Over the past year, innovative, blockchain-based projects and financial applications including Bitcoin, Ethereum, NFTs, and many others have been hailed as an emergent asset class. Described under the umbrella term of digital assets, they have seen an unprecedented rise not only in terms of price appreciation but also in prominence and adoption rates. 

As a result, we are observing a strong trend towards an ever-greater integration of digital assets into the mainstream financial industry. Such integration, along with the breathtaking pace of innovation within this space, means that digital assets are currently one of the most promising markets in the world in terms of upside potential.

Still, while the investor interest remains high across the board, technological complexity, high volatility, and ambiguous regulatory status are often perceived as strong barriers to entry. Undeniably, investing in digital assets requires an in-depth understanding of these issues which is why investors are hesitant to enter the digital asset markets directly.  

This provides a huge niche for boutique investment funds that, like ARK36, are able to provide investors exposure to digital assets with a hands-off investment and deliver consistent returns despite market volatility. However, this niche is becoming quickly saturated. In order to stay competitive, the funds must be able to meet the clients’ expectations in terms of asset selection, performance, and regulation.  

Navigating the Digital Asset Market

Successfully identifying assets with the most attractive risk-to-reward ratio is one of the biggest challenges digital asset fund managers face. The assets that currently comprise the larger digital asset ecosystem can be categorised into three main areas according to their inherent qualities and intended use. These areas are financial products, infrastructure projects, and services: 

• Financial products include cryptocurrencies that may be seen as a store of value as well as decentralized exchanges that allow for peer-to-peer trading of cryptocurrencies and other assets.
• Infrastructure projects include tokenization (a process in which a physical asset is represented as a unique digital asset registered on a blockchain) and smart contract platforms (automated, irreversible contracts existing on a blockchain that are executed when certain conditions are met).
• Finally, services include a wide range of blockchain-based technologies with use cases going far beyond the financial industry, including entertainment, healthcare, e-commerce, and more.

It is evident, then, that the rapid pace of innovation in this space provides abundant investment and portfolio diversification options. However, out of around 6,500 digital coins and tokens currently available on the market, only an extremely small percentage presents a viable investment opportunity.

On the other hand, small and lesser-known blockchain-based projects with innovative use cases may exhibit a strong upside potential. Recognising such projects is a complex endeavour. Significant trading experience in the digital asset market coupled with extremely solid due diligence is of utmost importance.

Asset Allocation for Consistent Performance 

From an investor’s perspective, the main value propositions of investing in a digital asset fund include diversification and superior returns. The diversification advantage this asset class provides is clear. In stress periods, portfolios with even a small digital asset allocation are shown to perform better than the Global Allocation 60/40 index.

However, meeting investors’ expectations with regard to delivering consistent performance is much more challenging. Digital asset markets are much more sentiment-driven than the traditional markets and the volatility they exhibit can be considered extreme from the traditional standpoint. Delivering consistent returns in spite of these challenges will require active exposure management with an extensive focus on risk and portfolio diversification.

For example, a digital asset fund manager must be able to identify leading assets in the digital market around the globe. At the same time, they should readily recognise how any given investment fits in the greater digital asset ecosystem, what kind of risk it exhibits, and whether the asset may be in any way correlated with other digital assets in their portfolio.

Importantly, experience from traditional investments may not be readily applicable to trading digital assets. Digital asset funds that aim to provide consistent returns for their clients should, therefore, work with portfolio managers with experience native to the digital asset market and a proven track record across more than one market cycle. For example, at ARK36, asset selection and portfolio allocation are performed by dedicated portfolio managers who have traded digital assets for nearly a decade - almost as long as these markets have existed.

Facing the Regulatory Challenges

Regulation is one of the most important topics of interest for all actors in the digital asset industry. Recently, digital assets have faced increased regulatory scrutiny in a number of jurisdictions. Often, the attempts to regulate these markets greatly influence investor sentiment and may have an indirect effect on the price of digital assets. For example, when China banned Bitcoin mining and transactions in May, the price of BTC fell 30% which had a ripple effect across the digital asset market.

On the other hand, more regulation can at times have a positive effect. Some investors will welcome clearer guidelines on digital asset investments and, for example, their place in the greater tax ecosystem. Regulation can also offer greater investor protection. All of that will likely draw even more investors to the markets and increase the pace of mainstream adoption of digital assets.

Fund managers should therefore strive to take a proactive approach to regulation and work closely with regulators to ensure full compliance. For ARK36, such a strategy paid off. Thanks to close cooperation with CySEC, we managed to become one of the first fully regulated entities of its kind in the European Union which we perceive as a strategic advantage.

As the digital asset investment funds market saturates, the unambiguous regulatory status will likely become an increasingly differentiating factor. To stay competitive and cater to compliance-conscious investors, a regulatory forward mindset will be more and more essential.