Author: Peter Habermacher, CEO and Founder, Aaro Capital
Source: Building Blocks – Crypto asset developments in the wake of COVID-19. Would you like to read our Building Blocks magazine? Please sign up for your digital copy via the form at the bottom of the page.
DLT and crypto assets: through the investor’s lens
Distributed ledger technologies (DLT) and crypto assets are now widely accepted as an inevitable part of the future of ﬁnance. Gartner Research foresees the blockchain industry delivering over USD 3.0 trillion in value by 2030. Global Custodian and BitGo found that 94% of endowment funds had recently undertaken crypto-related initiatives. Fidelity found that 60% of institutional investors view crypto assets as having a place in their investment portfolios. This is a powerful growth story and a great long-term strategic opportunity.
The hyperbole that has surrounded DLT and crypto assets can, however, breed confusion among investors. The lack of understanding that typically accompanies a new asset class, coupled with the fast-moving nature of an emerging sector, can cause some to enter for all the wrong reasons. Often, investors do not know what they are buying or why. Consequently, it can be hard to appreciate the level of risk being taken and difficult to identify long-term trends.
As an investor, the focus should always be on achieving the investment aims of a portfolio by improving its key performance metrics. Studies by Yale University and VanEck empirically show the portfolio diversiﬁcation beneﬁts from crypto assets whose returns are uncorrelated with other asset classes.  When diversifying into new asset classes, however, many investors commit the cardinal error of relying excessively on past performance to optimise portfolio allocation. By contrast, the most successful investors focus on expected future returns, which requires a much more detailed understanding of the investment opportunity.
Every asset class is distinct from each other and investment strategies need to be tailored to the speciﬁc characteristics of each one. For example, the most effective investment strategies in high grade bonds are very different to the most successful in emerging market equities. Making the most of each requires signiﬁcantly different approaches. Investors should always seek to develop and adopt the investment philosophy which will maximise the portfolio beneﬁts of any new asset class. The DLT and crypto asset class is truly unique and therefore, requires a bespoke investment approach.
The crypto space is full of compelling opportunities. Many investors who enter it, however, cling to their favoured investment strategies without discovering if this is genuinely the best approach. Sensible investors should gain a broad understanding of the crypto investment landscape before making a meaningful allocation. Regrettably, many pay the price for failing to do so.
For most investors, the holy grail of DLT and crypto assets investing is portfolio diversiﬁcation and the beneﬁts that this brings. In an academic study by Dr Daniele Bianchi (Queen Mary, University of London), Dr Massimo Guidolin (Bocconi University, Milan), and Manuela Pedio (Bicocca University, Milan) showed that crypto assets are not only uncorrelated with other major asset classes, but they are also independent from the underlying risk factors driving them. Crypto assets provide true risk diversiﬁcation. They also displayed empirically that the superior portfolio beneﬁts from diversiﬁcation within crypto assets, going beyond just holding bitcoin.
Furthermore, diversiﬁcation beneﬁts that beat buy-and-hold strategies are possible via the blending of different investment strategies. Every investment strategy within the realms of traditional ﬁnance, from market natural arbitrage to long-short trading to VC and ﬁxed income, also operates within this new and exciting ﬁnancial world. The opportunities, challenges and risks of these strategies are, however, distinct from their cousins in traditional ﬁnance.
Within this complex investment landscape, an understanding of the economic beneﬁts and limitations of the technology is vital for identifying the best investment ideas applicable to the asset class. This involves locating and understanding the growth potential and the risks involved. This is essential to building an effective crypto investment philosophy and fulﬁlling a portfolio’s objectives.
With a bespoke investment approach, DLT and crypto asset investment opportunities can be evaluated professionally. This requires insights across the investment and opportunity landscape. For example, a good crypto arbitrage fund should make at least 15-20% a year to compensate for the additional risk relative to traditional markets. Liquidity funds taking directional exposure require an expected return of 30% plus per annum to justify market risk, while less liquid, thesis-driven hedge and venture funds should have higher expected returns to compensate for the additional liquidity risk. Institutional investors, however, often stick with their slow and steady investment mindset when entering crypto assets, with a limited overview of the crypto asset investment landscape. This results in many being short-changed by slow-and-steady directional managers who return just 10-15% per annum.
By contrast, these information asymmetries also create signiﬁcant opportunities in the form of inefficient markets, from which knowledgeable, risk-conscious, and active investors can proﬁt. The potential outsized risk-adjusted returns from effective active management is an order of magnitude larger than in traditional markets.
The scale of value generation of active crypto managers was highlighted in a recent research paper by Dr Daniele Bianchi (Queen Mary, University of London) and Dr Mykola Babiak (Lancaster University Management School). They found that active crypto asset funds can generate sizeable value for investors, on average outperforming bitcoin by approximately 350% (net of fees) between March 2015 and March 2020. Strikingly, they also show great dispersion in crypto asset managers’ alpha. Investor value generation is driven by a small number of strategies and fund managers, with less than 20% of crypto funds having a statistically signiﬁcant positive alpha. They also show that manager alpha is persistent, with the top 10% and bottom 10% remaining in these performance bands over time. This shows that picking the top best performing crypto managers can be an effective investment approach to maximising the portfolio beneﬁts of DLT and crypto assets.
The fast growing DLT and crypto asset space offers unparalleled opportunities, but it is also widely misunderstood. It contains many opaque and confusing elements and traditional investment approaches can fall short. What is needed is a crypto-speciﬁc investment philosophy. This requires detailed knowledge of both the underlying technology’s economic drivers and the other unique features of the space.
The rewards can be rich for those with an in-depth understanding of this complex investment landscape. Without this, many otherwise experienced investors may fail to capture the full value-added potential from DLT and crypto assets for their portfolios. Rather like with hedge funds in their early days, investors who are less familiar with this exciting new asset class would do well to seek guidance from those with the necessary expertise.
About the author
Peter Habermacher co-founded Aaro Capital to help give investors access to the growing opportunity presented by DLT and crypto assets. He previously worked at competition economics consultancy RBB Economics, advising on multibillion-dollar global M&A deals, and draws on this background to provide a traditional competition and industrial economics framework to DLT and crypto assets at Aaro. Peter holds an MSc in Economics from the University of Southampton.Weiterlesen