Building a Bridge Between Worlds
Digital assets are a new and exciting asset class. From the unmatched returns of Bitcoin, the OG of the space, to the wild swings of Dogecoin and Shiba Inu, to the vast promised land of decentralized finance (DeFi) made possible by the smart contract capability of a blockchain, it’s hard to miss the signs that there’s something new afoot. It is even harder not to have an opinion on the matter!
Differing opinions can stem from differing perspectives, and there are many perspectives from which to consider and evaluate digital assets, including but not limited to:
Prospects for various and evolving underlying technologies
Impact of decentralized autonomous organizations on business
Geopolitical implications of borderless digital currencies
Impact of tokenizing private assets
Societal implications and potential disruption of decentralization in trusted interactions
Considerations for investing in digital assets
All of these points are worthy of discussion, consideration, and analysis. To the extent all may be considerations or inputs in thinking about investing in the space, this piece will highlight important considerations for investing in digital assets.
Early investors in digital assets earned stratospheric returns in exchange for grasping the potential of the technology and their incredible patience during periods of volatility and extended drawdowns. As the digital assets space starts to mature – meaning that the number of assets to consider grows beyond a handful and more and more of the trading and investing activity is conducted by professionals – we can postulate that the state of earning outsized returns by simply investing in the top few coins won’t persist [1]. The low hanging fruit will have been picked, which means increasing effort will be required to earn extraordinary returns. No asset class is ultimately exempt from the fundamental, time-tested approach to successful investing, namely the joint consideration of risk, return, costs, and horizon. It is worth repeating and highlighting this fact as digital assets continue their evolution from a technological curiosity to a full-fledged asset class.
Taking a step back from digital assets, we can distill our seven decades plus of experience into three axiomatic insights about investing:
Investing is simple
Investing is hard
Horizon is very important
Going through these one-by-one, we start with the insight that investing is actually pretty simple, certainly much simpler than it is made out to be. Investors are pitched a myriad of choices: smart beta, active, passive, enhanced, alternative beta, exotic beta, alpha, factor tilts, style premia, and more. It is a confusing jargon soup. Thankfully, the world is much simpler! There are only three sources of investment returns: risk premia, alpha, and arbitrage. It doesn’t matter what asset class you’re considering, which manager (or DIY), whether you’re quantitative, fundamental, or technical, or what horizon … these are the building blocks. But, these three building blocks are oftentimes misunderstood, and sometimes the language surrounding investing and investment products seems deliberately designed to obfuscate this simple yet powerful insight [2].
Second, investing is much harder than it is made out to be. Matching liabilities with fixed income instruments is fairly tractable, but when we try to increase returns by taking on risk, we get many unsatisfactory outcomes, both as individual investors and as professional investors. Morningstar has been doing research on this topic for many years. For the 10 years ending June 2021, just 25% of active funds beat their passive alternatives. If you came out of the doctor’s office worse than you entered 3/4 of the time, the medical profession would be outlawed. Yet, here we are with active management!
Last but certainly not least, horizon is far less emphasized in investing than it should be. Private equity investors have a good understanding of horizon. They normally do not evaluate their investments at a frequency much shorter than the horizon of their investments. This sensible understanding is not normally the case in public markets, where the liquidity of the underlying asset class seems to be a signal for how frequently one should evaluate investments. Does it make sense to evaluate a manager with multi-year horizons on a quarterly basis, and what actionable information can you get from such an activity? The higher the IC of the manager, the more counterproductive are evaluations at a higher frequency than the forecast horizon.
Successful investors, that is, long-term successful investors, operate within a framework. It may be a simple framework, such as dollar-cost averaging and long holding periods, or it may be a multi-layered, multi-horizon proprietary framework [3], or something in between. A key advantage of having a framework, and of being disciplined about working within it, is that you naturally ignore the noise in favor of signal. A consistent philosophy and implementation mean you don’t needlessly chase the flavor of the month or buy high and sell low. As we consider the information flow surrounding the digital assets space, this comment seems quite counter to the breathlessness of minute-by-minute tweets by crypto-influencers. It is easy to get caught up in the excitement and noise of news flow, but human behavior hasn’t really changed in thousands of years, and markets are ultimately driven by human behavior [4]. Experience with appropriate and relevant frameworks for investing can be an important bridge from traditional finance (TradFi) to digital assets. Is your digital assets fund manager able to convincingly articulate their investment framework and why it is relevant?
Turning our attention from frameworks to actually investing in digital assets, we can surmise that earning the risk premium of this new asset class is simple, as implied by the first insight – simply invest in one of growing number of passive funds or ETFs. To the extent that just a handful of the largest tokens, cap-weighted, will provide well north of 60% of the market cap of digital assets, capturing a sizable portion of the risk premium is conceptually straightforward, though operations may not be as easy. Fortunately, there are a growing number of cap-weighted indexes and index funds/ETFs offered by a variety of TradFi as well as new providers; the prospective investor has choices.
If we dig a little deeper into the nature of the risk premium, there’s an important and under-discussed insight about digital assets, namely that the names which make up the top digital assets change significantly over time [5]. The important implication here is that, at this time, the underlying risk premium of the digital assets class is fairly inefficient, in terms of the cost of maintaining an exposure. Developed asset classes normally have less churn among the largest instruments which give an index its representativeness and are thus more cost-effective to index.
To the extent that the underlying risk premium is relatively inefficient, a sweet spot exists in the digital assets space for active management relative to a cap weighted index under an aligned fee structure. However, we still must reckon with the second insight, that investing (successfully) is hard.
Active management, that is, earning alpha, requires an informational or behavioral advantage over other investors. It is a competitive endeavor which starts with domain knowledge. In conventional asset classes, domain knowledge of accounting (for financial statement analysis), statistics, MBA-level business courses, and data science capabilities are the table stakes for active management research [6]. That knowledge is not, however, sufficient for active investing [7] in digital assets.
The information required to assess digital assets either individually or in the cross-section is distinct as compared to that required to assess analog assets. Beyond market and trading data, information such as project whitepapers, developer activity, user adoption, decentralization and scalability, and yes, Reddit sentiment play a part in evaluating digital assets. The great news is that more and more of the market- and ecosystem-related data is being made available in a consistent format. In fact, there is so much information available [8] that we run the risk of overload, or worse, overfitting. Thankfully, seasoned quants from the TradFi space have experience with big data, data science, and avoiding overfitting, and that experience is something that potential investors in the digital assets space should be looking for. It’s an important bridge between TradFi and digital assets investing.
Moving from quantitative analysis of data to more fundamental analysis of information, we can ask, what are the conduits for information? An equity security analyst will read news, analyze financial statements, evaluate competitors in the industry as well as partners in the upstream and downstream supply chain, analyze target markets, search for idiosyncratic data, and interview company management and other stakeholders. It’s a blend of combining the top-down information (news, filings, supply chain, etc.) with synthesis of bottom-up details (interviews with stakeholders, idiosyncratic data, etc.) to arrive at insights different from the status quo.
To really understand the rapidly evolving world of digital assets, the alpha-seeking investor needs to actively participate in the ecosystem – set up and use hardware and software wallets, participate on global exchanges, use and vote on various protocols, stake, yield farm, and meet, speak, and possibly work with founders, inventors, and users around the world, especially in places where the use of digital assets, particularly cryptocurrencies, can be a life-changing edge against hyperinflation of fiat currencies, or high fees for money transfer. These participatory activities provide the earliest view into the bottom-up information to be synthesized and then combined with the top-down information to create an informational advantage. Importantly, it is a critical part of risk management. Large issues with investments start as small issues and if you can catch them while they are small issues, portfolio performance can be preserved.
Anyone can easily read the front-page news. It takes more effort to be the first to spot the page 10 news that will soon become front page news. Understanding what is necessary for developing fundamental insights and matching that with deep knowledge of the detailed workings of digital assets is another important bridge between TradFi and digital assets. Ask your digital assets active manager about their on-going participation in the ecosystem.
Finally, we come to the third insight – the importance of horizon. To put a finer point on it, being very explicit and specific as to the forecast horizons associated with each of your investments and to act at frequencies commensurate with that horizon. Most seasoned investors have developed a set of heuristics, including a sense of the “rhythm” of big global markets – generally moving up, with periodic crashes and the occasional bear market. Risk premia investors are used to be being in positive territory for longer periods of time than underwater. As with so many aspects of investing, digital assets challenge our heuristics. Long-term investing has been profitable in the digital assets space, but the characteristic nature of how those returns are generated is far more episodic as compared to the markets with which most investors are familiar. A successful digital assets passive investor may spend most of their time in a drawdown, depending on when they invested. If you’re a true long-horizon investor, patience provides the opportunity to earn once-in-a-generation returns. If you’re easily spooked by drawdowns, this can be a recipe for disappointment. Being thoughtful and deliberate about which heuristics from TradFi are brought to investing in digital assets will help build a stronger bridge between the worlds.
Investing in digital assets is a new and exciting area for allocators and investors looking to diversify their portfolios and to participate in what looks to be a new risk premium. As new as it seems, it is important to remember that the space is not outside the requirement for successful investors to jointly consider risk, return, cost, and horizon in their investment research and portfolio construction. Many people in TradFi have deep skills and experience with this approach yet may lack sufficient domain knowledge and ecosystem participation to mirror their abilities and outcomes of TradFi security research. Many people in the digital assets space have yet to develop deep investment experience, particularly portfolio construction taking into account risk and cost. An ideal investment team in this space brings together a team with experience that bridges the worlds of TradFi and digital assets, including people with both experience sets.
Notes & Sources
As long as the top few coins continue to constitute a majority of the market cap of the space, cap-weighting them is a viable way to earn the risk premium of the digital assets space.
See Jay Vyas’s paper “Sources of Investment Returns”
Unsuccessful long-term investors may have an overfitted framework which they mistakenly interpret to be sophisticated.
Possibly as programmed into algorithms as well.
To the extent one chooses to index the top, say, 500 digital assets, the in/out impact of the churn may be limited, but the cost/complexity of building the portfolio may be prohibitive.
Of course, this has to be combined with curiosity, a willingness to challenge the status quo, attention to detail, initiative, and enthusiasm, which are talents rather than skills.
With a clear distinction between investing strategies and trading strategies. The latter can be built and deployed with less accounting and business knowledge, particularly at higher frequencies.
Coverage at coinmarketcap.com (for example) shows the number of instruments nearly basically doubling the past four years, to over 16,200 currently. Each one of these instruments may have hundreds of relevant metrics (raw or derived) spanning social, chain, development, and applications, spanning multiple markets. Some of these variables have the frequency of tick data.