A Retail Investors Guide to Navigate Digital Asset Markets and the Case for Alpha Investing in Crypto
Alpha is defined as the excess return on an investment given the expected risks taken to generate those returns. Alpha is often referred to as “skill” or “edge”. On the other hand, beta is defined as risk premiums given by the market. In other words, “beta” is what you get for passively holding the “market” (Referring to S&P500 in traditional finance).
There is no denying that passively holding bitcoin, capturing “beta” in digital asset markets, has been extremely profitable as a digital asset investor. Since its inception to the end of 2019, bitcoin has had a compound annual growth rate (CAGR) of 232% and during its last three years, around the time crypto went mainstream, bitcoin has had a GAGR of around 120%. Meanwhile, in the last 3 years, the S&P 500 had a return of only 15%. That means if a traditional investor were to hold only 3% of their assets in bitcoin and the rest in the S&P500, for simplistic purposes, over the last three years, he or she would increase his or her CAGR by +3% a year from just passively investing in bitcoin.
With such astronomical returns, you are probably thinking why even try to achieve alpha in cryptocurrency markets when one could just hold bitcoin and capitalize on its beta? That is a great question and we believe that it is wise to allocate a percentage of your portfolio to passively invest in bitcoin. However, as an investor, if there is one thing investors love more than winning, it’s not losing.
As an investor in such a nascent asset class, substantial returns are a byproduct of substantial volatility. In other words, you may lose a lot before you make a lot. For example, an investor who invested in bitcoin since 2017 may have achieved a 120% CAGR, but he or she would have also faced a max drawdown, peak to trough decline in your profit and loss curve, of -83%. What is even more painful is that your investment would still be down around -68% from its max peak three years ago. Imagine, close to 70% of your capital disappearing for three years and still maintaining the belief that bitcoin will succeed. Unequivocally, you are going to start doubting your belief in your investment, but what is even worse is the emotional distress you will face, while “HODLING” that investment. Would it be great if you could capitalize on the volatility, high returns of bitcoin, while at the same time not lose as much money?
The solution is capturing alpha in digital asset markets. By allocating some of your capital to alpha producing strategies you get the substantial returns of bitcoin, without all the downside risk. The same concept used to be prevalent in traditional equity markets; however, equity markets have become so efficient, “crowded”, over the years that there is very little alpha left to capture, but being that crypto is a new asset class, there is a surplus of alpha within the market.
It is possible for the average retail investor to achieve alpha, but it takes years’ worth of investment experience to acquire the skills needed to be successful. So, that duty is usually outsourced to a professional investment manager. In digital assets, there is a surplus of professional investment managers, but not all deploy strategies that will allow you to capture the great returns of bitcoin and eliminate a lot of your downside risk.
More specifically, there are three major types of investment funds in the digital asset space. There is a long/short investment fund, that basically takes large long positions in promising digital assets and large short positions in unpromising digital assets similar to buying good stocks and shorting bad stocks. In traditional equity markets, this strategy works well because of all the liquidity, but digital asset markets are still nascent so an investment manager that shorts a bad cryptocurrency may be right on his investment thesis, but since there is a lack liquidity, the investment manager could have problems getting out of the investment and actually lose money. We have actually seen this recently in the markets where large short-sellers covering caused a large short squeeze in Bitcoin SV, Dash, and ZCash, in effect, causing short-sellers to lose a lot of money on their investments. Basically, these long/short investment managers just wind up being, net long, and as a result, heavily correlated to the rest of the cryptocurrency market.
There are also venture capital funds, injecting large amounts of capital into crypto projects they believe are the most promising. The strategy can pay off well if just one of the projects becomes the next “Google” per se, but the returns are volatile and the strategy is illiquid.
Then, there are quantitative investment funds like ours, that deploy statistical arbitrage strategies capturing inefficiencies in the cryptocurrency market. Basically, a quant fund's role is to push markets back into equilibrium when they deviate from their fair values. The returns of these funds are steady and consistent. This type of investment fund complements a bitcoin beta strategy perfectly as when bitcoin and/or cryptocurrency markets go down in price a quantitative strategy will ameliorate the losses. On the other hand, when bitcoin and/or cryptocurrency markets rally capturing beta will do a lot of the “heavy lifting” for the portfolio. Some quant funds like to take directional positions, but we prefer to stay market-neutral, not being net long or net short, in order to provide the highest returns with the least amount of risk. Especially as more government-regulated derivatives products come into the market, such as CME Bitcoin Futures and Options as well as ICE Bakkt Bitcoin Futures and Options, it gives institutional investors more sophisticated ways to hedge risks in this nascent asset class.
It is clear that the digital asset market is a very profitable asset class. With a historical CAGR of 232% bitcoin is a great asset to invest in allowing investors to capitalize on the parabolic growth that comes along with nascent markets. However, even though the returns can be massive, so can the losses. Luckily, by diversifying and allocating capital to both a professional digital asset manager and passive investing in digital asset markets, one can capture the great returns of digital assets, while eliminating the risk of huge losses that come with investing in the asset class.
-Edward Puccio, Digital Asset Analyst BKCoin Capital LP
