Felix Stratmann, head of research at Outerlands Capital, believes that institutions must diversify their crypto holdings to benefit from market innovation.
One of the few markets where diversification still seems undervalued is digital assets. Despite increasing creative new ideas, Bitcoin and Ethereum continue to lead the market capitalization, and many investment products offer only a small number of concentrated positions.
We at Outerlands Capital have written about the advantages of diversification for risk-adjusted returns. Smaller initiatives may have more risk on their own, but investing across a wide range of projects can enhance risk-return metrics such as the Sharpe ratio (returns normalized for volatility) and lower volatility. But diversity is about more than just having more excellent Sharpe ratios.
Diversification is crucial in a market as dynamic as cryptocurrency to expose oneself to the wide range of issues and industries developing around blockchain technology. Diversifying an investment portfolio involves calculating the power law distribution of returns, which pits many investments with lower or negative returns against a small number of highly positive outcomes. The phenomena of digital asset investments, similar to investments in disruptive technology firms, are well-documented in venture capital (VC) investing. By diversifying your holdings, you can ensure that your portfolio includes enough long-term winners to collect the most prominent winners.
A few tokens in a concentrated portfolio will not be able to cover the various fascinating crypto use cases now being created. Consider the top ten cryptocurrencies by market capitalization, a typical representation of a pre-made, “diversified” portfolio. Essentially, what you have here is a mixture of Layer 1s and currencies. Because of their larger size, these more significant tokens are occasionally viewed as less dangerous. However, this pick leaves out a lot of the current innovation in cryptocurrency.
When you expand to an actively managed portfolio that includes tokens from the Top 150 by market cap, you’ll see a much more dynamic picture that provides for real-world assets (RWAs), gaming and the metaverse, DeFi (from trading and lending to asset management), entertainment (including gaming), decentralized physical infrastructure networks (DePIN, which includes projects for distributed compute power with connections to AI), and Layer 1s and related infrastructure. Diversification aids in controlling the total risk of the portfolio, even though some of these projects can be riskier individually.
As projects throughout the industry continue to evolve and strive for product-market fit, portfolios should be positioned to capture emerging themes and new paths. It’s still far too early to declare winners, even in the more mature areas of the crypto ecosystem, like payments or Layer 1. Because of the rate of invention, disruption will always be the norm.
Because of the market’s youth and rapid change, managing a portfolio actively is essential—diversified does not equate to passive. Purchasing a more significant number of smaller assets is not the only way to create a well-diversified portfolio. It entails adopting a long-term outlook on the size and reach of the ecosystem for digital assets and allocating a portfolio to capitalize on the numerous possible outcomes.
After attending crypto conferences such as Consensus, AIMA Digital Assets, Token2049, and DAS, we are more specific in our opinion that the typical institutional crypto portfolio needs to include more exposure to the innovative use cases now being explored in digital assets. Emerging topics like DePIN, creative ways to scale both Ethereum and Bitcoin and putting real-world assets on the chain all call for a close examination of digital assets beyond the giant tokens and ought to promote portfolios of various industries and project sizes.
Recall that diversification adds time-tested risk benefits while increasing investors’ chances of capturing winners. It does not lessen the power of a portfolio. Diversity allows you to get more for less money.
