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

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

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

At the very least, you may think that’s the question to ask if you’ve read about the recent fall in the price of digital assets. Such a question calls for a binary response: as if the only two choices available were blind trust or complete mistrust. However, there is a much more relevant question to ask, but it requires adopting a more nuanced approach.

In contrast to this binary issue is the recent discussion of current equity losses and recession risk which are never expressed in binary terms. There is no mention of divesting 100% of the shares. In their outlook or their management comments, the asset managers address: the underweighting of equities, the rotation of cyclical stocks in favor of defensive stocks, the priority given to high-quality companies. So many nuanced and carefully considered strategies that allow an investor to understand the situation and its many uncertainties.

Investing in digital assets or other assets has nothing to do with a Shakespeare play. Investors never trade in absolute terms. It’s all about scenarios and probabilities.

Why would it be any different for an investment in digital assets? Why wouldn’t investors take the same nuanced approach to their investment in digital assets? Whether an investor takes a market portfolio approach by applying the 1% weighting to digital assets against all asset classes, or whether an investor takes a longer-term approach to benefit from the effects of digital assets on the Sharpe ratio, there are many ways to achieve an allocation that balances the risks and opportunities of this nascent asset class.

Investing 1% in digital assets: is it a rational choice?

Not investing in digital assets is actually an active management decision. It may reflect a belief that the digital asset segment will one day completely disappear. This opinion can turn out to 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 have 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. wallets.

Chart 1 presents the current market portfolio, i.e. the various listed assets available to investors and weighted by their total market capitalization. The total market is around $160 trillion following the recent drop in risky assets and digital assets are around 1% of that. In order to minimize this deviation from the hypothetical market portfolio, a passive investor or an uninformed investor should theoretically invest around 1% in digital assets. This is a rational choice in the absence of additional opinions or information. This is a safe position that allows the investor to benefit from the continued growth of the sector in positive scenarios and allows him to cap losses (at 1%) in more negative scenarios.

Chart 1: Current market portfolio

Source: Bloomberg, Wisdom Tree. As of May 31, 2022. Market capitalizations are presented 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 pushback when it comes to investing in digital assets is usually 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%. As part of a multi-asset portfolio, losses of 1% occur many times each month in the equity or other risky asset segments.
  • The performance required to justify the volatility similar to that of digital assets is not as high as investors think. Digital assets growing at more than 6% per year will be 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 multiple allocation techniques to find the right return/risk 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 investing 1% in digital assets versus a portfolio with no digital assets. The illustrated portfolio constantly invests up to:

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

Equity and bond performance and risk is 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% in order to study their impact on the illustrated portfolio.

Chart 2: The future volatility and performance of digital assets must vary very greatly in order not to benefit a multi-asset portfolio

Source: Bloomberg, Wisdom Tree. From December 31, 2014 to May 31, 2022. Calculated in euros based on monthly performance. It is not possible to invest directly in an index. Historical performance is not an indication of future performance and any investment may go down as well as up. For illustrative purposes only

It is clear that for most levels of volatility and performance of digital assets, the Sharpe ratio of the portfolio benefits from their integration into the portfolio (in ‘green’ in Figure 2). Digital assets have been performing 99.2% annually with volatility of 97% over the past seven years or so. While it’s questionable whether digital assets can perform like this over the next 10 years, assuming volatility stays the same (99%), the Sharpe ratio of a 60/40 portfolio is improved by the inclusion of digital assets provided that they record a performance of at least 6% per year.

Faced with this analysis, investors could ultimately argue that it is too late to invest in digital assets and that this exponential growth is a thing of the past. However, from an asset allocation point of view, this is not so obvious. Looking at Chart 2 rather than asking the Shakespearian question ‘to invest or not to invest in digital assets, that is the question’, the only relevant question is really: will digital stocks grow by 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.

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