How to Build a Diversified Crypto Allocation
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As the blockchain ecosystem develops and new cryptocurrencies spawn, investors are attempting to diversify their holdings to effectively capture the crypto market. After investors determine how much of their portfolios they want to dedicate to cryptocurrencies, a question soon follows: Which cryptocurrencies should constitute those holdings?
Several avenues for diversifying cryptocurrency portfolios exist. Investors should weigh the costs and benefits of each of the following three methods for purchasing and holding crypto assets: assembling a diversified portfolio by buying cryptocurrencies individually through an exchange, purchasing a crypto trust or ETF, or enrolling in an automatically managed crypto robo-advisor.
1. Purchase a diversified crypto portfolio through an exchange
The most straightforward way to invest in an assortment of cryptocurrencies is to buy them through an exchange. Popular exchanges include Coinbase, Kraken, Gemini, Crypto.com, and Binance.
Crypto exchanges generally charge transaction fees, which are based on the costs the exchange pays to miners that process crypto transactions on the respective blockchains. These fees tend to be relatively low compared to robo-advisor fees and ETF/trust expense ratios. For example, Coinbase charges up to 0.6% of the transaction’s value, and the precise amount varies based on market conditions, payment method, and order size. Additional fees are charged based on the payment method used to purchase the cryptocurrency. Traders can avoid payment method fees by funding their accounts with an ACH bank transfer or by using Coinbase Pro.
Most exchanges maintain insurance policies that provide protection against a certain amount of losses of customer funds due to criminal activities against the exchange like theft, hacking, and unauthorized employee access.
Since investors using exchanges must identify the cryptos they want to purchase and execute their own trades, they face a high research burden in deciding which cryptos to buy, how much to buy, and when to sell. Without the automated rebalancing provided by robo-advisors, exchanges require investors to react to market movements in real time, which can be pronounced when key events in a crypto’s lifecycle occur, such as when new partnerships are announced or a crypto becomes available to trade on a new exchange.
2. Purchase a crypto ETF or trust
Because trusts and ETFs are traded through brokers, SEC and FINRA security regulations provide some protection against hacking, losing wallet access, or custody mismanagement. These products are already diversified by professional managers, leaving the investor free of research or management of the portfolio. Since they are registered products, investors also benefit from some transparency around holdings.
Most trusts and ETFs only offer single cryptocurrencies rather than index funds consisting of multiple cryptocurrencies. Grayscale offers only three crypto trusts that consist of multiple assets: the Grayscale Decentralized Finance Fund, the Grayscale Digital Large Cap Fund, and the Grayscale Smart Contract Ex-Ethereum Fund. Since few ETFs consisting of multiple cryptocurrencies are available, investors seeking to diversify their crypto holdings must purchase shares of multiple trusts/ETFs and engage in periodic rebalancing. Building a diversified crypto portfolio using trusts or ETFs can be more time consuming and research-intensive than one might expect.
Additionally, the selection of cryptocurrencies is limited. While crypto exchanges tend to make cutting-edge cryptocurrencies available for purchase relatively quickly, there is often a significant delay before the same underlying assets become available for purchase within the shell of a trust or ETF.
Trust share prices do not always match the underlying asset value, because investors initially hold the shares for a lockup period. The end of lockup periods introduces additional volatility to the shares’ value.
Investors pay transaction and management fees through expense ratios. These fees often exceed the transaction fees charged by exchanges and can be as high as 2%.
A significant downside of crypto ETFs is that the only ETFs available use crypto futures rather than the underlying crypto. No spot ETFs have yet been approved by the SEC. Crypto futures prices are not directly based on the trading price of the cryptocurrency, and they may even move in the opposite direction from the price of the underlying crypto asset.
3. Automate a diversified investment strategy through a crypto robo-advisor
Robo-advisors harness the power of sophisticated algorithms to build and maintain diversified portfolios according to a chosen investment strategy. Investors can tailor their investment strategy based on their risk tolerance, financial goals, and personal interests.
Innovative robo-advisers, such as Makara and Titan, offer diversified crypto products. Makara and Titan are registered investment advisers (RIAs) regulated by the SEC. Makara and Titan’s robo-advisors are therefore bound by RIA fiduciary duties and must act in the investor’s best interests. They must file a form ADV and form CRS, which inform investors about relevant fees and actual and potential conflicts of interest, and indeed, their management fees compare favorably to the other diversification options discussed above, particularly given how little work it is for investors to set up and maintain an account. Additionally, robos must practice transparency and prioritize investors’ best interests in allocating investor funds, executing trades, and selecting and monitoring the crypto custodian.
These diversified offerings, such as Makara’s pre-made baskets, considerably reduce investors’ research burden by providing quick access to diversified investment products according to considerations like total market cap, cryptocurrency function (e.g., decentralized finance) or investment purpose (e.g., hedging inflation). Automatic rebalancing at the end of each quarter removes the work and cost of executing individual crypto trades on exchanges or through single-crypto ETFs.
Titan offers one crypto portfolio which it actively rebalances, consisting of about 5-10 coins, as one option alongside equity and other securities portfolios.
The investor protections provided by RIA registration are still somewhat murky, as Makara and Titan are pioneering crypto robo-advisors and few precedents exist governing crypto robo-advisor activities.
The selection of cryptocurrencies is more limited than exchanges. Like crypto ETFs and trusts, a delay between a cryptocurrency’s debut on an exchange and its appearance in one of Makara’s baskets or Titan’s portfolio may be considerable.
Since transactions are carried out through each robo-advisor’s chosen exchange, investors will always be charged that exchange’s prices and, in Makara’s case, fees for crypto trades done on its behalf. Investors are therefore deprived of opportunities to engage in arbitrage or shopping for the best deals.
Makara passes transaction fees from Gemini of up to 0.35% on to customers. Typical transaction fees through Makara will range from 0.10% and 0.15%. Makara also charges a 1% annual advisory fee for multi-asset baskets and actively managed baskets, but this fee is currently waived, and will be for the foreseeable future. Titan charges an annual fee of 1% of assets under management for accounts with net deposits that are $10,000 or higher and charges a fee of $5 per month for accounts with net deposits under $10,000.
Crypto products are notoriously difficult to compare, especially their technological and economic nuances. Advisers should consider all these nuances when helping clients with their portfolios. They may feel most comfortable with the crypto robos given their registration with the SEC, but they should caution their clients of the risks and make them aware of their other options.
Jasmin Sethi is the CEO of Sethi Clarity Advisers, a boutique consulting firm providing expert regulatory and business strategic advice to companies in the financial services industry. As a Harvard trained lawyer-economist, she is a thought leader on issues pertaining to how the asset management industry and financial regulation impact ordinary investors.
Michael Farrington is an associate at KML Law Group, P.C. and a former research associate at Sethi Clarity Advisers. He is interested in issues related to cryptocurrencies and blockchain.