Diversification is one of the most frequently used strategies for offsetting volatility risk. However, the digital asset sphere has unique features that make diversification more complex. This article provides some insights into the challenges facing portfolio managers when building a diversified cryptocurrency portfolio and offers some practical and systematic strategies for introducing more diversity into a crypto portfolio.
To diversify or not to diversify in crypto?
Diversification strategies can vary, but the overall goal is always to reduce exposure to any one asset or instrument to avoid risk. However, cryptocurrency markets are unlike many traditional financial markets, such as the stock market, where there is significant diversity across all segments. Large-cap stock indices like the S&P 500 comprise assets from many different industries, while it is also possible to trade stocks from different-sized companies within a given industry, creating many different diversification opportunities.
In contrast, two assets – BTC and ETH – often account for around 60% of the total market capitalization of crypto at any given moment. As such, these instruments, and BTC in particular, exert a substantial influence over the value of the rest of the market, which is a long tail comprised of thousands of altcoins.
Crypto is also more complex than traditional finance because it is a global market with no principal exchange, fragmented across many liquidity venues which use different pricing methodologies. As diversity tends to be measured using metrics like covariance and correlation of historical prices of portfolio assets, this makes it essential to have integrated, high-quality, comparable crypto pricing data – no small feat in such a fragmented and complex market.
The absence of a principal regulated trading venue also gives rise to a heightened risk of an exchange default, as we saw with FTX last year. Distributing funds across multiple wallets, exchanges, and custody providers mitigates the risk of losses from events like hacks, fraud, and venue collapse. In this regard, the risks inherent in the sector create a compelling argument to diversify the exchange and custody providers for individual assets within a portfolio.
Despite the dominance of BTC and ETH, diversification into altcoins provides the possibility to capture early opportunities available in altcoin markets. There are of course considerable risks involved, including low liquidity, projects folding, or in the worst cases, hacks and scams.
For all of these reasons, portfolio managers seeking to diversify their digital asset holdings will need to determine the acceptable risk parameters for the segments of their portfolio, and continually reallocate assets accordingly.
There are several practical ways of introducing diversification to a digital asset portfolio. Each comes with its own strengths and weaknesses, so portfolio managers should consider combining strategies in a way that best aligns with their investment goals.
By market capitalization
Given the dominance of BTC and ETH in the market, many investors opt to give them a similarly dominant role in their crypto portfolio, segmenting their holdings into these two assets and a third category for altcoins. One distribution example could be 40% BTC, 35% ETH, and 25% for other altcoins, with the exact split varying depending on the priorities of the portfolio manager.
An argument for adopting this strategy is that BTC and ETH typically have the lowest volatility, so most of the portfolio will be allocated to comparatively low-risk assets. This mitigates the risks of investing in lower-cap assets, which are more likely to fail. Adopting a market cap-driven approach to diversification also prioritizes liquidity.
On the other hand, by limiting the size of the altcoin allocation, investors may miss opportunities to participate in early-stage projects. It should be noted that although altcoins can outperform Bitcoin during bull cycles, over several market cycles most altcoins have underperformed Bitcoin. Effective risk management and rebalancing is therefore essential for a diversified crypto portfolio to continuously outperform Bitcoin.
By token type
Digital assets can generally be categorized into different types, including stablecoins, governance tokens, platform tokens, utility tokens, and more. Simply holding assets of different types is one potentially easiest ways to diversify into a range of different projects with varying risk profiles.
However, choosing projects based on the type of token is not necessarily a strategy to be used in isolation in the absence of a convincing investment thesis. Nevertheless, a diverse portfolio will often feature a range of token types across various sectors.
By industry or sector
Over recent years, several sectors have emerged as key growth areas within the Web3 sphere, providing ample opportunities for investors who have chosen to ride the wave. One example is the rapid growth of decentralized finance in 2020 or non-fungible tokens in 2021. Diversifying a portfolio by industry or sector offers a route into these high-growth markets. A 2022 research paper demonstrated that the sectoral division of cryptocurrencies (in this case, the defined sectors were finance, exchanges and business services) can contribute to reducing portfolio risk.
However, portfolio managers may wish to consider how feasible it is to follow such trends, particularly within a nascent sector. For instance, during DeFi’s ascent in 2020, many new tokens were emerging apace, creating a rapid succession of price peaks. Keeping track of these events in real time can quickly entail a big commitment of time and resources.
Diversifying using digital asset-based exchange-traded products is another option depending on the jurisdiction. For example, Switzerland and Canada both have active ETP markets with products from issuers such as Coinshares and VanEck trading on regulated venues. These instruments make it easy to gain exposure to single assets or bundles of assets without actively holding each of the underlying tokens. They could also offer a way to gain broad exposure to token prices across a particular industry or sector without needing to track the performance of individual projects, as described above.
Currently, the major drawback of investing in ETPs is that the markets are relatively underdeveloped except in a handful of jurisdictions. Another consideration is that the investor has no control over which assets make up the underlying.
Investing in the stocks of crypto-adjacent companies provides indirect exposure to digital asset markets through a traditional instrument. Stocks in companies such as Coinbase or Microstrategy have proven to be heavily correlated to the price of cryptocurrencies. However, as these stocks trade on standard, regulated exchanges — Coinbase Global Inc shares trade on NASDAQ for example — they involve a much lower level of exchange default risk.
A key drawback however is that these assets are likely to be heavily influenced by the price of BTC and will not allow investors to capture the upside potential of lower-cap tokens.
Focus on yield
These days, digital asset investors do not need to rely on volatility alone for returns. Proof-of-stake cryptocurrencies such as ETH, Polkadot’s DOT, or Cardano’s ADA all operate staking programs that offer a relatively steady yield to stakers. Such returns can act as a cushion against downside volatility risk, and investors can compound returns by re-staking their gains.
A note of caution when staking is that there are often rules that could introduce an element of risk. For instance, there are often minimum amounts that can be staked or lockup periods to unstake funds. In the event of extreme volatility, investors could be left watching funds lose value and be unable to sell during an unlocking period. Some operators offer staking programs that may circumvent these rules, but there may be other risks of staking via a third party, such as company bankruptcies, as we saw with Celsius, BlockFi and Voyager.
Attaining a diversified portfolio is only one part of the challenge — managing it is another. Effective portfolio management requires a robust toolset that can pull together your entire portfolio from every exchange, custodian, wallet, and staking pool into a single interface. Nuant delivers this, along with the ability to drill down into the performance of individual assets with real-time analytics, and the opportunity to streamline compliance using wallet intelligence and automated due diligence. Manage your portfolio risk and optimize your operational efficiency with our innovative portfolio management system - book a demo today.