Crypto Primer: Crypto as an asset class

Crypto Primer: Crypto as an asset class

What are the key considerations for cryptocurrencies as an asset class? This Crypto Primer article from our Sygnum Asset Management team gives a brief introduction to this developing asset class, the growth and institutionalisation of the cryptocurrency market, and the increasing interest in how crypto assets fit into an investment portfolio.

Are cryptocurrencies an asset class?

The native tokens of blockchain protocols such as Bitcoin and Ethereum are an entirely new type of asset. The underlying economic models and the risk and return characteristics of these tokens are different from those of traditional asset classes. Since the digital asset market has grown to critical mass, it is reasonable to approach it as a new asset class and consider a top-down allocation.

At the same time, the digital asset market is also replicating traditional assets and traditional business models on the blockchain. Some digital assets replicate fiat currencies, some are like equities, some generate yield, much like fixed income instruments, and others represent tangible assets such as real estate. Crypto assets that tokenize or recreate an existing asset in digital form, or those that mirror the economic model of traditional assets, can complement traditional portfolios. These assets do not form a part of the new asset class that we refer to as cryptocurrencies.

The original cryptocurrencies, native tokens of blockchain protocols, are still the largest segment of the digital asset market, and this is the market segment we refer to when we discuss crypto assets as a new asset class.

Portfolio construction considerations

As cryptocurrencies are investable assets representing an early-stage transformational technology, they offer the potential for extraordinary returns over the medium term. This makes them well suited for adding to the “high return potential/risky” portion of portfolios managed according to the Barbell methodology, with exposures at two ends of the risk spectrum.

When optimising for risk adjusted returns – which is still a dominant methodology for portfolio construction – estimating the parameters is quite challenging, because of the short history of this new asset class.

Expected returns

The hardest parameter to estimate is the expected risk premium. This is not surprising as even estimates for equity risk premium vary significantly, despite the availability of historic data going back very far.

In contrast, the crypto market has a short history, especially if we look beyond Bitcoin, and arguably, the historic returns of an emerging asset are not a meaningful guide for the future.

Looking at it from another perspective, a high potential emerging technology that is likely to be the foundational technology for much of tomorrow’s economy is likely to generate significant excess returns over time. However, estimating the likely magnitude of these returns for an asset allocation model is near impossible.

One approach might be to compare the trajectory to comparable technological leaps – such as the advent of the internet. No directly comparable investment products were available, as investments in the internet protocol itself was not possible; however, certain parallels may be found that provide some insight into a possible medium-term trajectory.

Secondly, as estimating the risk and the correlations is easier, the question can be posed in reverse: what excess return would justify an allocation to crypto assets? Assessing whether that return is reasonable and achievable may be easier than forecasting a medium-term risk premium for crypto assets.

Risk

As volatility is a function of market structure, market participants and liquidity, it is easier to forecast. Historic volatility is a reasonable starting point, and changes in the factors that drive volatility over the mid to long-term are easier to foresee.

Generally, the volatility of new assets tends to decline over time; and the changes as the crypto market matures also point in that direction.

Correlation to other asset classes

Correlation between assets is determined by the factors driving the economic value for the assets, the market participants, and their perspectives.

Historically, the crypto market has been largely uncorrelated to other asset classes, because the drivers were mostly idiosyncratic factors, and market participants did not overlap with the traditional markets.

The institutionalisation of crypto is likely to mean that it will correlate more with risk assets. At the same time, several of the key drivers for the crypto market will remain idiosyncratic (technology innovation, regulation, and security issues), limiting correlation with other asset classes.

Allocating to different types of crypto assets

Tokens that directly entitle the holder to the revenues or profits of a platform are like equity or venture capital investments, depending on the maturity of the project. It makes sense to consider these as alternatives to comparable investments.

Similarly, certain crypto assets or strategies provide yield, and can be considered as alternatives to fixed income investments.

Tokenized assets are digital representations of the underlying asset; and they can be considered in portfolios, if they offer an advantage in terms of valuation, access, or liquidity.

Tokenization also allows access to previously hard-to-own assets for investment with fractional ownership of artworks or other assets; and it can provide access to new sectors, such as tokenizing an athlete’s contract, widening the investable universe.

Finally, crypto hedge fund strategies can generate vastly superior returns relative to their counterparts in traditional markets; and hedge fund portfolios often benefit from adding an allocation to crypto hedge funds.

Key to remember

The evolution of cryptocurrencies as an asset class today presents a variety of opportunities for investors, including portfolio considerations and alternative sources of return and diversification.

The evolution of crypto assets has born a new investable asset class that investors can use to diversify and enhance portfolios. Meanwhile, different types of digital assets offer opportunities to improve returns in traditional equity, yield, or alternative investment portfolios.

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Disclaimer

This document is purely for educational purposes and has been issued by Sygnum Group. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication. It does not constitute an offer or a recommendation to subscribe, purchase, sell or hold any security or financial instrument. It contains the opinions of Sygnum Group, as at the date of issue. These opinions and the information contained herein do not take into account an individual‘s specific circumstances, objectives, or needs. No representation is made that any investment or strategy is suitable or appropriate to individual circumstances or that any investment or strategy constitutes personalized investment advice to any investor. Therefore, you must verify the above and all other information provided in the document or otherwise review it with your external advisors. Some investment products and services, including custody, may be subject to legal restrictions or may not be available worldwide on an unrestricted basis. The information and analysis contained herein are based on sources considered as reliable. Sygnum Group uses its best efforts to ensure the timeliness, accuracy, and comprehensiveness of the information contained in this document. Nevertheless, all information indicated herein may change without notice.

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