How Crypto Is Changing Portfolio Construction

Given the recent volatility in digital assets, it’s natural to wonder about future opportunities in the space – but whatever the volatility, they’re there. To better understand the potential of what is yet to come in the vast landscape of digital assets and blockchain technology in a Web3 context, turn the dial of your time machine with a few clicks to the left and set it to “1990”. Only a handful of people understood what the Internet could become. Timely sharing of information relied on fax machines. Smartphones and mobility linked to the Internet? Not even a glint in Steve Jobs’ eyes.

“Today we are in the early days of what is likely a 30-year, multi-decade investment opportunity that is Web3 blockchain technology,” said Scott Army, Managing Director and CIO, Galaxy Vision Hill, the multi-manager fund-of-funds offering at Galaxy Digital. “In the 1990s, it would have been very difficult to capture the full set of industries that would grow from the Internet. Entire application ecosystems were not yet designed. Today, we are at the basic level of re-architecting this full tech stack in many ways, and we’re only scratching the surface.

Many institutional investors – seasoned watchers and long-game players – share Army’s view. Venture capitalists invested over $33 billion in crypto/blockchain in 2021 – more than all other years combined. Additionally, valuations in the space were 141% higher than the rest of the VC space in Q4 2021.1 In short, institutional investors largely believe in the growth of blockchain technology and the wider space, and support it with allocations. Such investments are likely to lead to an improvement in the quality of the investment process. They may feel this because they already see it, for example, in detention.

“Asset security has always been important to institutional investors,” says Army. “Over the past five years, custodial solutions have improved dramatically, not only with Bitcoin and Ethereum, but also across many mid- and small-cap assets. Hedge funds and venture capital funds can hold and custody these digital assets securely in an institutional manner. Many traditional custodians in the asset servicing world partner with crypto-native custodians because they know there is a need and their customers demand it.

Evolutionary need for specialization

A common misperception in cryptography is that there is only one thing to allocate and everything is the same as everything else. In fact, there is considerable segmentation and specialization, much of which results from old-fashioned relationship building.

“Digital assets are a global asset class, and we invest globally, but localized transaction flow is important, especially for the early stages,” says Army. “We love the on-the-ground relationships at an early stage of entrepreneurship, where you’re really incubating and working closely with the founders, helping them recruit and hire the team. If you’re going to be practical, we’re going to be very value-added as a venture capitalist.

Institutional interest in digital assets is likely to grow as the space matures to provide more robust businesses to invest in – the actual earnings on certain stocks in the space and in venture capital investment the make it more familiar and easier to compare to a traditional assessment framework. This is seen to some extent as digital assets begin to disrupt other industries, such as gaming, healthcare, wireless, and data storage. Some non-traditional aspects of the investment process will also require adaptation.

“The importance of operational due diligence in crypto and digital assets is very different from that of traditional assets,” says Army. “Crypto is a new instrument, so operational due diligence is complex around new vendors, trading counterparties, counterparty risk, traded instruments, etc. Many internal teams cannot perform the level of operational due diligence required in the space, so we are frequently called upon to handle this for clients. Investment due diligence and operational due diligence are bifurcated within our team from the start due to the importance of a complete focus on both parts of the due diligence process.

Another area that requires a shift in perception is the context in which risk is perceived. “Institutional investors won’t change the way they allocate risky assets, so you tend to see teams engaging with digital assets in the same way,” Army says. “A venture capital group considering investing in emerging technologies, for example, can look at blockchain technology through a similar lens and allocate some of their normal venture capital allocation to the space. It’s been the easiest way for institutions to enter the market because it’s the clearest path — and oftentimes, a decades-long technology iteration is a good fit for that enterprise allocation. An absolute return-focused hedge fund team will look at digital assets and consider whether there is relative value and might see it as a potential substitute for equity volatility or absolute equity return.

The net result has been increasingly specialized products for different types of investors. For example, an agile multi-family office with a higher risk tolerance may want to move aggressively in certain parts of the directional market. Larger, more risk-averse institutions not only want to allocate risk the right way, but also understand volatility and liquidity metrics, among other things.

“We have a market-neutral fund that speaks very well to those who are more risk averse,” says Army. “Our venture capital fund is well suited for people who are fine with investing for a longer duration and who don’t want more market risk. We see the issues becoming more nuanced and the demand for 24/7/365 expertise in this space is very high. Many of our partners see us as a de facto OCIO in addition to being a multi-manager fund manager.

Changing Perceptions

With new investors frequently entering the sphere of digital assets amid the movement towards decentralized finance, it is common for investors to wonder exactly when this decentralization will happen. In short, this will not happen overnight.

“Societies have been centralized for thousands of years,” says Army. “There is a role for trust and centralization. Not everything needs to be decentralized. We’re going to move into a Web3 world, but there’s a 2.5 in between that maybe has decentralized protocols as a base layer with centralized business models on top that can add a layer of trust if needed. Then process improvement can happen at the protocol level.

This type of idea is ubiquitous in an investment approach that is a very diverse expression of the thesis that is crypto and blockchain technology.

“We try to capture future winners from emerging categories, maximize opportunities and minimize idiosyncratic risks, whether with a single project or a single lead,” says Army. “How do you do that? By making high-quality allocations to top crypto-risk managers – both emerging and marquee type managers.

1Galaxy Digital Research, 2022.

Leave a Reply