Sovereign wealth funds, family offices, private equity funds, VCs and UHNWIs, worldwide interest of digital asset class is growing, still lot of questions are arising about risks associated with volatility, returns, and to which extend digital asset allocation should be integrated in a strategy of diversification.

Digital assets have been attracting more and more attention from both retail and institutional investors around the world, especially cryptocurrencies thanks to a much improved regulatory environment.

They have become increasingly accessible by those institutional investors looking to diversify their portfolios. Today’s consideration to include digital assets can be compared to hedge funds appearing in the pension funds’ allocation in the 90s or, more recently, to Emerging Markets BRIC (Brasil, Russia, India, China) investments in the early 2000s

Its diversification power and low correlation to traditional asset classes may explain the success of this relatively new asset class.

A non-traditional Asset Class

Very rarely a new asset class does not conform to traditional behaviours. One can attempt to make predictions on how equity and debt markets will react to different market events and influences such as geopolitical and credit risks, corporate earnings, GDP reports, monetary and fiscal policies, etc…

With digital assets, values are derived from a different panel of drivers namely utility function, cap supply, volatility of digital coins, adoption of the Blockchain / Protocol etc… Those drivers ultimately affect crypto-asset correlations to traditional assets and can strategically be used to help diversify an investment portfolio.

Cryptocurrencies are materially different from traditional fiat currencies in that fiat are subject to predefined monetary policy. However, we notice cryptos, such as Bitcoin (BTC), are being priced more according to their utility as well as their capped supply and growing demand. Demand is directly linked to an asset’s utility function: the higher the utility, the greater the demand. And, unlike fiat currencies, there is only a predefined supply of Bitcoin.

Regulators’ acceptance of crypto-assets is increasing. Many jurisdictions have begun building regulatory frameworks for the issuance and trading of such assets. In addition, this growing acceptance has fueled a boom in digital infrastructure developments.

The recent Sovereign Ordinance in Monaco No. 8.258 of September 18, 2020 implementing the Bill No. 1.491 of June 23, 2020 relating to token offering, allows a digital platform to issue, register, store, and transfer tokens. Last June, the government of Monaco has formalized a Memorandum of Understanding with Tokeny Solutions as its technology provider to support the issuance of tokenized financial instruments.

Major financial institutions have launched offerings including cryptocurrency trading and custody platforms, making such assets a more secure investment.

As we know with traditional banking and investments, the security of trading platforms and the custody of assets (referred to as “wallets” in the digital asset space) is as important as the value of the asset itself; the asset cannot exist and be widely accepted without a safe and secure infrastructure and a clear regulatory framework.

Digital assets Diversification Power

According to Investopedia, “Modern portfolio theory (MPT) asserts that an investor can achieve diversification and reduce the risk of losses by reducing the correlation between the returns of the assets selected in the portfolio. The goal is to optimize the expected return against a certain level of risk.”

This makes digital assets especially attractive since their correlation with traditional asset classes is low. While digital assets have a reputation of being highly volatile, their weak correlation with other asset classes makes them excellent diversifiers. A small allocation in digital assets could significantly decrease the risk of a broader and traditional “60/40” portfolio, as example.

From the table below, it appears digital assets have little correlation to traditional assets over the long run.

All correlations are calculated using the daily performances from 31 Dec 2016 to 31 Aug 2020. Data are labelled in USD, sourced from CryptoCompare for digital assets and Alpha-Vantage for other market data.

List of assets: iShares MSCI World Index ETF, SPDR S&P 500 ETF, SPDR EURO STOXX 50 ETF, iShares MSCI Emerging Markets Index, Xtrackers Harvest CSI 300 China A-Shares ETF, SPDR Gold Trust, United States Oil Fund, iShares 20+ Year Treasury Bond ETF, iShares Core U.S. Aggregate Bond ETF, Bitcoin (BTC), Ether (ETH), Ethereum Classic (ETC), Litecoin (LTC), Monero (XMR), Ripple (XRP), Euro, UK Pound Sterling, Swiss Franc, Chinese Yuan, Japanese Yen, Russian Ruble.

Bitcoin (BTC) is obviously the most popular digital asset among institutional investors but many of them are also exploring investments into more sophisticated products such as crypto indices.

For Laurent Barocas, former Bloomberg senior manager, and head of index solutions at Trakx – the crypto traded indices platform backed by Consensys:

“Including a small proportion of Crypto Traded Indices (CTI’s) in a portfolio offers a more favourable Sharpe Ratio than direct BTC investment, and thus a potentially higher portfolio return in a more controlled risk environment and guarantee greater diversification.

By observing market interest from an ever increasingly diverse group of investors, even including sovereign entities, one can imply digital assets will play a large role in the future of financial markets.”

Trakx is not the only institution with such beliefs. Reports from Bitwise Asset Management and Fidelity Digital Assets have consistently argued for an increase in adoption of digital assets by institutional investors.

Highly regulated entities have already entered the space. It is therefore expected that less regulated entities such as hedge funds and family offices will jump on the trend and adopt it at an even faster pace very shortly.

Digital assets are becoming an indispensable part of some institutional investor’s portfolio construction. Those taking the step are considering that adding a digital allocation, such as Bitcoin, in an investment portfolio can potentially result in significantly increased returns.

This addition does present some risks associated with added volatility, that qualified investors mitigate through diversification and use of the Sharpe Ratio to guide and construct a portfolio that fits individual risk/rewards requirements.

Article : Joana Foglia – interview Laurent Barocas – Trakx