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The active management toolbox: Essential strategies for digital assets | Image by Unsplash
Active management is key to maximizing returns in the dynamic world of digital assets. In our previous articles, we explored the role of active management in leveraging market volatility and the unique market microstructure of digital assets. Now, we turn our attention to the core techniques that empower active managers to achieve superior risk-adjusted returns.
Active managers utilize a diverse array of investment management techniques tailored to the unique characteristics of digital assets. In particular,
- Trend-Following: Systematically identifying and investing in sustained price movements, both upward and downward, to generate returns.
- Derivatives Strategies: Employing options and futures contracts to hedge against price volatility, accumulate coins or express views on future price movements.
- Risk Management: Deploying sophisticated risk management practices to safeguard investments such as position sizing, stop loss orders, and hedging.
Let’s explore each of these techniques and how they collectively contribute to a robust and successful investment strategy in the digital asset space. To learn more about the role of active management in digital assets, download the whitepaper "The Role of Active Management: The Next Step in Investing in Digital Assets”
Trend-Following: Capitalizing on market momentum
What it is:
Trend-following strategies are investment strategies that identify and capitalize on sustained price movements, profiting from both upward and downward trends.
Key benefits:
This strategy optimizes returns while mitigating risk by dynamically adjusting to market conditions, delivering uncorrelated performance that stabilizes portfolio volatility.
Impact on portfolio construction:
Adding a trend-following on cryptocurrencies strategy to a traditional 60/40 portfolio boosts diversification and provides dynamic flexibility, improving overall risk-adjusted returns.
Trend-following strategies thrive on the principle of momentum—once prices begin moving in a particular direction, they often continue in that trajectory for some time. Active managers leverage this by systematically identifying and riding these sustained price movements, whether the market is trending upward or downward.
This approach relies on careful analysis of momentum indicators, such as the 30-day momentum signal often used with assets like Bitcoin. For example, if Bitcoin’s price has shown a steady increase over the past 30 days, an active manager might initiate a long position, anticipating that the upward trend will persist. Conversely, if the price has been on a downward trajectory, the manager might take a short position, aiming to profit as the decline continues.
Annualized information ratio (IR)**
*Hypothetical simulated performance results have certain inherent limitations. There is no guarantee that the market conditions during the past period will be present in the future. **Information ratio: Defined differently from standard finance definitions to mean just the (Average annual return x SQRT (12) / (Standard deviation of monthly returns) and not taking into account returns relative to a benchmark. IR in this context just indicates how much return an investment generates relative to the amount of risk taken. A higher information ratio implies better performance relative to risk.
Enhancing a 60/40 portfolio with Trend-Following strategies
Integrating trend-following strategies into a traditional 60/40 portfolio—60% equities and 40% bonds—can significantly boost performance by enhancing returns and reducing risk. While the 60/40 portfolio balances growth and stability, adding trend-following strategies, especially in digital assets, optimizes this mix.
- Better risk-adjusted returns: Trend-following strategies capture sustained price movements, independent of traditional asset classes, enhancing portfolio performance, particularly when equities or bonds underperform.
- Risk reduction: These strategies adapt to market conditions by shifting between long and short positions, providing protection against downturns and reducing overall volatility.
- Diversification: Trend-following introduces uncorrelated returns, offering valuable diversification that smooths portfolio performance, especially during market stress.
- Dynamic management: The inclusion of trend-following allows for more tactical flexibility, with active managers adjusting exposure based on market trends, improving risk-adjusted returns over time.
Derivatives strategies: Enhancing returns with options and futures
What it is:
Derivative strategies involve using financial instruments whose value is tied to an underlying asset, like Bitcoin. One common approach is volatility selling, where traders capitalize on market fluctuations by writing options. Specifically, selling put options allows investors to generate income from the option premiums, benefiting from periods of heightened volatility. This strategy also positions them to acquire assets like Bitcoin at a discount if prices dip below the option's strike price, effectively turning market downturns into buying opportunities.
Impact on portfolio construction:
Volatility-selling strategies balance income generation with risk management, protecting holdings during market volatility while still offering opportunities for growth.
Actively managed derivatives strategies, particularly those involving options, offer a sophisticated approach to generating income while managing risk. A prime example is the use of put options in volatility-selling strategies. Here, active managers systematically write put options, which provide the buyer the right to sell Bitcoin for example at a predetermined price. This strategy is particularly appealing to investors who already hold assets and are looking to generate additional yield on their existing holdings.
BTC accumulation (max notional exposure of 65% of AUM)
Volatility-selling strategies
By selling put options, managers collect premiums, providing a steady income stream. If Bitcoin’s price remains stable or rises, the options expire worthless, and the manager retains the premium, effectively enhancing returns without requiring any additional investment in Bitcoin. On the other hand, if the price of Bitcoin falls, the put options may be exercised, allowing the manager to acquire more Bitcoin at a lower price. This not only preserves capital but also potentially adds to the investor’s Bitcoin holdings at a discount, creating opportunities for future gains.
Balancing returns and risk
This strategy is particularly effective in managing risk during periods of market volatility. By prioritizing capital preservation and systematically generating yield, volatility-selling strategies offer a balanced approach that protects digital assets holdings from significant downside while still providing opportunities for income. It’s a way to make market volatility work in favor of the investor, turning potential risks into strategic advantages.
Maximum drawdown of volatility-selling strategies
Risk management: Ensuring investment security with strategic precision
What it is:
Risk management involves applying market expertise, strategic thinking, and continuous monitoring to safeguard investments, particularly in the volatile digital assets space.
Key benefits:
Effective risk management protects against rapidly downside risks through strategies like hedging and liquidity management, while real-time data monitoring allows for swift adjustments to market changes.
Impact on portfolio construction:
By understanding risks, active managers ensure portfolios are not taken unintended and remain secure, resilient, and well-positioned to capitalize on opportunities in dynamic market conditions.
Effective risk management is the cornerstone of successful investing, particularly in the volatile and rapidly evolving world of digital assets. Active managers apply a combination of market expertise, strategic thinking, proactive decision-making, and continuous monitoring to safeguard investments and optimize returns. Here’s how they do it:
In-depth understanding of market dynamics
Active managers have a deep understanding of the dynamic and rapidly evolving crypto markets, allowing them to anticipate and mitigate any unintended risks effectively. They are well-versed in the unique risk profiles of various cryptocurrencies, enabling informed risk management decisions.
Risk management strategies
To protect against the inherent risks of digital assets, active managers employ a variety of strategies:
- Hedging: By using derivatives like options and futures, managers can hedge against potential adverse moves. For instance, they might use options to lock in prices, thereby protecting the portfolio from extreme market movements. This strategy not only shields the portfolio from losses but also provides a safety net during periods of heightened volatility.
- Liquidity management: Ensuring sufficient liquidity is another critical aspect of risk management. Active managers strategically maintain adequate liquidity to meet potential redemption requests or quickly capitalize on sudden market opportunities without being forced to sell assets at a loss. This approach ensures that the portfolio remains flexible and responsive, even in turbulent market conditions. Effective liquidity management protects the portfolio from liquidity crises and allows for tactical allocation changes as market conditions evolve.
- Prudent leverage: Active managers strategically employ prudent leverage to amplify returns and capitalize on specific market opportunities without disproportionately increasing risk. By carefully controlling leverage, they invest in high-conviction investment ideas at opportune moments. Strict risk management ensures borrowed capital enhances performance while keeping risk within acceptable boundaries. This approach makes portfolios more dynamic and responsive, leading to superior returns.
Continuous monitoring and real-time data
Risk management in the digital asset space requires more than just a set of static strategies—it demands continuous monitoring and real-time responsiveness. Active managers leverage advanced data analytics and proprietary systems to monitor market conditions and portfolio performance in real-time. This real-time data allows them to make swift adjustments to the portfolio, responding proactively to emerging risks. Additionally, they track key performance metrics and risk indicators such as volatility and drawdowns. By keeping a close eye on these metrics, managers maintain a comprehensive understanding of the portfolio’s risk profile at all times, ensuring that it remains aligned with the overall investment strategy and risk tolerance.
Active management plays a crucial role in navigating the complexities and opportunities of the digital asset market. By employing investment management techniques such as trend-following strategies, derivatives, and dynamic risk management, active managers can significantly enhance portfolio performance while effectively mitigating risks. These tailored approaches ensure that your investments are not only protected but also positioned to capitalize on market opportunities, regardless of volatility.
For investors seeking to optimize their digital asset portfolios, active management offers a pathway to superior risk-adjusted returns, enhanced diversification, and strategic flexibility. Whether you're looking to generate yield, protect your assets, or dynamically adjust your portfolio to market conditions, the expertise of active managers can be a game-changer. Connect with us to learn how our active management solutions can help you achieve your financial goals in the dynamic world of digital assets.
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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.
