Innovative Investing for Institutions
The empirical impact of digital assets on institutional portfolios.
Nov 21, 2023A profound transformation is unfolding in the world of finance. Prominent financial institutions are directing significant attention to digital assets and distributed ledger technology (DLT), strategically increasing their allocations to this space.
Institutions are increasingly investing in digital assets and contributing to the funding of transformative applications of DLT. Their involvement has long been recognized as a key catalyst for the wider adoption of the asset class, bringing the promise of substantial capital influx, the establishment of clear regulatory frameworks, and the enhancement of digital asset utility by bridging efficient technological innovations with outdated financial systems.
The stage is being set for a transformative era: foundational technologies are evolving, supportive infrastructure is taking shape, real utility is emerging, regulatory frameworks are crystallizing, and institutional interest is abundantly clear.
The Digital Revolution: Creative Destruction & the “New Internet”
Digital assets epitomize a market with unparalleled growth potential, poised to usher in a transformative era within the financial landscape. This digital revolution is a multifaceted journey.
Creative Destruction
The rise of fintechs and the advent of digital finance brought novel ways of conducting transactions and triggered a paradigm shift, challenging traditional financial structures. This is underpinned by a concept deeply rooted in economic theory, creative destruction, in which long-standing practices become obsolete as they give way to more efficient, technology-driven solutions.
At the vanguard of this technological shift are DLT and digital assets, promising to redefine established frameworks. Their decentralized and transparent nature challenges traditional transaction methods, paving the way for a more efficient, secure, and inclusive financial ecosystem. Payment and settlement systems are being improved by this technology, and new use cases such as tokenized private funds are revolutionizing the investment landscape.
A Disruptive Force
There exists immense growth potential for the digital asset class. At its core, digital assets embody a disruptive technology, reminiscent of the advent of the Internet, which, notwithstanding initial skepticism, brought about a profound transformation in how we communicate and access information. Drawing a parallel between the adoption of digital assets and the Internet, 2017-2022 cryptocurrency user growth closely resembles the Internet’s user expansion from 1995-2000, suggesting digital assets are still in the nascent stages of adoption.
Figure 1: Five-Year Growth in Crypto Users is Analogous to Five-Year Growth in Internet Users
Sources: Statista “Estimate of the monthly number of cryptocurrency users worldwide 2016-2022” published by Raynor de Best, November 17, 2023; Our World in Data “Number of People Using the Internet” based on International Telecommunication Union (via World Bank) and UN (2022).
Figure 1 compares the number of users during the initial phases of adoption for both the Internet and cryptocurrency. Figure 2 extends the narrative beyond this five-year period, indicating substantial potential for further expansive growth in the user base. The blue line marks the five-year period, highlighting where cryptocurrency is now relative to Internet adoption.
Figure 2: Growth in Internet Users Highlights Growth Potential of Crypto Users
The Opportunity Set
To further underscore the nascent nature of digital asset investment opportunities, it is worth noting the relatively modest amount of capital currently allocated to this asset class compared to more established asset classes. The estimated market capitalization of all cryptocurrency assets is roughly $1.4 trillion as of November 2023, meager compared to established assets, as highlighted in Figure 3. This, along with the anticipated widespread adoption of the disruptive technology, underscores the potential for substantial growth of and capital inflow into the digital asset class.
Figure 3: Market Capitalization as an Indication of Potential Capital Inflows into Digital Asset Class
Estimated market capitalizations as of November 2023; Global Fixed Income as of December 31, 2022, most recent available according to SIFMA.
Institutional Investors Foster Development and Growth
Influential institutional players, who once publicly expressed skepticism regarding digital currencies and blockchain technology, are changing their stance. A substantial number of institutional investors have expressed interest in investment exposure to the digital asset class, with many actively participating in its ongoing development and growth.
“Digimentality”
Despite challenges and negative headlines surrounding cryptocurrency in 2022, financial institutions have continued to increase their allocations to digital assets and build out offerings for retail and institutional clients.
Recent survey findings indicate significant support for digital assets among institutional investors. A 2022 survey by the Economist, dubbed “Digimentality”, found that 85% of investors “agree there is a need for open-source digital currencies as a diversifier in a portfolio or treasury account.” This optimistic sentiment is supported by a 2023 EY survey of more than 250 institutional investors which found that 93% believe in the long-term value of blockchain technology and/or digital assets, 69% expect to increase their allocations to digital assets and/or related products in the next 2-3 years, and 45% of institutions with assets exceeding $500 billion allocate more than 1% of their portfolio to digital assets. Additionally, it was found that many of these financial institutions have funded initiatives to provide increased digital asset exposure to their clients.
The Road to Adoption
As with any asset class, active institutional involvement paves the way for wider adoption.
Several leading financial institutions, among them BlackRock, Fidelity, Franklin Templeton, Invesco, and Grayscale, have submitted applications to the U.S. Securities and Exchange Commission to launch spot bitcoin exchange-traded funds (ETFs). It is anticipated that the SEC will approve a spot bitcoin ETF by Q2 2024, broadening access to this asset class.
Financial institutions have been pivotal in the funding and development of secure institutional-grade custody solutions worldwide. For instance, Fidelity has established its own digital asset custody offering, providing digital asset exposure to their clients, while Nomura funded a joint venture to establish Koimanu, an institutional digital asset custodian.
Furthermore, a new cryptocurrency exchange, EDX Markets, is backed by Fidelity Digital Assets, Charles Schwab, and Citadel Securities, an initiative to provide a framework for safe, efficient, and regulatory-compliant crypto trading.
Institutions are also backing DLT projects to improve the efficiency of financial markets. Goldman Sachs, BNP Paribas, Deloitte, and more than 30 other firms launched the Canton Network in May, a new global blockchain network of networks for financial market participants and institutional assets.
Increasing Allocations
Many attractive digital asset investment opportunities exist, often beyond the reach of retail investors. Institutional investors looking to capitalize on early digital asset opportunities are actively seeking to diversify their exposure to the asset class through various investment vehicles, as illustrated in Figure 4.
Figure 4: Institutions Expect to Increase Allocations to Digital Asset Products In the Next 2-3 Years
Source: EY “Staying the Course: Institutional Investor Outlook on Digital Assets,” May 10, 2023.
Enhancing Portfolios through Digital Asset Investment
Institutional-grade digital asset investment products have demonstrated their ability to add value to a portfolio, despite their nascency.
Adding a crypto hedge fund allocation to a typical 60/40 portfolio has a significant positive impact on returns in up months, as shown in Figure 5. Here we model the historical implications of both a 3% and a 5% allocation to digital assets on top of a base portfolio of 60% equities and 40% bonds.
Figure 5: Effects of Adding an Allocation to Digital Assets to a Traditional 60/40 Portfolio
Conventional 60/40 portfolio as represented by the S&P 500 TR Index and iShares Core US Aggregate Bond ETF, which seeks to track the Bloomberg US Aggregate Bond Index. Digital Assets as represented by VisionTrack Crypto Hedge Fund Composite Index. Data from February 2018 through September 2023.
Digital assets have often been associated with heightened volatility and perceived investment risk, causing apprehension in many investors. Yet a closer examination of the data reveals a more optimistic picture. The table inset in Figure 5 shows that adding a small allocation to crypto hedge funds increased volatility by less than 1%. Figure 6 plots crypto hedge funds against traditional assets in a risk/return matrix, illustrating that while digital assets may be considered volatile, potential returns of risk-managed products may outweigh the risks.
Figure 6: Risk-Return Matrix — Digital Assets vs. Traditional Allocations
Data as of September 30, 2023. U.S. Equities as represented by S&P 500 TR Index; U.S. Bonds as represented by iShares Core US Aggregate Bond ETF, which seeks to track the Bloomberg US Aggregate Bond Index; Gold as represented by S&P GSCI Gold Index; BTC/USD and ETH/USD sourced from Yahoo Finance Historical Data; Fundamental, Quant Directional, and Market Neutral Crypto Hedge Funds as represented by Galaxy VisionTrack Indices.
Stocks, bonds, and gold behave as expected, landing in the southwest quadrant, indicative of lower returns at reduced risk. Ether exhibits the most risk with minimal reward, while bitcoin generates greater returns at its heightened volatility levels. The northeast quadrant signifies that, while cryptocurrencies and fundamental crypto hedge funds have proven to add value to a portfolio in the long term, they may dampen portfolio returns in the short term due to their pronounced volatile nature.
The southeast quadrant has traditionally been the most desirable, representing outsized returns at acceptable volatility thresholds. Quantitative directional hedge funds land here as they focus on leveraging the upside potential of the market while actively managing and minimizing losses during downturns.
Most notably, however, market neutral crypto hedge funds have historically returned 20.2% with 7.1% volatility, significantly outperforming traditional stocks and bonds with bond-like risk. These funds are designed to reduce market exposure through beta neutral strategies or arbitrage opportunities, strategically capitalizing on market inefficiencies.
Figure 6 highlights the potential benefits of digital asset investment products, as sophisticated investors may reap higher rewards for navigating the dynamic nature of this asset class.
Widespread Institutional Adoption is Imminent
Institutional interest in digital assets signifies not just a trend, but a paradigm shift in the financial industry. As surveys indicate, most institutional investors believe in the long-term value of digital assets and plan to scale investments into the asset class over the next couple of years.
Heightened client demand for exposure to the digital asset class has further prompted financial institutions to support the necessary infrastructure for adoption at the institutional level, as well as advocate for the creation of regulations that allows for the growth and adoption of the asset class.
The anecdotal evidence is underscored by quantitative analysis. As the stage is being set for proper infrastructure for wider institutional adoption of digital assets, the data shows that adding an allocation to crypto boosts risk-adjusted returns. With investors increasingly convinced of the potential of digital assets, the landscape is primed for a surge in innovation and investment opportunities.
