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Why Digital Assets Require Active Management

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For investors looking to access the rapidly growing digital assets ecosystem, there are now a number of options.

While both the number of issuers addressing this market and their offerings should continue to expand, today these products largely fall into four broad categories:

  1. Passive single-asset;
  2. Passive multi-asset;
  3. Active liquid; and
  4. Active illiquid.

Passive index, or multi-asset investing, has grown noticeably in popularity across more traditional assets, such as equities. This is largely due to the products’ lower fee structure and the efficiencies of the markets in which they are participating. In short, if there is no true alpha to generate, one is better off paying as low of a fee as possible for beta. While this makes perfect sense for more efficient markets, thoughtful active management can help provide real value in nascent, rapidly evolving markets, like digital assets.

Different assets offer varying opportunities based on the size and sophistication of the market participants.

All asset classes and technologies have an inherent growth curve, or life cycle, to them. We believe the reason to be bullish on digital assets is relatively straightforward; blockchain technology is an economic innovation that is in its infancy. Investing in digital assets now is akin to investing in the internet in the early ‘90s. In other words, although there will be volatility over the next few years, the beta of the market should be the investor’s friend. Further, and similar to early technology investing across equities and venture capital, there are inherent asymmetries of information and corresponding advantages for sophisticated investors. Historically, all trades have winners and losers, and today within digital assets, typically the winners are actively managing their investments and risk while the losers are passive index vehicles.

Market Inefficiencies

The First is Always the Hardest.

We are collectively witnessing the first 24 hours a day, 7 days a week, 52 weeks a year, global asset class. Consequently, new operational procedures are being created and implemented to support the industry that never sleeps. A market like this lends itself to a plethora of inefficiencies around timing of information access, accurate interpretation of information, access to global markets in a time sensitive manner, and most importantly, access to scalable and institutionalized processes and infrastructure. The “New York City of assets” has a continuous news cycle. Without any Reg FD, an SEC rule that prohibits disclosing pertinent information to a select, limited group of individuals, information that affects investments can be released at any time and to anyone. Even more valuable than speed of information is the ability to accurately interpret it. The talent needed to react to catalysts and events in an asset class that does not have standard reporting cannot be understated. Experienced managers with scalable infrastructures are not only better equipped to access information, but we think they are far superior at interpreting and acting on this information. This trend is not dissimilar from traditional equities markets. However, because the majority of the market participants are not institutional, and do not have access to the same advantages as they do in traditional markets, there are substantial alpha opportunities in digital assets that simply don’t exist elsewhere.

Niche Subject Matter

Jack of All Trades, Master of None.

The digital asset space encompasses unique and nuanced sectors, such as Web 3.0, NFTs, DeFi, music/fan engagement and gaming, to name a few. How can investors expect to have expertise in all of these unfamiliar subjects unless they are immersed in research and thematic conversation daily? The fact that most active managers are not competing amongst themselves but with a global retail audience presents a massive disparity in investor sophistication and access. Active managers have extensive portfolio teams with access to professional information networks, whose sole responsibility is being informed on these different sectors. The index that passive vehicles are built off of is formed by the unsophisticated majority, not by the highly capable minority that historically feast on these dynamics.

However, this ecosystem also has a shortage of published information by reputable experts, an array of factually incorrect content, and prevailing media headlines that take precedence over noteworthy announcements. Sifting through the propaganda and interpreting data is an active role that requires deep research and analytical experience.

Resource Allocation & Collaboration

Two Heads are Better Than One.

Sourcing and parsing information takes expertise from all different disciplines – investment, research, legal, compliance, sales, marketing, and more. Digital assets come in many shapes and sizes, with different attributes, requiring a measured look from multiple disciplines to cultivate the best thematic investment opportunity.

In an industry as new as this, knowledge sharing is welcomed and crucial to its success. Teaming with the digital asset and blockchain project leaders themselves to evaluate their methodology and pivot direction, as needed, has proven to be beneficial. Professional asset managers have the resources to steward projects on behalf of investors in order to maximize the value accrual mechanisms of their token. These cooperative, in-depth relationships are exclusive to large stakeholders and reputable professionals.

Rate of Change

Stagnation is Death.

The digital asset market is evolving faster than a static rules-based index can adjust. As such, passive indexes become obsolete minutes after being released. A quick look at the configuration of the Bitwise, Galaxy, or Grayscale indexes show how outdated these constructs can become. The ability to identify, change, and adopt investment positions accordingly requires sufficient attention, monitoring, and flexibility.

Further, change has a relative domino effect, whereby one alteration has a consequential effect on multiple others. For example; positive press about Ether affects its price, the buying and selling behaviors for that asset, but also for the countless other tokens hosted on the Ethereum blockchain. As a result, more investors and creators are attracted to the growth, thereby enabling new innovations for the greater Ethereum ecosystem. Further, the growth of new layer 1 blockchains, such as Solana, Luna, and Polkadot far exceed the digital assets included in the aforementioned passive indexes.

Risk Management

“Risk comes from not knowing what you are doing.” – Warren Buffett

Risk management is more than just price management. It starts with evaluating counterparty risk, and continues to sizing, liquidity, risk/reward, and stress tests. The financial crisis of 2008 showed us that your trading counterparty matters just as much as your asset exposure, i.e., Lehman Brothers and MBSs. The need for extensive service provider evaluation is that much more crucial in an industry without regulation or frameworks to standardize processes. Managers of actively managed products take these characteristics into account when conducting operational due diligence. They provide safeguards by allocating capital to financial vehicles that have downside protection tools in place, managing volatility risk over time, and ensuring cash reserves to purchase price dips.

There is no one-size-fits-all strategy for blockchain and digital asset investing. Passively-managed products have a clear place in the financial ecosystem, but we believe it isn’t in digital assets right now. The market inefficiencies, niche subject matter, resource demands, rapid rate of change, and need for risk management call for professional investors to continuously supervise and re-adjust capital exposure. If you are a risk conscious investor that is interested in digital asset exposure – actively managed products may be a great place to start.

Peter Hans is Managing Director at Arca.