Disclaimer: This is not financial advice. Anything stated in this article is for informational purposes only and should not be relied upon as a basis for investment decisions. Triton may maintain positions in any of the assets or projects discussed on this website.
TL;DR
For those avid readers of our posts, one might notice that we have dedicated a fair amount of page space to defining what digital assets and blockchains actually are in practical terms, and more importantly, what the native characteristics of digital assets are that make them a fundamentally investable asset class. That likely resonates at a micro level – valuations, cash flows, multiples, check - but taking a step back with a more macro perspective, one might ask: Okay, so how should I invest in these then?
This post provides a potential framework to help position digital assets in a broader portfolio context.
Back to basics
Let’s start at the top. Modern portfolio theory relies heavily on diversification across the entire opportunity set of investable assets when constructing the risk-adjusted optimal portfolio. Diversification across industry, stage, country, and asset type (e.g. equities, bonds, art, real estate) based on correlations allows investors to construct a portfolio at the ‘efficient frontier’ that maximizes expected return at a defined level of risk. The driving factor in why this works is investing across non-perfectly or weakly-correlated assets. This is the general framework against which most large portfolios are built. When implementing this, at the highest level one can typically divide a portfolio into a few main buckets: liquid equities, private allocations, diversifiers, and low-risk fixed income and cash. Cambridge Associates, one of the leading investment management advisory firms in the world, generally applies this view for its institutional clients:
Digital Assets vs. Equities
Though on the surface it may seem that digital assets are most akin to higher-beta equities (e.g. tech), the comparison breaks down when one starts to look at the underlying return profiles. The simplest view is to understand correlations between digital assets and tech equities. The absolute return potentials are clearly different – Bitcoin for example has been the best-performing asset in 9 of the past 12 years – but that doesn’t tell us much about how it acts directionally relative to other assets.
Example correlations between a few asset pairs throughout Q2 2024 are shown below. Bitcoin’s recent correlation to the Nasdaq is just 0.19. Other foundational digital assets, such as Metaplex (the top protocol for creating fungible and non-fungible tokens on Solana) and Render (the top decentralized GPU network), have recently decoupled from the Nasdaq (-0.06 and 0.08, respectively). That is to say, digital assets do indeed present somewhat differentiated return profiles from higher-risk equities such as tech.
Zooming out to a longer time horizon and looking at just Bitcoin’s correlation vs. equities, it’s clear the risk profiles are quite different. There are assuredly times of high correlation (and correlations increase slightly as the period expands – 90 days vs 30 days, for example), but also very frequent periods of little to negative correlation. Compare that to the S&P500 and Nasdaq – very highly correlated with each other, as one would expect two equity indices to be. Looking at Total3 vs. Nasdaq (i.e. QQQ), you see a very similar deviation in correlations (note: Total3 represents the digital asset market excluding Bitcoin and Ethereum). That is to say, digital assets – especially liquid exposure - should likely be considered as their own bucket in a diversified portfolio, rather than viewed as an extension of an equity growth allocation. A major corollary of that is liquidity expectations should be lower given the volatility and nascent nature of blockchain technology. Given the size of the industry and the range of options available to get digital asset exposure today, investors who are not allocating to digital assets are making an intentional decision to exclude them from their investable universe. That is, they are effectively taking an intentionally short position on the asset class.
Digital Assets vs. Fixed Income or Cash
Fixed income and cash allocations are low-risk, high-safety positions and likely shouldn’t be viewed as strong return drivers. As such, this is likely not the right allocation against which to compare digital assets. There is a time and place for taking risks, but your cash position is not one of them.
Note: With that said, for the more crypto-savvy investors with a higher appetite for contract risk, tokenized treasury management products such as Midas (tokenized T-bills and tokenized basis trade) or Ethena (dollar-pegged tokenized basis trade yielding 17% currently), can be used in place of cash or fixed income positions for better digital asset liquidity and potentially higher passive yields. Blackrock’s Ethereum-based BUIDL money market fund is another example of blockchain-native cash products.
Digital Assets as Private Investments
To date, venture capital has been the primary way for investors to get exposure to digital assets at scale. According to Galaxy, $2.5B in venture investment went into the space through the first quarter of 2024. Though far lower than the $12B peak seen in 1Q 2022, this represents a large increase from 4Q 2023, up almost 70% quarter-on-quarter in terms of new deals. The number and size of new funds raising capital has also started to tick up again. 22 new funds raised roughly $650M in 1Q 2024, but just last week, Paradigm announced it had closed on $850M for its third fund, one of the largest funds in digital asset history (Paradigm also raised $2.5B in 2021). Pantera is also said to be targeting another $1B for its new all-in-one fund. Important context: as measured by aggregate token market cap, the entire digital asset industry is still ~$1 trillion smaller than Nvidia.
What is interesting, however, is for digital asset VC, exit liquidity is far different than traditional VC. With traditional venture, the flow is generally: raise rounds through Series C or D and then IPO if you have not been acquired along the way:
With digital assets, this is completely different. First and foremost, acquisitions are exceedingly rare and are not a truly viable expectation for founding teams to hold (though do happen from time to time). That leaves IPO – or in digital asset terms, token generation events (TGE) - as the primary liquidity event for venture investors. These come with an added catch: investors are typically subject to 24-48+ month lockup on their token allocations despite them being freely tradeable on the open market by retail and other investors. The difficult part here is that TGEs are not selling to large-scale sophisticated institutional investors as is the case with IPOs. Instead, TGEs take place on exchange launchpads such as Binance and Jupiter or via airdrops, where they are largely acquired by retail investors, protocol users, and just a small number of liquid funds:
A major takeaway of this is that illiquid venture allocations are not the only path through which to access the earliest stage projects. Most quality investor-backed TGEs take place right around the Series A/B stage of development, with established user bases and integrations and on a path to real revenue generation and at-scale deployment. Whereas in traditional equity markets, the only way to access companies at this stage is through VC, in digital assets, liquid funds are able to invest at these stages without the associated lockups and 7-10-year liquidity restrictions on LP funds.
Beyond the benefits of liquidity and early-stage access, hold periods are also a major driver to consider. For the vast majority of recent token launches, the traditional model is as follows: at TGE, release 5-10% of total token supply into the market via airdrops, launchpad sales, and community/treasury allocations, with the remainder subject to multi-year vesting and lockups, often restraining any new supply coming online for at least 12 months.
In other words, for high-demand projects with strong traction, there is potentially up to a year of concentrated buy pressure on just a fraction of the total token supply. Liquid funds are able to participate in those markets and benefit from the supply/demand mismatch but retain the option to exit as unlocks and vesting begin to happen for the team, earlier investors, and other locked allocations. When digital asset markets have historically seen significant 4-year cycles, having this option to exit is incredibly valuable. There is a very real chance that any private investments with 2-3 year vesting schedules unlock into a bear market should history repeat itself.
Digital Assets as Diversifiers
Although venture capital remains the preferred method for accessing nascent industries in traditional equity investing and for investing in operating companies in digital assets where value accrues to equity, the nature of liquid token markets suggests that a diversifying allocation in this space makes strong sense. Specifically, the unsustained correlations between digital assets and equities, the ability to access early-stage projects, and the dynamics around liquid token markets and TGEs, all suggest that a semi-liquid allocation to liquid fund managers is a well-suited match.
Bloomberg’s Head of Commodities and Crypto Product Management, Jigna Gibb, recently investigated how adding a small allocation to digital assets enhances portfolio characteristics. Specifically, she modeled 1-5% allocations to a Bitcoin+Ethereum basket as part of a diversified portfolio including equities (56%), bonds (38%), and commodities (6%). Readers can review her full article here, but the key findings show that greater allocations to digital assets increase expected Sharpe and Calmar ratios, but with greater potential downside in scenarios of acute market stress (note: she modeled the ‘crypto’ allocation going to $0 in those scenarios – an essentially zero-chance likelihood at this stage of the industry).
When evaluated against specific drawdown scenarios over the past decade, she found that a 1% allocation to crypto actually increased portfolio outcomes during those events on average. In just 1 of 4 events analyzed, a portfolio with crypto underperformed the default multi-asset portfolio (Volmageddon in February 2018 where 1 day losses in short-volatility ETPs exceeded 90%). In the other 3, portfolios with a small crypto allocation performed better (start of the Fed hiking cycle, COVID, and the Russian Invasion at a time of historically high inflation):
Separately, HSBC ran a similar analysis in April to model 10 million market portfolios with a range of similar allocations (1-5%) to crypto. In an unconstrained portfolio (e.g. allocations could range from 0-100%), the optimal crypto allocation was found to be around 4%. When a more realistic, constrained model was used (e.g. US equity allocation could only be 40% or more), the optimal crypto allocation increased to 7% on average. While it is highly unlikely that most institutional allocators would be comfortable with that degree of exposure, a far more moderate allocation of even just 0.5-1% still allows investors to improve risk-adjusted outcomes for their portfolio.
Given the volatility of digital assets and the nascent state of the industry, allocations here should not be viewed as offering the same liquidity as public market equities or more vanilla equity-focused hedge fund strategies. The cycles within the industry and the early-stage nature of the projects that many tokens provide access to (e.g. Seed and Series A) require an appetite for longer holds and significant volatility. In stressed markets, liquid token allocations should not be seen as a primary source of liquidity. Reflecting this, many managers have restrictions on liquidity and gates in place to protect the fund through these scenarios.
Conclusion
The characteristics of digital asset markets, and especially the differences from traditional equities, suggest that a small allocation to digital assets through diversifying strategies provides a risk-adjusted improvement to a well-built portfolio. Though VC has been the primary path to exposure historically, liquid token strategies are a fundamentally well-suited vehicle to invest in digital assets, with proven portfolio benefits once included in an investor’s asset universe.
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