The 3 Reasons why Active Management Is Key when Investing in Bitcoin Mining Stocks

Chaos is unfolding in the bitcoin mining industry as several overleveraged companies struggle to make debt payments. Even though the industry has seen better days, investors still want exposure to these stocks, which we believe is wise, considering the current depressed valuations of these companies. The mining stocks’ recent poor performance reflects their nature: they tend to outperform bitcoin during the good times but underperform in bear markets.

Investors who want to buy into the sector should know one thing: active management is critical when investing in these stocks. There are three reasons why, which we explain in this article.

Mining stocks’ performances differ widely, making it crucial to pick the winners and avoid the losers

Just like other industries, bitcoin mining has its winners and losers. Bear markets tend to separate the wheat from the chaff. We see that some companies struggle while others have strong balance sheets and low production costs, which should enable them to ride out the bear market to reap the rewards in the next bull market.

The performance differences between different bitcoin mining stocks become apparent when looking at the chart above. Since August, Core Scientific’s stock has plummeted by 93% as the company has deteriorated further toward bankruptcy. Argo is also struggling, seeing its stock fall by 83%. Meanwhile, Marathon and Riot have been able to keep their value quite well considering the bear market, declining by 12% and 23%.

The performance differences are also apparent when looking more long-term. Investors who bought Core Scientific at its all-time high would have lost 99% of their investment. Many reasonable investors who wanted exposure to the industry could have looked at this company and thought:” Core Scientific is the biggest public bitcoin miner. If I want exposure to the industry, I better buy that one”. That is a usual way of making investment decisions in other sectors.

The problem is that bitcoin mining is not a normal industry. It’s a new and exceptionally volatile industry, where picking the winners and avoiding the losers is crucial for your portfolio’s performance. An actively managed fund does that for you.

The bitcoin mining sector is exceptionally volatile, making diversification key

Bitcoin mining is a high-beta bitcoin play. As you already know, bitcoin is incredibly volatile, making the bitcoin mining industry one of the most volatile in the world. Diversification is essential in all sectors, particularly in the volatile bitcoin mining industry.

In June, we published an article applying the modern portfolio theory framework to bitcoin mining stocks. We found that a small exposure to a diversified bitcoin mining portfolio improves the Sharpe ratio of a portfolio. The important caveat here is that the bitcoin mining portfolio should be diversified. Simply adding one or two bitcoin mining stocks will not improve your portfolio’s performance.

Some investors solve the diversification problem by buying an index fund that gives exposure to an entire market or sector through a market cap-weighted bucket. Index funds work very well in traditional industries, but as I explained in the previous section, it’s crucial to avoid the bad apples of the bitcoin mining industry.

The only way to develop and manage a diversified, actively managed bitcoin mining portfolio is to spend countless hours collecting and analyzing financial information from all these companies. Understandably, most investors don’t have all this time to allocate to a single industry and would be better off outsourcing the portfolio management process to an actively managed fund.

Bitcoin mining is an emerging sector where deep industry knowledge is the secret to identifying great investments

Bitcoin mining is a new sector that is still in development. In such an industry, making great investment decisions requires deep industry knowledge. These stocks are not trading according to the efficient-market hypothesis. Bitcoin mining stocks are often significantly mispriced due to many investors’ lacking a deep understanding of the industry.

Such mispricing was evident when Core Scientific recently announced its liquidity issues, and the stock responded by plummeting by 80% in one day following the announcement. Bitcoin mining analysts who studied Core Scientific’s finances understood that the company was in danger of running out of liquidity. At the same time, the rest of the market needed an official warning from the company before taking action.

A passive investor would have held Core Scientific’s stock all the way down. Actively managed funds have a deep understanding of the sector and can therefore identify such mispricings, which are pretty common since the industry is so young.

Conclusion

The emerging bitcoin mining industry has three main traits that make active management crucial. Firstly, as we have witnessed lately, bitcoin mining stocks’ performances differ widely, making it essential to pick the winners and avoid the losers. Active fund managers apply their understanding of the market to do exactly that.

Secondly, the bitcoin mining sector is volatile, making diversification immensely important. You could achieve sufficient diversification by investing in a passive fund, but this is far from optimal, as it exposes you to the losers and the winners equally. You only achieve optimal diversification by investing in an actively managed portfolio.

Thirdly, bitcoin mining is an emerging sector where deep industry knowledge is the secret to identifying great investments. Mispricings of companies are quite common in the industry. Active fund managers can take advantage of such mispricing to deliver superior returns for investors.