy in to capitalize on the lower prices.
Variety of trading venues
The proliferation and variety of trading venues is another crucial element of the digital asset market structure. The extensive landscape of over 200 centralized exchanges (CEX) and more than 500 decentralized exchanges (DEX) offers a wide array of platforms for cryptocurrency trading. This diversity is beneficial for active managers in several ways:
- Risk management and diversification: By spreading trades across various exchanges, active managers can mitigate counterparty risk associated with any single platform. Additionally, the ability to trade on both CEX and DEX platforms allows managers to diversify their strategies, incorporating different levels of decentralization, regulatory environments, and security features.
- Arbitrage opportunities: Different venues often exhibit price discrepancies, presenting arbitrage opportunities. For example, managers can buy an asset on one exchange at a lower price and sell it on another where the price is higher, thus generating risk-free profits.
- Access to diverse liquidity pools: Multiple trading venues provide access to diverse liquidity pools, ensuring that managers can execute large trades without significantly impacting the market price.
Spot and derivatives markets (Variety of instruments)
The seamless integration of spot and derivatives markets within the digital asset space presents a considerable advantage for active managers. With substantial liquidity in both markets, they can implement sophisticated trading strategies and manage risk more effectively.
For instance, as of August 8 2024, Bitcoin (BTC) boasts a daily spot trading volume of $40.44 billion and an open interest in futures of $27.75 billion. Additionally, derivatives such as futures, options, and perpetual contracts enable managers to hedge positions, leverage trades, and employ complex strategies that can amplify returns.
Overall, the benefits for active managers include:
- Hedging and risk management: Derivatives offer a powerful tool for hedging against unfavorable price movements, enabling more efficient risk management. For instance, a manager holding a substantial amount of Bitcoin in the spot market can use Bitcoin futures contracts to safeguard against potential price drops, thereby enhancing risk control.
- Access to leverage: Managers can use derivatives to leverage their positions, amplifying potential returns while maintaining control over risk exposure. For instance, by employing options, a manager can gain exposure to an underlying asset with only a fraction of the capital needed for a direct spot purchase, thereby enabling more capital-efficient investment strategies.
- Strategic flexibility: By integrating spot and derivatives markets, managers can implement sophisticated strategies designed to capitalize on diverse market conditions. For instance, they may engage in volatility selling, where options are sold to generate income from market volatility, regardless of price direction. Additionally, managers can leverage favorable funding rates in perpetual futures markets to enhance yield generation. Basis trading, another strategy, involves taking offsetting positions in spot and futures markets to profit from price differentials, enabling returns that are independent of market movements.
Exploiting market inefficiencies
Digital asset markets, being relatively nascent, are less efficient compared to traditional financial markets. These inefficiencies arise from various factors, including regulatory differences, market segmentation, and varying levels of market maturity. For example:
- Pricing anomalies: Phenomena like the "Kimchi premium," where cryptocurrency prices in South Korea trade at a premium compared to other markets, create arbitrage opportunities. Managers can exploit these by buying assets in one market and selling them in another at a higher price.
- Exploiting mispricings: Active managers can identify and capitalize on mispricings caused by market inefficiencies, using strategies such as statistical arbitrage and mean reversion.
The unique aspects of the digital asset market structure create an exceptionally conducive environment for active management. Continuous trading hours and diverse venues provide the flexibility to react quickly to market changes, ensuring timely execution of trades. The availability of both spot and derivatives markets supports a wide range of sophisticated trading strategies, from hedging to leveraging positions. Market inefficiencies and pricing anomalies offer numerous opportunities for generating alpha, making active management particularly effective in the digital asset space. Furthermore, the ability to hedge and manage risk through derivatives, along with exploiting uncorrelated performance, enhances portfolio resilience and stability.
In our next article, we'll delve into the various techniques active managers employ in the digital asset markets, showcasing real-world use cases.
