Over the last 11 years, cryptocurrencies have blossomed from a one-horse town into a marketplace with thousands of tradable assets and billions in market capitalization. Despite the exponential growth in just a decade, digital assets remains a fringe asset class suffering from poor liquidity and a lack of clear regulatory oversight. And yet, digital asstes offer a compelling return profile. These characteristics are reminiscent of frontier markets that are viewed by sophisticated allocators as an opportunity for outsized growth and an important tool for portfolio diversification.
While they may be worlds away from each other, the challenges and benefits of investing in frontier markets are similar to those of digital assets.
It’s easy for investors to overlook frontier markets given their exotic nature and variety of disadvantages associated with them. The added complexity of introducing frontier exposure to a portfolio further makes the investment less of a priority for many. Many of the challenges associated with frontier markets extend into digital assets.
Regulatory Oversight – A key feature of a developed marketplace is a properly functioning regulatory environment that can foster fairness and efficiency. Frontier markets have less mature financial regulatory systems and struggle to maintain investments in policy, regulation and supervision. Similarly, the systems of regulation that monitor digital assets are less evolved and inconsistent across jurisdiction. While many digital asset-innovators feel that regulatory governance is unnecessary and even at odds with the decentralized nature of the industry, the absence of a clear rules environment remains an obstacle to mainstream investors.
Bad Actors – Underdeveloped markets with limited oversight are more prone to bad actors. While developed markets are not immune to fraud (Bernie Madoff alone defrauded $10-17 billion from investors, which dwarfs any instance in crypto) this risk is elevated in the absence of robust regulatory oversight. The digital asset space has its fair share of rogue actors, fraudulent issuances, unsecured exchanges, and outright theft. An investor looking for frontier exposure must be prepared to deal with corruption, scams, and the possibility of theft.
Sporadic Liquidity – Frontier markets are known for lower volumes than those in the developed world and studies show that they are relatively illiquid. Similarly, digital assets suffer from low liquidity exposing investors to the decisions of a few highly capitalized entities with outsized influence on price in even the most liquid of assets. Investing in less liquid markets typically means wider bid-ask spreads which must be accounted for in an investment strategy.
Low Signal-to-Noise – Separating genuine opportunity from inference is challenging in an unfamiliar space. Nascent markets are often beset with skewed reporting with media sources focusing on sensational stories to drive viewers. In traditional frontiers, this often-skewed representation of reality manifests itself in stories of citizen unrest, violence, floods, famine. This makes the task of finding the value creation and technological innovation happening a cumbersome problem requiring local expertise.
Despite these challenges, frontier markets offer commensurate benefits to consider.
Historically, frontier markets have demonstrated low correlations with the developed world and are widely considered a potential source of high returns. From the end of January 2017 to the end of 2019, frontier markets (as represented by the S&P Frontier BMI) demonstrated a correlation of 0.45 and 0.28 to the S&P 500 and FTSE 100, respectively. As such, an allocation to these assets may result in an overall improvement in portfolio performance. The explosive price appreciation of Bitcoin and its historical uncorrelated returns have given birth to a broader market of investable assets with similar investment characteristics. Bitcoin and the Bitwise BITX (an index that reflects the top 10 crypto assets) have demonstrated correlations of -0.01 and -0.02 (respectively) to the S&P 500.
Perhaps the digital asset market is not much different from other frontier markets.
The digital asset market is small (measured by market cap), largely illiquid, absent of clear regulations with limited correlation to developed markets. While the digital asset industry is still in the early phases of its lifecycle, a foundation is being built to support a sustained advancement. At one point China was a frontier market and many of today’s “emerging” markets were considered frontier less than 50 years ago. Both digital asset and traditional frontier markets have shown the potential to improve the risk-adjusted returns of a diversified portfolio of equities. Inclusion of these assets in a diversified portfolio can potentially lower portfolio volatility and increase returns. Savvy investors should look beyond the headlines and noise to find parallels between the known and unknown.