Don’t Forget Important TradFi Lessons!
October 2023 Commentary
And just like that, the winter is over. Due to some combination of possible regulatory clarity, hoped-for spot ETF approvals, and fading memories of traumatic events, investors seem to be paying some attention to the digital assets space.
In addition to, and possibly related to the reasons just stated, returns are also demanding and commanding attention: as of October 31, 2023, the Bitwise 10 Large Cap Crypto Index is up 84% YTD, Bitcoin is up close to 109%, and Ether is up 52%. For comparison, according to data by S&P Dow Jones Indices, the S&P 500 total return is up by just 11%, while US Treasury Bonds are down by –2% and emerging market equities are essentially flat.
It’s no wonder that people are once again looking at and talking about digital assets!
YTD as of 31-Oct-2023.
Sources: Firinne Capital, Coingecko, Bitwise 10, S&P Dow Jones Indices
While we’re pleased to see increased activity and interest in digital assets investing, we think it is unfortunate that investors seem to be ignoring a number of important best practices from TradFi.
What best practices are we referring to?
First, invest! If you want to earn the returns from risk premia, you need to have exposure to those risk premia. In this case the risk premium is the asset class beta for digital assets. To gain that exposure, you actually need to be in the market. Given recent performance, it’s not surprising that there is greater investor interest in crypto, but many of those interested investors unfortunately missed this year’s performance. It’s possible some investors were waiting for a “safer” entry point than over the past couple years when there was plenty of uncertainty. We’ll just say that trying to time markets is generally a fraught activity, even for professionals. According to research from 21e6 Capital, crypto funds across the board underperformed in the first half of 2023 due to larger-than-normal cash positions.
Second, there is an established way to diversify away the risk of investing at the wrong time, namely dollar cost averaging. This important systematic approach from TradFi has investors buying more units at low prices and fewer at higher prices and diversifies entry points over time. It also removes the fear of investing at times of distress which is often the best time to invest. This disciplined approach has a lot of merit as investors look to allocate to digital assets.
Third, the importance of asset diversification, as a complementary approach to the time diversification just discussed. At this point, Bitcoin does seem synonymous with digital markets due both to its size and prevalence in the news headlines. Its performance has also dominated other large tokens this year.
Unless you think that Bitcoin’s dominance will continue to grow – which is certainly a possibility in the short term – investing in a diversified basket of tokens that broadly represents the market allows an investor to participate in the growth of altcoins as the space matures with close to no work on their part. How is it no work? Because investors can access index funds such as the aforementioned Bitwise 10 Large Cap Crypto Index and others. We’ve also written about the case for active management in the digital assets space - investors have the opportunity to earn both the asset class risk premium as well as alpha on top of that.
Fourth and finally, the importance of rebalancing strategic portfolio allocations. For investors whose allocations are roughly cap-weighted across asset classes, their portfolio is self-rebalancing. For investors whose allocations are based on risk contribution or policy (for example) the recent outperformance in digital assets should be a trigger to analyze whether portfolio rebalancing is called for.
Related to the first point, having exposure to risk premia, we at times find ourselves in discussions with individuals and organizations with a purported interest in gaining exposure to digital assets, yet their primary interest is in market-neutral strategies. We politely point out that, by definition, you don’t have exposure to digital assets if you’re market neutral. Market-neutral strategies are sometimes called “portable alpha” because the investor can port the alpha on top of whichever asset class beta they desire.
If your digital assets manager is not having discussions with you along these dimensions, it may be that they don’t have the necessary and valuable understanding of best practices in investment management which come from TradFi. These best practices are fully applicable and relevant to investing in digitals assets.
Crypto is a new asset class for investors, and investors will be enriched by ensuring they don’t leave TradFi best practices behind as they enter and participate in the space.