To invest or not to invest in digital assets, that is the question

The investors who first adopted digital assets are the true passive investors.

At the very least, you might think that’s the question to ask yourself after reading about the recent digital asset price drop. Such a question calls for a binary answer: as if the only two choices available were blind trust or outright distrust. However, there is a much more relevant question to ask, but one that requires a more nuanced approach.

Contrasting with this binary theme is the recent discussion of current stock losses and recession risks that are never expressed in binary terms. There is no talk of selling 100% of the shares. In their outlook and management commentary, the asset managers address: the underweighting of equities, the rotation of cyclical stocks in favor of defensive stocks, the prioritization of high-quality companies. So many nuanced and carefully thought out strategies that allow an investor to understand the situation and its many uncertainties.

Investing in digital assets or any other asset has nothing to do with a Shakespearean play. Investors never trade in absolute numbers. It’s about scenarios and probabilities.

Why should investing in digital assets be any different? Why shouldn’t investors take the same nuanced approach when investing in digital assets? Whether an investor takes a market portfolio approach, applying the 1% weighting to digital assets versus all asset classes, or an investor takes a longer-term approach to benefit from the impact of digital assets on the Sharpe Ratio, there are many ways to do this achieve an allocation that balances the risks and rewards of this emerging asset class.

Investing 1% in digital assets: is that a rational decision?

Not investing in digital assets is actually an active management decision. It might reflect the belief that the digital asset segment will one day disappear entirely. This opinion may turn out to be ambitious. In fact, the market cap of digital assets reached $3 trillion in November 2021. Despite the current fix, the ecosystem and number of use cases has been growing steadily for more than a decade. The size of digital assets remains similar to emerging market small caps, listed real estate investment trusts (REITs), or global high yield bonds – assets that are part of most asset allocations and markets.

Chart 1 shows the current market portfolio, ie the various listed assets available to investors, weighted by their total market capitalization. The total market is about $160 trillion after the recent drop in risky assets, and digital assets make up about 1% of that. In theory, to minimize this deviation from the hypothetical market portfolio, a passive investor or an uninformed investor should invest around 1% in digital assets. This is a rational decision as there is no additional opinion or information. This is a safe position that allows the investor to benefit from the continued growth of the sector in positive scenarios and to limit losses (to 1%) in more negative scenarios.

Chart 1: Current market portfolio

Source: Bloomberg, Tree of Wisdom. As of May 31, 2022. Market caps are in billions of dollars. It is not possible to invest directly in an index.

Why is 6% growth per year enough to justify an investment in digital assets?

An investor’s biggest setback when investing in digital assets is usually the volatility and risk of loss. However, these fears tend to ignore two important facts:

  • Regardless of the volatility of digital assets, if an investor invests only 1% in digital assets, its maximum loss is 1%. As part of a multi-asset portfolio, there are multiple 1% losses each month in the equity or other risky asset segments.
  • The performance required to justify volatility similar to that of digital assets is not as high as investors think. Digital asset growth of more than 6% per year is enough to justify an investment in the hypothetical portfolio.

In the recently published taxonomy article WisdomTree Insights – A New Asset Class: Investing in the Digital Asset Ecosystem, we use several allocation techniques to find the right risk/return profile offered to an investor in long-term digital assets. As an example, Chart 2 shows the difference between the Sharpe ratio of a portfolio that invests 1% in digital assets compared to a portfolio with no digital assets. The portfolio shown continuously invests up to:

  • 59% in the MSCI All Country World Index
  • 40% in the Bloomberg EUR Agg Index
  • and 1% in digital assets

Equity and bond performance and risk are estimated using JP Morgan Asset Management’s 2022 Long-Term Capital Market Assumptions (LTCMAs) to estimate performance, volatility and correlation over the next ten years. Historical correlation of digital assets with stocks and bonds is used. We vary the annualized performance and volatility of digital assets from 0% to 100% to examine their impact on the portfolio shown.

Exhibit 2: The future volatility and performance of digital assets must vary widely not to benefit a multi-asset portfolio

Source: Bloomberg, Wisdom Tree. From December 31, 2014 to May 31, 2022. Calculated in Euro on a monthly performance basis. It is not possible to invest directly in an index. Past performance is not a guide to future performance and any investment can go down as well as up. For illustration only

It is clear that at most volatility and performance levels of digital assets, the portfolio’s Sharpe Ratio benefits from their inclusion in the portfolio (in “green” in Figure 2). Digital assets have achieved an annual performance of 99.2% with a volatility of 97% over the past seven years. While it is questionable whether digital assets can perform in this way over the next 10 years, assuming constant volatility (99%), the Sharpe ratio of a 60/40 portfolio will be improved by including digital assets provided they perform at record at least 6% per year.

Ultimately, given this analysis, investors could argue that it is too late to invest in digital assets and that this exponential growth is a thing of the past. From an asset allocation perspective, however, this is not so obvious. Looking at Chart 2, rather than asking the Shakespearean question “to invest in digital assets or not, that is the question,” the only relevant question really is: Will digital stocks grow more than 6% or 7% in the future?

If you think the answer is yes, they deserve to be included in your asset allocation.

#invest #invest #digital #assets #question

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