Increasing Numbers of Investors and Portfolio Managers Wonder Whether Crypto Assets Should Be Included in an Investment Portfolio.

By Karl Seelig and David Doss, MBA ?

Table of Contents

Executive Summary

Crypto Assets: Sound Investments, Fraud, or Based on Mere Market Exuberance?

Most Crypto Assets Are Not Ponzi Schemes

Do Crypto Assets Rely on Sound Business Models?

Should a Diversified Investment Strategy Contain Crypto Assets?

How to Give a Client Access to Crypto Assets for Portfolio Diversification?

Executive Summary

Should a diversified investment strategy include crypto assets? With growing numbers of high-net-worth individuals around the world personally investing into digital assets such as NFTs, bitcoin, cryptocurrencies, and other crypto assets, investors have been placing ever-mounting demands on financial firms, private bankers, and advisors to adopt crypto asset diversification techniques. Aside from experiencing pressure to add such crypto assets to their clients’ portfolios, investment managers are also facing the intricacies and dangers that the realm of crypto assets poses. In addition to market risks, the crypto asset world is plagued by the complexity of navigating through the countless options available and the constant fear of losing funds –?not only due to immature infrastructure but also due to malicious actors. According to our research, such risks and complexities reflect the fact that just about 10% of investment firms, private bankers, and investment advisors provide their clients with such diversification options, while about 30% of investors are driving the demand for such services. Thus, this overview addresses whether a diverse investing strategy should contain crypto assets when focusing on three questions: First, are crypto assets a sound investment, fraud, or based on mere market exuberance? Second, what would be the right diversification strategy? Third, how and when should such diversification be offered to investors and clients –?and how and when should it not?"

This overview explores potential answers to the above questions by summarizing topics covered at Digital Davos 2023. Disclaimer: This article does not provide any investment or legal advice. It merely expresses the authors’ opinion and is intended to spark further conversation about the topic. We encourage everyone to conduct further research and seek professional advice before undertaking any investments.

Crypto Assets: Sound Investments, Fraud, or Based on Mere Market Exuberance?

It goes without saying that no investment decision should be based simply on client demand, since investment firms, private bankers, and investment advisors should base their decisions on their own research, applicable laws, and the particular needs and circumstances of their clients. Merely succumbing to demand pressures has caused numerous markets to experience exuberance (bubbles) over the years, costing investors trillions of dollars. However, it's important to acknowledge that, at times, a market correction (for example, the internet bubble burst in 2000) is just a market correction and nothing else. None would contend today that investments made in the internet more than 20 years ago would have been a bad investment. Although many internet businesses have clearly failed, it is also clear that investments in internet-related businesses helped launch many of the most influential and successful companies in existence today. Nonetheless, history is also full of bubbles that never recovered after bursting, such as the tulip bubble in 1637.

Most Crypto Assets Are Not Ponzi Schemes?

Bad actors exist in any market – exploiting others and committing fraud. The crypto industry is no exception. Simply put, a Ponzi scheme is where a con artist steals money from investors without intending to create anything of value for them, then uses the money from new investors to repay the money from previous investors, diverting more and more money from the expanding investor pool to himself. In most scams, the con artist will take advantage of the promise of high returns on the investment and will confuse investors with obfuscated operations that, while bogus, might seem impressive to some investors.?

Crypto assets are prone to such scams because they are confusing to the layman. These assets use novel terminology, focus on mathematical concepts, and employ complicated techniques. That said, fraud occurs frequently in various industries – from hedge funds claiming to invest in the traditional stock market to real estate, options trading, art, and even lending, to name a few.?

For those who have watched the Netflix original film "Tucker: The Man and His Dream," which depicts Mr. Tucker's path toward building a better car, may recall that he was accused of operating a Ponzi scheme but was cleared of this charge. In the film, he explains in court that since he planned and made the cars, it was just an investment, not a con. The same is true for crypto in general: usually, digital assets are indeed produced, and blockchains are frequently implemented for alternative use cases such as decentralized as data storage. Thus, the question is not whether crypto is a Ponzi scheme but rather whether it is based on economically sound principles. At this point, blindly trashing a new technology by claiming it is a Ponzi scheme seems unethical and slanderous, disqualifying such uninformed opinions from being taken into further consideration. That said, as of 2023 there are upwards of 22,000 cryptocurrencies in existence, and it is worth questioning the soundness of the business principles underpinning this exponentially growing market.

Do Crypto Assets Rely on Sound Business Models?

To address whether the crypto market stands on fundamentally sound business principles, one must dissect the market into its various segments. Grossly oversimplified, one can divide most crypto assets into four components:

1. Decentralized data
2. Currencies
3. Service providers
4. Applications

For each component, the current and potential stakeholders must also be examined.?

Since the Bitcoin network’s inception in 2009, market development in each of those listed components can be observed in various ways. The number of offerings (and their rate of adoption) in the currency subcategory of the blockchain and digital asset market has been steadily increasing. At first, individuals used crypto currencies to settle accounts privately between themselves, but today, major companies and even governments accept crypto payments. The service component (which keeps the blockchain ecosystem running) is continuously developing in scope and sophistication. New investments in capital and coins, tokens and mining farms, and other infrastructures are constantly being undertaken by an increasing mix of stakeholders. The application and database components include use cases across a range of industries like law, medicine, gaming, gambling, health, finance, art, supply chain, defense, aerospace, entertainment, and sports, as well as still nascent industries.

Thus, crypto asset projects in this day and age are undertaken in nearly all industries closely related to our daily lives, but in some cases, they are an adaptation of disruptive technology across several industries and may fail to adhere to sound business concepts. It has been frequently demonstrated that if new technologies are not deployed rapidly enough, the technology itself may become superfluous. History is rife with examples of excellent technologies with minimal market penetration losing out to merely good technologies that gained market share faster. For instance, Betamax, which predates VHS by around two years, featured higher recording capacity, smaller tapes, and better resolution compared to VHS. However, the marketing and business development efforts of VHS were more successful, rendering Betamax a niche product. The failure of HD-DVD and the success of Blu-ray followed a similar pattern. Time to market and rapid adoption are often crucial.

It must be recognized that despite cross-industry engagement and the eagerness of the public to invest in crypto assets, the total crypto asset market size and investment volume lags far behind the preceding internet revolution by a factor of over 12X –?$800 billion for the crypto asset market and $12 trillion of the internet market within a comparable 10-year period. That said, not all technologies – even wildly successful ones –?are adopted at the same pace. For example, the color television was first exhibited in 1923, but did not reach 80 percent U.S. adoption until 1981. Similarly, the microwave oven (invented in 1945) did not reach 80 percent U.S. adoption until roughly 1990.

Many participants in the crypto market point to regulations that need to be clarified as a major obstacle –?and the regulatory climate around crypto assets continues to evolve. Consumers and the public point out insufficient user-friendliness and the often-higher cost of implementing crypto assets and blockchain technology as some of the obstacles to their adoption –?for example, the historically unpredictable costs and variable speed of transactions on the Bitcoin and Ethereum networks have historically created uncertainty for many businesses looking to adopt the technologies, although improvements to these networks (as well as new competitors to them) have begun to address some of these objections. Crypto assets today are a one trillion-dollar market with very high volatility. It is not unusual for cryptocurrencies to lose more than half of their value in only one month, only to triple in value within another six months. This fact alone may render most cryptocurrencies a less attractive substitute for fiat currencies for the time being and make usage of the decentralized technology an unpredictable cost to businesses. Some noteworthy possible exceptions may include certain kinds of stablecoins (assets pegged to other mainstream assets like the U.S. dollar). Still, most coins and tokens are part of an internal payment system to reward those who maintain blockchain infrastructure, and for this functionality, digital asset payment systems can often function quite well.

Sometimes, the losers in the adoption race are ironically the visionary ones that enter the market too early. Slower market adoption may indicate that the underlying technology is ahead of its time – e.g., Tesla Turbine (1913), Tucker cars (1947), or Trio Devices (2000).?However, it is unlikely that crypto assets are based on concepts and technologies that are too advanced for our current time. In fact, crypto assets have become a one trillion-dollar industry today – roughly equal to the size of the global silver market –?and there is growing demand from 30 percent of investors to get into the crypto asset market. When considering high-net-worth investors in particular, some studies even put the demand as high as 70 percent. This demand is seen across all major industries, and efforts are being undertaken by enterprises both small and large to leverage blockchain and digital asset technologies across industries like supply chain management, gaming, real estate, health care, banking, and sustainability. Thus, the problem is not the market segment itself, but rather the ability to spot the right investment opportunities within this general market segment and avoid bad actors and projects that are based on unsound business models, and/or faulty economic principles. It is worth noting that the same is true in any market segment and was also true during the internet revolution (especially from 1995 to 2000).?

This summary deliberately avoids discussing the technical details or structural merits of alternative technologies, because we consider such considerations to fall outside the scope of this paper, which focuses primarily on practical investment applications based on perspectives within finance. For example, the average person doesn't care how a microwave functions. They care what they can cook with it, and how much time and money they can save with it. The same is generally true with crypto assets. While discussions around energy usage differences between blockchains, effects of regulation on the market, the viability of various consensus algorithms, differences in transaction speeds, and the pros and cons of myriad token-economic models (among other topics) may be necessary for the analyst making specific investment decisions, they are far beyond the scope of this summary as they vary from project to project in this market segment.

Crypto assets are likely here to stay for a long time to come. As for the optimal holding period and the return that can be achieved, analysts’ opinions are incredibly varied. Bill Gates once said that "Most people overestimate what they can do in one year and underestimate what they can do in 10 years." Mr. Gates, although notably skeptical of crypto assets, was not referencing blockchain in this comment. However, it is worth reflecting on whether this principle may be true for the crypto industry.

Nonetheless, analysts predict that one bitcoin could be worth between $800,000 and $1 million in ten years. Some even go as far as to predict a $1 million price target by 2030. Others expect a more moderate growth rate. Such assumptions depend on the analysts, and it is not the goal of this paper to endorse one or the other view. Further, this paper doesn't merely focus on bitcoin, but rather on crypto assets in general. This summary aims to discuss whether diversification into crypto assets can be a sound investment strategy for an investment portfolio. Thus, the goal is not to predict if crypto assets are in a current bubble, or if and when future corrections will occur for one or more cryptocurrencies.

Should a Diversified Investment Strategy Contain Crypto Assets?

The decision to include any asset in an investment portfolio can depend on various factors, including an individual's risk tolerance, investment goals, and investment horizon, among other considerations. The same is true for crypto assets.?

Based on the Modern Portfolio Theory (MPT) developed by Markowitz in 1952 and the Capital Asset Pricing Model (CAPM) developed by Sharpe in 1964 and Lintner in 1965, investment portfolios are diversified to reduce risk exposure. Following these two principles, portfolio managers tend to invest in assets with an inverse correlation among different asset classes to reduce risk exposure. Simply put, they don't put all their eggs in the same basket; rather, they hope that when one market segment depreciates, one or more other segments will appreciate due to inverse correlation. With this in mind, until the present today no direct correlation has been definitively shown between crypto assets and any other major asset classes in the market – e.g., stocks, commodities, currencies, or real estate. Crypto assets move with a high degree of independence. It follows that many trained investors drawing conclusions from the established portfolio theories referenced above would prefer that around four to five percent of a portfolio should be invested into crypto assets. This four to five percent range appears to be instinctively preferred by most investors willing to invest in crypto assets, according to a survey conducted by ChainBLX SPC.?

Of course, today's investment managers generally take the above-mentioned theories into account. Still, they are also well aware that the Modern Portfolio Theory and The Capital Asset Pricing Model are more than half a century old. The usage of past data sets in those models, even when combined with a linear regression to estimate risk, is far too simple and only partially applies to our current market conditions. Today, only four companies comprise 17 percent of the total S&P 500 index. Thus, allocating a majority percentage of investor assets to an S&P 500 index fund is excessively high degree of risk exposure according to MPT and CAPM. In addition, investors today consider various other factors such as?Environmental, Social, and Governance?(ESG) criteria in their investment decisions, measuring a company's progress toward achieving social impact goals while creating shareholder value. With shifting market conditions and evolving investor expectations, these and many other current factors must be factored into the traditional models. Therefore, for many investment managers, rigorous fundamental analysis of assets is crucial. In combination with fundamental analysis, many hedge fund managers use derivatives to optimize their portfolio strategy. Today, the game is optimizing the alpha value. ?

The investment manager, advisor, or private banker should carefully evaluate the investors' risk tolerance and align on investment horizons and allocation percentages accordingly. In general, the question must be asked whether the investor would accept a total loss in this asset class.?

Thus, some of the main reasons to add crypto assets from a fund manager's view are:?

1. The returns on some crypto assets have been spectacular, especially in recent years, leading many consumers to seek to invest.
2. Adding crypto assets to an investment portfolio can provide diversification benefits, as they often have a low correlation with traditional asset classes like stocks and bonds.
3. Some investors see crypto assets as a potential hedge against inflation since they are not subject to the same monetary policies as traditional currencies.
4. As more companies and individuals accept and use cryptocurrencies, their value could increase enormously.

How to Give a Client Access to Crypto Assets for Portfolio Diversification?

Given investors' (clients’) increasing demand on financial firms, private bankers, and advisors to adopt crypto asset diversification techniques, such organizations’ refusal to do so may result in the loss of significant clients. It is obvious that at this point, clients expect any advisor to possess a well-formulated opinion about crypto assets, and a mere dismissal or avoidance of the question is not possible anymore. This situation leaves many advisors in an uncomfortable position. The dilemma is that navigating the crypto asset world is complex and dangerous, but not doing so may deprive investors of an enormous potential return on their investment. In addition, the internal cost of providing such services is high; accounting and taxation for crypto assets are complicated. Furthermore, basic security and liability to hold the crypto assets are risky, market analysis is complicated because of a constant influx of new players and bad actors, and (last but not least), long-term reliable models do not yet exist due to a lack of sufficient data within the still-nascent digital asset market. ??

Every financial expert must decide whether to offer this service to each client individually. Such a tailored approach may require restructuring of policies and budgets and might even necessitate hiring and training specialized professionals. Similarly, starting a hedge fund to attract accredited investors may look like a good concept in theory, but comes with a significant initial setup cost to get the hedge fund up and operating. Control is lost when work is delegated to outside parties. That said, while there may be significant threats to a financial firm entering this market, huge opportunities can also arise. The vast majority of the competition will need years to catch up, and such laggards are likely to lose significant market share to companies and consultants offering such services. The assets under management for innovators are likely to increase not only because of the new influx of clients but also because of the higher potential returns predicted in the crypto asset space. Simply put, rather than staying put and not changing, it is often a better strategy to be ready to serve new generations and adapt to new markets.

There are three main pathways for financial professionals to consider in regards to adapting to increasing digital asset diversification demand from their clientele, and each has its own costs and benefits to consider:

1. Separately Managed Accounts: Providing each client individually with crypto allocation services can incur the highest costs to the client and in order to be economically feasible should in most cases only be undertaken for major clients with large portfolios far above the $25 million USD mark –?or perhaps the $10M USD mark when utilizing partnerships designed to take advantage of economies of scale, such as digital asset management solutions from sidecar portfolio enablers like ChainBLX SPC and CKC.fund. However, there are two other solutions that should be considered.
2. Third-Party Managed Funds: Recommending a third-party managed hedge fund can reduce the work for the internal team to a mere evaluation of different funds and can still provide the investment manager with a significant amount of income through referral fees. For example, when referring investors to CKC-SP – a crypto asset fund managed by ChainBLX SPC and operated by CKC.fund – financial experts can obtain referral fee revenue throughout the investor’s 5-year minimum holding period. Assuming the client is an accredited investor, this solution tends to be valid for nearly any investment portfolio size. However, while this is often one of the safer solutions, it comes with the drawback that the investment firm might not establish a core competency for itself in crypto asset trading. Thus, while the firm or financial advisor might not take full advantage of the existing demand from investors for such assets, there may still be significant monetization potentials in adopting this strategy –?as well as minimal time and low to no costs required.
3. In-House Funds: Opening a hedge fund for crypto asset trading is often the most expensive solution for the financial expert and requires hiring several experts and administrators. Such a solution may cost $75,000?if the firm goes with a hedge fund enabler like ChainBLX SPC –?or close to $500,000 or more when done from scratch. However, the advantage is that the firm and investment advisor will put themselves at the forefront of a growing market and may take full opportunity of the increasing market demand and the insufficient degree of professional assistance from most other firms.

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