Digital assets may be one of the few markets where diversification still seems underappreciated. Bitcoin and Ethereum remain dominant by market cap despite a growing number of innovative new projects, and many investment products provide only a handful of concentrated positions.

At Outerlands Capital we have written about the benefit to risk-adjusted returns from diversification. Individually, smaller projects may carry higher risk, but investing across a broad mix of projects can reduce volatility and improve risk-return metrics like the Sharpe ratio (returns normalized for volatility). However, there’s more to diversification than higher Sharpe ratios.

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In a market as dynamic as crypto, diversification is essential to gain exposure to the varied and evolving mix of themes and sectors built around blockchain technology. Diversification is about solving for the power law distribution of returns, whereby a portfolio’s return is driven by a small number of highly positive outcomes against a larger number of investments that deliver lower, or negative, returns. This phenomenon is well documented in venture capital (VC) investing, and the concept carries over to digital asset investments, which are akin to investments in disruptive tech startups. Diversifying makes sure your portfolio has enough shots-on-goal to capture the biggest winners over time.

A concentrated portfolio of just a handful of tokens will struggle to capture the range of exciting crypto use-cases being developed today. Take, for example, the 10 largest cryptocurrencies by market capitalization – a popular take on a ready-made “diversified” portfolio. You have here, essentially, a mix of currencies and Layer 1s. While these larger tokens are sometimes seen as less risky on account of scale, such a selection fails to capture much of the current innovation happening in crypto.

Expand to an actively managed portfolio encompassing tokens from the Top 150 by market cap and you start to see a much more dynamic picture, spanning Layer 1s and related infrastructure (like scaling solutions and interoperability), DeFi (from trading and lending to asset management), entertainment (including gaming and the metaverse), decentralized physical infrastructure networks (DePIN, including projects for distributed compute power with tie-ins to AI), real-world-assets (RWAs), and more. While some of these projects may carry greater risk on their own, diversification helps manage the risk of the overall portfolio.

Portfolios should be positioned to capture emerging themes and new directions as projects across the space continue to innovate, searching for product-market-fit. Even in the more developed parts of the crypto ecosystem, such as payments or Layer 1s, we believe it is still much too early to call winners. The pace of innovation means disruption will continue to be the norm.

The nascency of the market and its fast-paced evolution also mean that an active approach to portfolio management is imperative: Diversified is not equal to passive. Building a well diversified portfolio does not mean just buying more, smaller assets. It means taking a long-term perspective on the scale and scope of the digital assets ecosystem, and positioning a portfolio to take advantage of the many different potential outcomes.

Coming out of crypto conferences like Consensus, AIMA Digital Assets, Token2049, and DAS, we are again emboldened in our assessment that the average institutional crypto portfolio is simply not exposed to enough of the disruptive use-cases being tested in digital assets today. Budding themes such as DePIN, innovative scaling solutions for Ethereum and also Bitcoin, and bringing real-world-assets on-chain all require a deep look past the largest tokens, and should encourage portfolios of digital assets spanning many sectors and project sizes.

Remember that diversifying doesn’t make a portfolio less potent - it actually gives investors more opportunities to capture winners, while still providing time-tested risk benefits. In essence, diversification gives you more for less.

Disclosure: The information herein is for general information purposes only and is not investment advice. An investment involves a high degree of risk. Past performance is not necessarily indicative of future results.

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Felician Stratmann

Felix Stratmann is the head of research at Outerlands Capital, a data-driven digital asset manager pioneering factor investing in Web3. He focuses on the Firm’s investment strategy and factor research and is the primary researcher and writer for Outerlands’ externally published research. Prior to joining Outerlands, Felix spent 8 years at Morgan Stanley, including a stint in Debt Capital Markets within Investment Banking and six years in the Fixed Income Research department, where he attained the title of Vice President. At Morgan Stanley, Felix focused on US corporate credit markets. He authored or contributed to numerous publications, including foundational work on the application of systematic investment strategies in corporate bonds and credit derivatives, the integration of ESG into corporate bond analysis, and the escalation of leverage at US corporations via M&A and share buybacks. Felix graduated from the University of South Carolina with a degree in Finance.