For investors looking to access the rapidly growing digital asset ecosystem, there are now a number of options.
While both the number of issuers targeting this market and their offers should continue to increase, these products are now broadly divided into four main categories:
- Single asset passive;
- Multi-asset liabilities;
- Active liquid; and
- Active illiquid.
Passive index investing, or multi-asset investing, has grown significantly in popularity among more traditional assets, such as stocks. This is largely due to the weaker pricing structure of the products and the efficiency of the markets in which they participate. In short, if there is no real alpha to generate, your best bet is to pay as low a fee as possible for the beta. While this makes perfect sense for more efficient markets, thoughtful active management can help deliver real value in rapidly changing emerging markets, like digital assets.
Different assets offer varying opportunities depending on the the size and sophistication of market participants.
All asset classes and technologies have an inherent growth curve, or life cycle, of their own. We think the rationale for optimism about digital assets is relatively straightforward; Blockchain technology is an economic innovation that is in its infancy. Investing in digital assets today is akin to investing in the internet in the early 90s. In other words, while there will be volatility over the next few years, the market beta is expected to be the friend of the investor. In addition, and as with the early technologies of equity and venture capital investing, there are inherent asymmetries of information and corresponding benefits for sophisticated investors. Historically, all trades have winners and losers, and today in digital assets the winners typically actively manage their investments and risks while the losers are passive index vehicles.
The first is always the most difficult.
We collectively witness the first 24 hours a day, 7 days a week, 52 weeks a year, global asset class. Therefore, new operational procedures are created and implemented to support the industry that never sleeps. A market like this lends itself to a plethora of inefficiencies regarding timing of access to information, accurate interpretation of information, accessing global markets in a time sensitive manner and, more importantly, access to scalable and institutionalized processes and infrastructure. The “New York City of Assets” has an ongoing news cycle. Without Reg FD, an SEC rule that prohibits the disclosure of relevant information to a select group of individuals, information that affects investments can be disclosed at any time and to anyone. Even more valuable than speed of information is the ability to interpret it accurately. The talent required to respond to catalysts and events in an asset class that lacks standard reporting cannot be underestimated. Experienced managers with scalable infrastructures are not only better equipped to access information, but we believe they are far superior to interpret and act on that information. This trend is no different from traditional equity markets. However, since the majority of market players are not institutional and do not have access to the same advantages as in traditional markets, there are substantial alpha opportunities in digital assets that simply do not exist elsewhere.
Jack of All Trades, Master of None.
The digital asset space encompasses unique and nuanced industries, such as Web 3.0, NFT, DeFi, Music / Fan Engagement, and Gaming, to name a few. How can investors expect to have expertise in all of these unfamiliar topics if they are not immersed in research and thematic conversation on a daily basis? The fact that most active managers do not compete with each other but with a global retail audience presents a huge disparity in sophistication and investor access. Active managers have extensive portfolio teams with access to professional information networks, whose sole responsibility is to stay informed about these different sectors. The index from which passive vehicles are built is formed by the unsophisticated majority, and not by the highly skilled minority who historically feast on these dynamics.
However, this ecosystem also suffers from a dearth of information published by reputable experts, an array of factually incorrect content, and media headlines that prevail over notable ads. Sifting through propaganda and interpreting data is an active role that requires extensive research and analytical experience.
Resource allocation and collaboration
Two heads are better than one.
The sourcing and analysis of information draws on the expertise of all disciplines: investment, research, legal, compliance, sales, marketing, etc. Digital assets come in many shapes and sizes, with different attributes, requiring measured analysis from multiple disciplines to cultivate the best thematic investment opportunity.
In an industry as new as this, knowledge sharing is welcome and essential to its success. Teaming up with the digital assets and blockchain project managers themselves to assess their methodology and pivotal focus, as needed, has proven to be beneficial. Professional asset managers have the resources to manage projects on behalf of investors to maximize their token’s value accumulation mechanisms. These cooperative and in-depth relationships are exclusive to major players and reputable professionals.
Rate of change
Stagnation is death.
The digital asset market is moving faster than a static rule-based index can adjust. As such, passive indexes become obsolete within minutes of their publication. A quick look at how Bitwise, Galaxy, or Grayscale indexes are configured shows just how stale these constructs can become. The ability to identify, modify and adopt investment positions therefore requires sufficient attention, monitoring and flexibility.
In addition, the change has a relative domino effect, with one change having a consequential effect on several others. For example; the positive press on Ether affects its price, buying and selling behavior for this asset, but also for the countless other tokens hosted on the Ethereum blockchain. As a result, more investors and creators are drawn to growth, thus enabling new innovations for the larger Ethereum ecosystem. In addition, the growth of new layer 1 blockchains, such as Solana, Luna and Polkadot far exceed the digital assets included in the aforementioned passive indices.
“The risk comes from not knowing what you are doing.” – Warren Buffett
Risk management is more than just price management. It starts with the assessment of counterparty risk, and continues with sizing, liquidity, risk / reward and stress testing. The 2008 financial crisis showed us that your trade counterparty matters just as much as your exposure to your assets, ie Lehman Brothers and MBS. The need for a thorough assessment of service providers is all the more critical in an industry without regulations or a framework to standardize processes. Managers of actively managed products take these characteristics into account as part of operational due diligence. They offer guarantees by allocating capital to financial vehicles equipped with downside protection tools, managing volatility risk over time, and securing cash reserves for purchase price declines.
There is no single strategy for investing in blockchain and digital assets. Passively managed products clearly have a place in the financial ecosystem, but we believe this is not currently the case in digital assets. Market inefficiencies, niche topics, demands for resources, the rate of rapid change and the need for risk management call for professional investors to continuously monitor and readjust capital exposure. If you are a risk conscious investor interested in exposure to digital assets–actively managed products can be a great place to start.
Peter Hans is Managing Director of Arca.