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Beyond Bitcoin Beta and Towards A Digital Asset Investment Strategy

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Most arguments advocating for digital asset exposure are singular in focus: there is just one asset contemplated — bitcoin (BTC) — and the analysis applies exclusively to long-only exposure within a standard 60/40 stock/bond portfolio.

This is understandable given BTC’s dominance in terms of market capitalization and popular culture, and the 60/40 model is reasonably representative of a benchmark portfolio. However, we believe this approach is too simplistic, particularly for institutional allocators who tend to think idiosyncratically rather than holistically when it comes to new strategies.

Discussed herein is an alternative method for gaining digital asset exposure, one that involves a more diversified approach aimed at mitigating downside risk without sacrificing the upside return potential that has come to characterize the space.

Several studies have made the case for outright exposure to BTC, including those from the likes of Fidelity and Coinshares. The upshot of these analyses is that a relatively small allocation to BTC has been shown to improve the absolute and risk-adjusted returns of a typical 60/40 portfolio despite the considerable volatility displayed by BTC on a standalone basis (thanks to diversification effects).

This makes good academic sense and surely factors into the thinking of many seeking exposure to digital assets. However, such reasoning can be difficult for certain investors to accept, particularly in organizations where allocation decisions are consensus-driven and committee-based.

Institutional allocation activity typically occurs within broadly diversified portfolios and decisions are often directed by an investment committee (IC), which makes the calculus different from what one might find in a 60/40 context.

First, institutional allocations are subject to an intense competition for capital that occurs across myriad strategies, geographies, and asset classes. For example, instead of the straightforward equity/fixed income split contemplated by the 60/40 approach, the endowment model also includes exposure to hedge funds, private equity, commodities, and real estate, among others. This means any BTC allocation must be justifiable in that broader context, where capital flowing to it will need to be sourced from a strategy that has proven tried-and-true.

Investing is the discipline of relative selection. — Sid Cottle

Second — and perhaps more important — are the behavioral dynamics present within investment committees. As with many group exercises, certain heuristics often come into play when discharging IC duties. These include:

  • Groupthink, where the desire for unanimity can outweigh the motivation to consider new and difficult ideas;
  • Overestimation, where confirmation bias dominates and a sense of infallibility prevails;
  • Close-mindedness, where all decisions are rationalized and alternative approaches are ignored or quickly dismissed; and
  • Uniformity, where dissent is unwelcome and self-censorship occurs.

There is also a default effect to be considered (also known as status quo bias). With most investment teams, the easy answer is “no” when it comes to new opportunities. Attention and reputation are scarce resources to be managed, so the friction of pursuit is typically avoided unless success can be virtually guaranteed. That success often comes in the form of political capital first and investment results second.

To do nothing is within the power of all men. — Samuel Johnson

The sequential nature of decision-making is the last piece of the puzzle here. Typically, investment opportunities are initially assessed idiosyncratically, then judged against a plethora of alternative exposures, and lastly considered in the context of broader risk/return dynamics at a holistic portfolio level.

  1. When first analyzed idiosyncratically, BTC is marked by significant volatility, uncertainty, and unfamiliarity. It therefore takes some chutzpah for an analyst to pitch her IC on an entirely new asset whose future is unknown and which has demonstrated substantial downside volatility. Challenges pertaining to BTC thusly come into finer focus when it is considered on a standalone basis. Significant historical upside has been demonstrated with BTC but so too have dramatic drawdowns. Achieving annualized returns of one hundred percent have also required willingness to stomach -75%+ years along the way. Per Kahneman and Tversky’s prospect theory, “losses loom larger than gains”; this is especially relevant in a committee context, where someone must be willing to own those face-ripping drawdowns. So as attractive as BTC’s potential upside might appear, the accompanying downside volatility gives many institutional allocators pause. Indeed, as research by Fidelity Digital Assets has indicated, volatility is the primary gating mechanism for these investors.
  2. On the off chance that a BTC allocation is being assessed by an openminded IC, we then move to the next step, which is consideration of where it will compete for capital within investor portfolios. Is it against venture capital? Hedge funds? Growth equities? It is important to note that these decisions are likely not made dispassionately. Institutional investment teams are often organized in silos, where an analyst team is given responsibility for specific asset classes and/or strategies. Consequently, the analyst pitching BTC will effectively be pitted against the analyst(s) defending the potential source of funding (e.g., venture capital, hedge funds, etc.). Consensus-building can be quite challenging when such battle lines are drawn.
  3. If the conversation manages to advance beyond that difficult second stage, BTC is lastly contemplated in the context of an investor’s overall portfolio in order to determine the sizing of any potential allocation. The debate has been mostly won by this point since— thanks to the diversification effects highlighted above — one can reasonably expect that BTC will prove value-additive to a broadly diversified portfolio.

All of this conspires to form a significant headwind for BTC adoption within institutional asset allocation programs. These dynamics are particularly important in the context of blame aversion, where self-preservation dictates that Chief Investment Officers maintain the status quo (it is better for reputation to fail conventionally) and analysts tend to conform in order to advance their careers.

As Howard Marks has observed:

Committees rarely take high-risk positions for which the members can be criticized. They rarely embrace idiosyncratic opinions. They rarely capture the most insightful member’s uniqueness, as expressed in a lone non-conformist viewpoint. And thus they rarely produce highly superior investment results.

While some institutions have allocated to digital assets by way of venture capital (VC), more liquid exposures remain broadly elusive. As we have previously discussed, the embrace of less liquid exposures makes sense for these investors. Crypto can be viewed as an emerging technology — hence the venture bucketing that occurs — and aforementioned behavioral dynamics likely inform a desire to delay judgment as long as possible. The wisdom of direct BTC ownership can be assessed real-time thanks to 365/24/7 mark-to-market whereas VC investments are typically given years to play out.

The good news is that there is more than one way to skin the crypto cat. Similar to Goldilocks and her three bowls of porridge, there are different approaches available for institutional investors contemplating exposure to digital assets: direct ownership can be too hot for some (i.e., too volatile) while venture capital can run too cold for others (i.e., payout duration), making a diversified approach that includes more liquid active exposures perhaps just right. Such exposure could come in the form of digital asset hedge funds. We believe the digital asset class is among the most inefficient in the world, making it fertile ground for alpha-centric investment approaches.

Our aim is therefore to present a diversified alternative that allows for crypto exposure in a manner that proves compelling on a standalone as well as portfolio basis. It also encourages development of a digital asset strategy that embraces nuance and extends well beyond a directional bet on further BTC upside.

The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk. — Seth Klarman

We start by solving for risk-adjusted digital asset exposure by performing a constrained portfolio optimization using BTC and crypto hedge fund returns since 2017. We use the Vision Hill Composite Index as a foundation upon which to build a crypto hedge fund proxy.¹ Since that index only goes back to January 2018, we extrapolate 2017 returns using a separate methodology.²

The net result of this optimization calls for a 13% allocation to BTC and 87% allocation to actively-managed alternative strategies, collectively referred to hereafter as the Digital Asset Strategy (DAS). Ideally, the 87% alternative allocation would include venture capital, but the periodicity of that strategy’s performance reporting makes it difficult to assign a proxy for its returns.

As illustrated in the below table, taking a more diversified approach to digital assets improves on the risk-adjusted returns of a standalone BTC allocation while achieving roughly similar absolute return outcomes. Most importantly, downside volatility and peak-to-trough drawdowns are cut nearly in half. Risk-adjusted returns improve meaningfully, particularly when measured in Sortino terms (where upside volatility is not penalized) as well as by the Calmar ratio (which measures annualized return divided by maximum drawdown).

For the period January 2017 — December 2020. Standard deviation is annualized based on monthly returns. Crypto HF Composite = Vision Hill Composite Index plus 2017 year of extrapolated returns (detailed in footnotes). Traditional HF Composite = Eurekahedge Hedge Fund Composite Index. BTC = bitcoin gross returns as measured by TradingView. Digital Asset Strategy = 13% BTC & 87% Crypto HF Composite January 2018 — December 2020. Calendar year 2017 based on extrapolated returns (detailed in footnotes).

The takeaway here is that, when measured over a market cycle, DAS has demonstrated the potential to provide investors with similar levels of the annualized upside they find appealing about BTC but in a more attractive volatility-adjusted manner. Said differently, 100%+ annualized returns appeal more when punctuated by drawdowns of just -44% rather than -76%.

Whenever we consider an investment, we think just as much or more about what can go wrong as about what can go right, and we put the avoidance of losses on a high pedestal. — Howard Marks

Let’s now examine how DAS might add value to the 60/40 benchmark portfolio. As illustrated below, an allocation to DAS delivers roughly similar results as a standalone BTC investment. This is precisely what we would want to see from such analysis, as it proves that BTC-type outcomes can be achieved in a portfolio context in significantly risk-mitigated fashion.

For the period January 2017 — December 2020. Standard deviation is annualized based on monthly returns. BTC = bitcoin gross returns as measured by TradingView. Digital Asset Strategy = 13% BTC & 87% Crypto HF Composite for period January 2018 — December 2020. Calendar year 2017 based on extrapolated returns (detailed in footnotes). 60/40 = 60% SPDR S&P 500 ETF Trust and 40% iShares Core U.S. Aggregate Bond ETF. 60/40 adjusted pro-rata to account for BTC & DAS allocations.

In order to make the analysis more relevant for institutional investors, we replace the 60/40 benchmark portfolio with the endowment model (as measured by the Endowment Index, ticker ENDOW). Here again an allocation to BTC is shown to meaningfully improve the endowment model’s absolute and risk-adjusted returns. And here too we see a DAS allocation provide a similar result when compared to an outright allocation to BTC.

For the period January 2017 — December 2020. Risk free rate = 1%. Standard deviation is annualized based on monthly returns. BTC = bitcoin gross returns as measured by TradingView. Digital Asset Strategy = 13% BTC & 87% Crypto HF Composite January 2018 — December 2020. Calendar year 2017 based on extrapolated returns (detailed in footnotes). Endowment Model = Endowment Index, ticker ENDOW.

There are important limitations to consider with our analysis. First, hedge fund index returns suffer from several biases, namely availability (only capturing what is made available) and survivorship (those returns being captured are those that have survived long enough to be reported). In addition, our method of estimating crypto hedge fund returns in 2017 is imperfect in that it does not specifically reference actual index returns and is instead based on a linear extrapolation.

We extrapolated 2017 crypto hedge fund returns in order to increase the observable data set from three to four years, which we believe improves the statistical significance of this exercise. Even then, the timeframe being studied is limited since four years represents only one market cycle (if that). Given the limited data set, out-of-sample backtesting was unlikely to provide meaningful results; we therefore had to make do with in-sample bias. Relatedly, past performance is not indicative of future results, which is a limitation with all such analyses.

These caveats aside, an earnest effort was made to introduce the concept of a thoughtfully constructed and diversified digital asset strategy. We believe this is particularly important for institutional investors given the constraints under which they operate and tendency to allocate in fund form.

Judging by these results, a case can be made for complementing one’s direct BTC exposure with alpha-centric, actively-managed digital asset investment strategies. Since there is no investable crypto hedge fund index available — nor do we expect there being one anytime soon — we believe a fund of fund approach is the most effective way to implement such a program.

Source: https://medium.com/@dalpha/beyond-bitcoin-beta-and-towards-a-digital-asset-investment-strategy-43407974ad4b?source=rss——-8—————–cryptocurrency

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