Wealth management is a multi-billion-dollar business. As the market capitalization for cryptoassets grows, it will be interesting to apply the concepts of wealth management to cryptocurrency investments.
This article looks at how the traditional wealth management industry works, covering the following areas:
- Portfolio management theory
- Strategic and tactical asset allocation
- Client risk profile
- Portfolio construction
Next, we will synthesize our approach to apply modern portfolio management practices to cryptoassets.
Portfolio Management Theory
The key principles of portfolio management theory are as follows:
- It is assumed that higher potential returns are associated with higher risk and vice versa.
- Assets are to be diversified, such that the volatility of various assets balance each other out, allowing investors to achieve the best return for the chosen risk level.
Different types of assets have different characteristics:
- Expected historical return — for example, equities have higher returns than bonds.
- Expected risk (volatility) — for example, equities have higher volatility than bonds.
- Correlation with other assets — different correlations mean that asset classes move in different directions during the same market events. For example, equity performance has a medium correlation with bonds, but an even lower correlation with alternative assets.
So, the basic idea is to combine different assets in order to:
- Reduce expected portfolio volatility
- Optimize expected return for the chosen risk level
Strategic and Tactical Asset Allocation
The overarching asset classes in traditional portfolio management are:
- Real estate
- Alternative investments
Each of the asset classes has its own characteristic return; in the long run, equities have the highest return, then bonds, followed by real estate. Alternative investments exhibit similar returns to equities and additionally they should correlate negatively with other assets (at least in theory). Return and risk are correlated — the higher the returns, the higher the risk. In this context, high risk implies high risk to the downside (losses in portfolio value).
Strategic asset allocation defines the asset allocation between the main asset classes. Strategic asset allocation accounts on average for 92 percent of the variation of returns over time (Brinson, Singer and Beebower).
Tactical asset allocation focuses on the asset allocation within the subcategories of the main asset classes.
For example, in the case of equities the possibilities are investing into the following subcategories:
- Equities of developed countries
- Equities of emerging countries
In the case of bonds, we can choose between:
- Corporate bonds
- Sovereign bonds
- Long-duration or short-duration bonds
- High-rating or low-rating bonds
If interest rates are low, then equities would perform relatively well, and larger parts of the portfolio could be allocated to equities. If the economy is in the phase of recovery, equities of developed countries have potential; the further we move into recovery, the more potential lies in emerging countries’ equities.
If interest rates are declining, it makes sense to invest in bonds — the value of bonds will increase as interest rates fall. Additionally, the longer the duration of these bonds, the higher the performance effect through the declining interest rates.
The main idea is that investors do not need to “pick stocks” or “pick bonds”. Instead, most of their portfolio performance will be delivered through strategic asset allocation and tactical asset allocation.
Client Risk Profile
Each wealth management client will have an investment policy statement comprising:
- Financial objectives — what is the time horizon of the investments?
- Risk profile — what risk level can and will the client accept?
- Need for liquidity — what monthly/yearly liquidity needs does the client have?
- Investment restrictions — do some sectors like tobacco and gambling raise ethical concerns?
- Asset liability management — what is the general asset/liability situation of the client?
We assume here that the client has a multi-year time horizon, there are no monthly liquidity requirements and no investment restrictions are applied.
The client risk profile is the key determinant when constructing the client portfolio. The main factors here are:
- Risk tolerance
- Risk ability
Risk tolerance is determined by the client’s investment experience in years, their interest to follow market developments, and their loss sensitivity and risk awareness.
Loss sensitivity can be characterized as the way in which the client would react, for example, to the hypothetical scenario of 30-percent losses on the value of their portfolio:
- Reduce all or most positions
- Reduce some investment positions
- Maintain current positions
- Increase some positions
- Increase all or most existing positions
Risk awareness is determined by the following:
- Would the client prefer greater profit potential for higher underlying risk — for example, 30-percent return for 20-percent risk, or;
- Would the client prefer smaller profit potential for lower underlying risk — for example, 5-percent return for 1-percent risk?
Loss sensitivity and risk awareness are determined by psychometric characteristics. In other words, how does the client deal with risk? Some clients are willing to take higher risks for the chance to receive higher rewards, but quite a lot of clients would sleep better if they faced lower risks.
Risk ability is determined by rational factors:
- Time horizon — in which time horizon would the client need the assets?
- Free asset ratio — what is the ratio of free assets (financial assets less bound assets) to the client’s total assets?
- Annual loss compensation rate — what is the ratio of (annual income — annual expenses) / free assets?
Client risk profile indicates which level of risk the client can take. It is derived from risk tolerance and risk awareness. Both are ranked according to the following levels:
The client risk profile is the lower value of risk tolerance and risk awareness. It is the key determinant for client portfolio construction.
Client risk profiles are divided into five different risk levels, and a standard portfolio will be constructed for each of these risk levels.
At a higher level, cryptocurrencies can be allocated into the following sub-classes:
- General blockchains
- Smart contract blockchains
- Anonymous payments
- Resource sharing (storage/compute power/network)
- Prediction markets
- Fiat proxies
Standard portfolios are constructed from these sub-classes. The idea is not to have exposure to every specific cryptocurrency, but to have exposure to crypto sub-classes. Some of these sub-classes will have higher returns (and higher risks) and vice versa.
We would calculate the historical returns and volatility for each of these sub-classes and use these values as inputs as part of the standard portfolio management approach. This calculation could look as follows:
The portfolios for different sub- classes could be constructed as follows:
The client would have to:
- Complete the questionnaire for determining their risk profile
- Transfer assets to the platform
And that’s all:
- Client portfolio construction will be an automated process based on the client risk profile
- Portfolio adjustments will be executed automatically if sub-category ratios leave a predefined range
- The client will receive regular portfolio performance reports
The client would pay a monthly or yearly fee to the platform and would be relieved from the day-to-day management of their assets. The client would be able to focus on areas that are most relevant and important to them.
Note: This article is provided for educational purposes only. For actual investment advice, always consult your professional investment advisor. The author accepts no liability for any consequences of decisions taken on the basis of the information contained in this article, nor does the author guarantee the correctness or up-to-dateness of the information contained herein despite the author’s best faith.
- Brinson, Gary P., Brian D. Singer, and Gilbert L. Beebower. 1991. “Determinants of Portfolio Performance II: An Update.” Financial Analysts Journal, vol. 47, no. 3 (May/June): 40–48.