Applying traditional risk management practices to a crypto portfolio

by | Jul 29, 2022

After the fall out of the LUNA/TERRA ecosystem collapse, the risk management, or lack thereof, for many crypto businesses has been laid bare, in the words of Warren Buffet “Only when the tide goes out do you discover who’s been swimming naked” have never been more apt. While digital assets are on the journey toward becoming a part of mainstream investment portfolios, there is no substitute for traditional risk management practices in this nascent asset class.

As the first new asset class in a century and a half, digital assets have captured a great deal of interest, but it is still a relatively misunderstood sector. It is a volatile asset class, but it is not alone in that distinction. Even that volatility opens up possibilities for its use as a way to diversify portfolios, by accessing a different risk premium. While the headlines about the “digital revolution” and the proliferation of strange new terms such as “decentralised finance” or DeFi, “tokenisation” and “Web 3.0” confuse many investors with no experience of the sector, at its heart, digital assets are just like any other asset class: the differing investment exposures within it vary widely in terms of investment quality and reliability. Digital assets has its equivalents of blue-chip shares and speculative stocks, and has its equivalents of low-risk (in terms of repayment) AAA-rated bonds and sub-investment-grade high-yield issues bearing high credit risk.

As a digital-asset fund manager, Merkle Tree Capital focuses on a low-risk strategy in this volatile asset class, through a rigorous portfolio construction and risk management process, to offer investors wanting exposure to this emerging asset class a managed portfolio of the digital assets that we believe will deliver the best long-term prospects for investors; and that neutralises, as much as possible, the inherent risk of the asset class. In this way, risk management principles can be applied as they would be in a fund investing in any other asset class.

The primary pillar of this risk management strategy is to apply research and assessment skills to choosing the investments. We believe that long experience in, and deep understanding of, the digital assets space, enables our team to generate skills-based returns as investors.

In particular, we believe that the digital assets ecosystem is characterised by very deep information inefficiencies, and that a skillful investor can extract alpha, or outperformance, from it.

Using proprietary research, we choose to hold at any time 15-25 positions in a portfolio of crypto assets, with a bias toward proven protocols and the top 100 coins/tokens by market capitalisation; essentially, the blue-chips of the digital assets universe. Predominant in this is Bitcoin, our largest allocation, which we consider to be both a currency for the portfolio and an investment, a store of wealth. We would expect to have up to 25 per cent of the fund allocated to Bitcoin at any time.

Within that, our target asset allocation is focused on coins that provide exposure to blockchain infrastructure – the backbone infrastructure of digital assets – with somewhere between 40 per cent–70 per cent of the portfolio directed to this sector. We believe that blockchain infrastructure is a lower-risk digital asset, and is able to generate income as well as capital growth.

This ‘Infrastructure layer’ that typically forms the bulk of the portfolio is also referred to as ‘Layer 1’ or “smart contract” platforms. A smart contract is best described as a virtual intermediary, built on blockchain technology – it’s an automated digital version of a traditional real-world contract. Some digital assets, for example Ethereum, are both cryptocurrencies and smart contract platforms.

If a cryptocurrency/smart contract platform you own allows “staking’ – such as Solana – you can lock-up, or ‘stake’ some of your holdings in a staking pool and earn a percentage-rate reward over time, because the blockchain puts it to work by securing the network. This situation is akin to earning interest income from your investments; it is something we do, after careful consideration of counterparty risk and liquidity risk, it introduces an element of income return that lessens the reliance on capital growth and decreases the impact of volatility.

In practice, this means that our portfolio is based around Layer 1 and Layer 2 digital assets. Layer 1 refers to the base level of a blockchain architecture. It's the main structure of a blockchain network. Bitcoin and Ethereum are examples of Layer 1 blockchains; Layer 2 refers to networks built on top of other blockchains. These kinds of assets are often less established and offer a higher risk and return profile for their more dedicated use case.

Defensively, our portfolio can be buttressed with a holding in cash, and a holding (up to 10 per cent) in stablecoins, which are digital assets pegged to something else, typically USD. But all stablecoins are not created equal, we only use stablecoins that are fully collateralised with high quality assets, that are pegged to a real currency; we consider algorithmic-based stablecoins as too speculative for our purposes.

Portfolio selection is the primary risk management strategy. Secondary is to be long only, with the use of leverage, short selling and derivatives not permitted. We might miss out on having our gains magnified, but neither will we have investment losses balloon in size. That is what we can assert from Applying traditional risk management practices to a crypto portfolio.

Poorly managed and unconstrained use of leverage, investing in newer, less-proven technologies with little evidence of sustainable use-cases, have been some of the most pertinent problems experienced in digital-asset investment. Through proprietary research informing the construction of a high-conviction portfolio of high-quality digital assets, and avoidance of leverage, we can invest in digital assets in as risk-controlled a manner as possible.