Digital Nugget: Constructing crypto portfolios

As institutional investment in crypto assets increases, more attention focuses on what exactly to invest in. Initially, new investment in crypto tended to flow simply to Bitcoin and increasingly to a mix of Bitcoin and Ether. Investments have even targeted a basket of crypto hedge funds or larger crypto assets without a particular theme. As crypto investor sophistication increases, there is greater interest in creating crypto portfolios based on a defined set of drivers.

What to include in a crypto portfolio?

The motivation for creating crypto portfolios is primarily exposure to a medium to long-term "megatrend" based on the new technology or portfolio diversification.

As far as exposure to the crypto megatrend is concerned, it is important to consider which market segments and asset types best express this view. Ultimately, the greatest upside is in the use cases of blockchain technology to displace or complement traditional business models across a range of industries, and the tokens of decentralised applications have the most direct link to this upside.

Native tokens of the underlying blockchain protocols (such as Bitcoin, Ethereum, etc.) also benefit from the use cases built on top of them. They also offer direct upside from the growth of the original use of cryptocurrencies as money and a store of value.

Traditional corporations active in the crypto market may have tokens or publicly traded shares in issue. These can be part of a crypto portfolio if their business is primarily crypto – but a company with a side-line in blockchain projects should not be included.

Some crypto investments, such as venture capital or long-only hedge funds, can offer excellent participation in upside, with the best of them outperforming the market, but they have reduced liquidity which may or may not suit portfolios.

Some segments of the crypto market should be excluded. Stablecoins or tokenized assets do not belong in a crypto portfolio as they track the value of other underlying assets. They do not offer exposure to the upside in the crypto market – although they do have some crypto-specific risks. NFTs also typically represent a different type of risk (e.g. art and collectibles). While their prices correlate with crypto market sentiment, they are not productive assets.

The crypto market also offers other sources of return that do not participate in the "megatrend" but may be attractive risk diversifiers. These include crypto yield and various absolute return strategies such as arbitrage.

Choice of vehicles

Directly interacting with crypto assets requires a new operational setup. Investing into instruments that offer traditional wrappers with underlying exposure to crypto may be preferable, especially initially.

The choice of the investment vehicle also depends on the investment horizon and whether the strategy involves short-term trading or medium-term buy and hold. Some investment products have real-time liquidity, others daily, and some are quite illiquid.

In addition to operational considerations and liquidity requirements, the choice of instruments should be driven by the types of views the investor is looking to express. These could range from a diversified crypto portfolio which is held over the medium term without being actively traded, to incorporating some market timing and sector rotation, to a fully actively managed portfolio of tokens.

While developing the capabilities for active token selection may take time for new entrants to the crypto market, developing views on sector drivers is within relatively easy reach of professional investors.

To the extent that investment vehicles are used, these may be passive or actively managed. The requirement for passive vehicles is to be well constructed and to reflect the underlying view accurately, sector or theme. For active investments, the skill of the manager is an additional consideration.

Constructing a portfolio

The underlying blockchain protocol layer (Bitcoin, Ethereum, etc.) still represents about three-quarters of the crypto market. However, the crypto megatrend is primarily represented by the developing use cases, and overweighting the application sectors relative to the protocol layer positions the portfolios accordingly for the medium term.

If private companies that service the crypto market are included in the portfolio (whether through their tokens in issue or through publicly traded shares), these should have a reduced weight in the portfolio as they benefit less directly.

Less liquid-directional strategies, such as crypto venture capital or long-only crypto hedge funds, can generate outperformance relative to the market if their reduced liquidity is acceptable for the strategy.

Crypto yield and absolute return strategies may be incorporated to finetune the risk/reward profile of the crypto portfolio.

Summary

Constructing a crypto portfolio involves various considerations regarding the choice of instruments, outsourcing versus developing in-house resources, and finetuning portfolios according to the risk appetite and liquidity requirements.

But the most important consideration is building the portfolio around the investment view, which may range from a diversified exposure to participate in the medium-term megatrend to more actively traded portfolios. It is reasonable to overweight the decentralised application use cases over the medium to long term, and if appropriate instruments are available, the sector investments can be rotated and timed.

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