Investors who are early adopters of digital assets are true passive investors.
At least you might think it’s a question worth asking if you’ve read about the recent plunge in digital asset prices. Such a question requires a binary answer: as if the only two choices available were blind trust or complete distrust. However, there is a much more relevant question, but it needs a more nuanced approach.
In contrast to this binary issue is the recent discussion of current capital losses and recession risk, which are never expressed in binary terms. There is no question of alienating 100% of the shares. In their forecasts or management commentary, asset managers address: underweight stocks, rotation of cyclical stocks in favor of defensive stocks, priority given to high-quality companies. There are so many nuances and carefully thought out strategies that allow the investor to understand the situation and its many uncertainties.
Investments in digital assets or other assets have nothing to do with a Shakespeare play. Investors never trade in absolutes. It’s all about scenarios and probabilities.
Why would it be any different for digital asset investments? Why shouldn’t investors take the same nuanced approach to their investments in digital assets? Whether an investor takes a market portfolio approach, applying a 1% weight to digital assets across all asset classes, or an investor takes a long-term approach to benefit from digital assets’ exposure to the Sharpe ratio, there are many ways to achieve an allocation that balances risk and opportunities of this nascent asset class.
Investing 1% in digital assets: is it a rational choice?
Refusing to invest in digital assets is actually an active management decision. This may reflect the belief that one day the digital asset segment will disappear entirely. This opinion may be ambitious. Indeed, the market capitalization of digital assets reached $3 trillion in November 2021. Despite the current correction, the ecosystem and number of use cases has been growing steadily for more than a decade. The size of digital assets remains similar to the size of small wallets of emerging markets, 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, i.e. the various listed assets available to investors weighted by their total market capitalization. The total market is about $160 trillion after the recent fall in risky assets, and digital assets are about 1% of that. To minimize this deviation from a hypothetical market portfolio, a passive or uninformed investor should theoretically invest around 1% in digital assets. This is a rational choice in the absence of additional opinions or information. It is a safe position that allows the investor to benefit from the continuous growth of the sector in positive scenarios and allows him to limit losses (at the level of 1%) in more negative scenarios.
Chart 1: Current market portfolio
Source: Bloomberg, Wisdom Tree. As of May 31, 2022, the market capitalization is presented in billions of dollars. It is not possible to invest directly in the index.
Why is 6% growth per year enough to justify investing in digital assets?
The biggest turn off for an investor when it comes to investing in digital assets is 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, his maximum loss is 1%. Within a multi-asset portfolio, 1% losses occur many times a month in stocks or other risky assets.
- The efficiency required to justify volatility similar to that of digital assets is not as high as investors think. Digital assets growing at more than 6% per year would be enough to justify investing in a hypothetical portfolio.
In a recently published taxonomy article, WisdomTree Insights – A New Asset Class: Investing in the Digital Asset Ecosystem, we use several allocation methods to find the right return/risk profile offered to the long-term digital asset investor. As an example, Chart 2 shows the difference between the Sharpe ratio for a portfolio that invests 1% in digital assets and a portfolio with no digital assets. The illustrated portfolio continuously invests in:
- 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 assessed using JP Morgan Asset Management’s Long Term Capital Market Assumptions (LTCMA) to 2022 to assess performance, volatility and correlation over the next ten years. The historical correlation of digital assets with stocks and bonds is used. We vary the annual performance and volatility of digital assets from 0 to 100% to examine their impact on the illustrated portfolio.
Figure 2: Future Volatility and Performance of Digital Assets Must Be Very Different for a Multi-Asset Portfolio Not to Benefit
Source: Bloomberg, Wisdom Tree. From December 31, 2014 to May 31, 2022. Calculated in euros based on monthly figures. It is not possible to invest directly in the index. Historical performance is not an indication of future performance, and any investment can go down as well as up. For illustration only
It is clear that for most levels of volatility and performance of digital assets, the Sharpe ratio of the portfolio will benefit from their integration into the portfolio (“in green” in Figure 2). The digital asset has performed 99.2% annually with 97% volatility over the past seven years or so. While it is doubtful whether digital assets can perform this way over the next 10 years, assuming volatility remains the same (99%), the Sharpe ratio for the 60/40 portfolio is improved by the inclusion of digital assets, provided they record a performance of at least 6% per year.
Faced with this analysis, investors may ultimately argue that it is too late to invest in digital assets and that exponential growth is a thing of the past. However, from an asset allocation perspective, this is not so obvious. Looking at chart 2, rather than asking the Shakespearean question of “to invest or not to invest in digital assets, that’s the question”, really the only relevant question is: will digital stocks grow more than 6 or 7% in the future?
If you think the answer is yes, then they deserve to be included in your asset allocation.