Where Do Digital Assets Fit Into an Institutional Investor’s Strategy?

Are cryptocurrencies a once-in-a-lifetime investment, like the internet was a generation ago? Only time will tell. But as the crypto phenomenon becomes too big to ignore—with Super Bowl ads, congressional hearings, and fortunes won and lost—one thing’s for sure: Plenty of institutional investors are eager to explore its potential.

“At every institution, there are closet crypto enthusiasts,” says Steve Kurz, Head of Asset Management at Galaxy Digital, a financial services and investment firm that is a leader in digital asset management.

Kurz knows because he’s met many of them. They’ve watched as Bitcoin and other cryptocurrencies have bounced back repeatedly from bouts of volatility, as the use cases for crypto have multiplied and the investment infrastructure has matured.

Now, many of these enthusiasts are taking leading roles in their firms, and their question about crypto investing is no longer if, but how.

How crypto changes the investment landscape

“No matter the institution, everyone’s looking for diversification, market performance and reduction of volatility,” says Kurz. “When you look at the traditional asset classes and how they’re performing, it’s clear that there’s a need for new thinking and action-oriented portfolio management, and crypto is a part of that discussion.”

Even many pension funds—traditionally the most conservative of institutional investors—are exploring crypto. They’re recognizing its potential to become, as Kurz puts it, “a foundational technology that may disrupt multiple verticals and sit behind much of what happens in economic activity, but also human and social activity—the same way the internet in the early 1990s started to have a dramatic effect on everything we did.”

Institutional investors can’t plunge into crypto as easily as individuals, but they have the patience, discipline and scale to make the most of emerging asset classes. Witness the spectacular success Yale and other university endowments have had with commodities, private equity and hedging strategies. With a long horizon and top-flight active management, they can ignore the market noise and focus on the assets that will create (or store) the most value in the long run.

“Price can be wildly different from value,” notes Kurz. “Value has to do with the characteristics of the system—what are the use cases, not just in the world today, but to where it's going, and how does it fit into this broader ecosystem that's growing outside of just one asset or one project.”

Whether those use cases leverage store-of-value (like with Bitcoin), the decentralized internet (Web3 and decentralized finance), the metaverse or digitized payment, the potential for upside is enormous. What’s more, institutional investors can now easily diversify within crypto (and potentially reduce volatility) through a Galaxy crypto fund based on an index co-branded by Galaxy and Bloomberg, the Bloomberg Galaxy Crypto Index.

But there’s another rationale behind crypto investing that is seldom explored: its potential as a hedge. Many institutions have significant holdings in finance, media, entertainment and tech. If these industries are disrupted by blockchain- or crypto-linked technologies, the gains from crypto holdings could help offset portfolio losses.

It may seem strange to think of crypto as a risk reducer. But many institutional investors assumed that bonds were low-risk based on decades of historical performance, and look where we are now, Kurz notes. Maybe it’s time to explore how emerging asset classes could add new dimensions of diversification.

“It’s important to talk about crypto’s volatility. I understand that’s a real risk,” Kurz says. “But the world today is different than it was pre-Covid, and you have to think differently.”

Where does cryptocurrency fit in an institutional investor’s strategy?

As fiduciaries, institutions are also expected to perform greater operational due diligence than the average retail investor. In future articles in this series, we’ll address operational considerations including security, custody and regulatory risk. Many of these issues are now being addressed as established players in accounting, banking and law have stepped up to help ensure that crypto holdings are secure and compliant.

That still leaves investment due diligence. For institutions that are getting serious about crypto, the early questions revolve around allocation and sizing: How does crypto fit in their portfolio, and how much should they buy?

From an allocation perspective, crypto can be hard to pin down, Kurz says. It’s got the growth potential of a venture investment, but it’s much more liquid than venture, which typically requires a lock-in of several years. Its pricing is also much more transparent than venture, thanks to real-time price monitoring of exchanges.

In addition, different assets have different risk characteristics depending on their value propositions, from store-of-value to macroeconomic hedge, to innovative tech play. As crypto grows, its portfolio bucketing should become clearer; in the meantime, institutions will need to be flexible.

Another consideration for institutional investors is sizing: How much? Let’s start with zero, because that’s where many institutional investors are today. Consider that the market capitalization of cryptocurrencies today is roughly $1.3 trillion, and global economic activity stands at a bit over $400 trillion. If you believe a portfolio should roughly reflect global economic activity, then that would translate into a portfolio allocation of 0.33%, or 33 basis points.

“If you don’t have 33 basis points of crypto,” Kurz notes, “you’re actually short crypto, implicitly, on an allocation basis.”

The recommended allocation grows if you rely on modern portfolio theory (MPT), which posits that by holding assets that are uncorrelated, one can increase returns without a proportional increase in risk.

To use Bitcoin as an example: A Galaxy Digital study shows that the strongest marginal improvement in the risk-return balance from investing in Bitcoin occurs with an allocation between 1% and 2%. This demonstrates that even a small percentage allocation to Bitcoin in a portfolio may have a sizable impact.

Staying nimble in the market with trusted partners

A similar analysis could be performed for a basket of cryptocurrencies. But for institutions intrigued by the potential of crypto and the blockchain, the options go well beyond dabbling in one asset or another. They include diversified, market cap-based crypto index investing; venture investing in crypto- and blockchain-related companies; and market-neutral strategies—all strategies that can be accessed through Galaxy Fund Management.

With so many assets, and new firms supporting so many potential use cases, it might be tempting to try to “go map out the entire space,” Kurz says. “But by the time you do that, the space will have fundamentally changed.”

Instead, find a specialist like Galaxy, which is entirely devoted to finding the best investment opportunities in this fast-moving and highly technical field.

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