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Navigating crypto volatility: the advantages of active management

News

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July 22, 2024

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XBTO

Navigating crypto volatility: the advantages of active management | Image by XBTO

Navigating crypto volatility: the advantages of active management | Image by XBTO

TL;DR: In the evolving digital asset markets, active management is essential for optimizing returns and mitigating risks. With high volatility and low correlation to traditional assets, digital assets offer unique opportunities for active managers, who can leverage these characteristics for alpha generation, diversification, and risk management. For more insights, download the white paper "The Role of Active Management: the next step in investing in digital assets”.

In the dynamic world of digital assets, active management has become increasingly crucial for investors aiming to achieve optimal returns while mitigating risks. Digital assets, characterized by their high volatility and low correlation with traditional assets, offer distinct opportunities that are well-suited for active management strategies.

The DNA of digital assets: high volatility and low correlation

One of the most defining features of digital assets like cryptocurrencies is their high volatility. This volatility can be daunting for some investors, but for skilled active managers, it represents a significant opportunity to generate alpha. By capitalizing on price movements and leveraging short- to medium-term trends, active managers may achieve superior returns.


Moreover, the low correlation between digital assets and traditional asset classes such as stocks and bonds provides a valuable diversification benefit, facilitating the balance of losses and gains across different asset classes and enhancing overall risk-adjusted returns.

High volatility, high opportunity

Many investors are daunted by crypto assets because of their high volatility. The volatility of crypto assets is relatively high compared to traditional asset classes such as equities, gold and other commodities.

digital asset management strategy: volatility of bitcoin vs. traditional assets


A recent survey by Fidelity among institutional investors also identified high volatility as the No. 1 most-cited barrier keeping investors from allocating to crypto assets. However, it is important to recognize that high returns are inherently accompanied by volatility. In other words, growth inherently entails volatility.

For active managers, this same volatility represents an opportunity. With the right strategies, they can take advantage of the frequent price movements to generate alpha.They utilize this volatility to execute tactical trading strategies, identifying and exploiting market inefficiencies. By doing so, they can capture price movements that may not be evident to passive investors.

Risk-return tradeoff

Skilled active managers can capitalize on volatility  through tactical trading and by identifying short & medium-term trends.

For instance, they may engage in arbitrage opportunities, where they buy an asset at a lower price on one exchange and sell it at a higher price on another, locking in risk-free profits. Additionally, active managers can capitalize on short-term price dislocations, taking advantage of temporary mispricings in the market.

Sector rotation strategies are another tool active managers deploy to take advantage of cyclical trends within the digital asset market. By shifting investments between different sectors based on market cycles, they can optimize returns. For instance, they might invest more heavily in DeFi projects during a period of high sentiment, and then rotate to NFT-related assets as market interest shifts.

Moreover, active managers might employ momentum trading to benefit from prevailing market trends. By following the direction of the market's momentum, they can ride the upward or downward trends to maximize returns. On the other hand, they might use contrarian approaches to invest in undervalued assets during market downturns, buying when others are selling to capitalize on future recoveries.

Diversification

Including cryptocurrencies in a portfolio can potentially enhance risk-adjusted returns due to its uncorrelated nature. Active managers adept at navigating these uncorrelated markets can provide portfolios with resilience against broader market downturns, enhancing overall risk-adjusted returns. For instance, when traditional assets underperform, active managers' allocations to cryptocurrencies can provide differentiated returns, thereby mitigating overall portfolio risk.

Moreover, during periods of market stress, active managers can tactically rebalance portfolios to include a higher proportion of uncorrelated assets, preserving capital and reducing overall volatility. By dynamically adjusting the asset mix, they ensure that the portfolio remains resilient and positioned the prevalent market conditions.

This active approach not only enhances risk-adjusted returns but also provides a buffer against the volatility inherent in both traditional and digital asset markets. Active managers’ ability to exploit the independent behavior of cryptocurrencies during market fluctuations underscores their crucial role in modern portfolio management, particularly in the evolving landscape of digital assets.

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Returns vs volatility

Bitcoin and S&P 500 returns versus volatility


Uncorrelated performance for diversification

Since 2010, cryptocurrencies have demonstrated low correlations with traditional financial assets, which enhances diversification and reduces overall portfolio risk.

This uncorrelated nature makes digital assets an attractive addition to investment portfolios, particularly for those looking to hedge against market volatility in conventional asset classes.

For instance, during periods of market stress, digital assets often exhibit price behavior that is uncorrelated with traditional markets. This uncorrelated performance enables active managers to diversify their investment strategies, thereby enhancing portfolio stability and resilience, and providing opportunities for returns during broader market downturns.

Key benefits of digital asset’s DNA:

  1. Enhanced diversification: Including cryptocurrencies in a portfolio allows for greater diversification, reducing overall risk by balancing losses and gains across different asset classes.
  2. Unique performance drivers: Cryptocurrencies often respond to different market drivers than traditional assets. Active managers can exploit these unique dynamics for alpha generation.
  3. Risk mitigation: The low correlation between digital assets and traditional assets contributes to effective portfolio risk management and stability during periods of market stress.

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Correlations with S&P 500 since 2010

Bitcoin correlations with S&P 500


Active management plays a crucial role in the digital asset market, offering investors the expertise and strategic insight needed to navigate its complexities. By leveraging high volatility, low correlation, and the unique market characteristics of digital assets, active managers can enhance portfolio resilience and achieve superior risk-adjusted returns.

In the next instalment of our series, we will delve deeper into the market microstructure of digital assets and how active managers can exploit these unique characteristics for alpha generation.

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