FPA algorithm for crypto funds – Hedge Capital
Most crypto funds hold large spot Bitcoin holdings, some multi-asset ones bet long-term on Altcoins. All need new alpha and decrease relative risk. FPA strategy on Bitcoin seems to fit the bill.
First, let’s recap what Hedge Capital and FPA algorithm essentially do. We’re pragmatical Bitcoin (BTC)ers so Hedge Capital is Bitcoin focused fund (for qualified investors with BTC investments in min. equivalent of €125.000). We run a quant fund as we use proprietary algorithms to prevent mistakes arising from timing the market, emotional biases and missing Bitcoin’s 10 best days. We’re focused on long-term Bitcoin value and so does our conservative FPA algorithm. It invests (some may argue it swing trades) over long-term using futures derivatives aiming to deliver 2–4x multiple in Bitcoin terms over the upcoming bull market. Depending on market dynamics it may return potentially higher multiples as it’s built to ride and exit parabolic trends. To get a sense of how it’s simplified free version works read Simple FPA strategy.
Long-term crypto funds (3+ years) hold large portions of their portfolios in spot Bitcoin and their investors increasingly start to dislike paying high 20% carry fees for what they might get way cheaper and feel funds are taking a free ride. Funds without lock-up periods are thus less competitive, funds with lock-ups face even harder investors push back.
Most secure and free option is to hold Bitcoin in self-custody cold storage. Convenient to some seems Grayscale Bitcoin (BTC) trust. Presumably the largest spot Bitcoin fund managing over $2bn as of Nov 2019. Highly liquid and without lock-ups, charging only 2% maintenance fees. Although it’s real costs are higher by approx. 20% price premium people pay for essentially convenience and custody services, it’s still way cheaper than paying 20% carry on all Bitcoin appreciation over dollar.
We’ve seen few approaches how crypto funds tackle this issue. Some funds consider recommending their investors from the onset to self-custody their spot Bitcoin (BTC)s (kudos!). Funds with multi-asset crypto portfolios either consider to open Bitcoin sub-funds (to run Grayscale model themselves) or lower blended fees as a result of lowering fees on their Bitcoin positions to arrive at effectively the same. With FPA algorithm some funds think they may solve the issue without doing any of that. Offloading part of their Bitcoin holdings to FPA strategy creates additional alpha, justifies their fees and makes their investors happier. As this may increase their portfolio risk, we see funds to consider taking some chips off their Altcoin allocations and throwing them into FPA strategy to balance the risk off while keeping upside potential (see second part on Altcoins why it makes sense.)
Specific use case have crypto funds (or VC funds) holding spot Bitcoin in their own treasury as either long-term holdings or for their future investments. As Hedge Capital charges no entry/exit fees and has no capital lockup, placing some of their Bitcoin holdings into long-term conservative FPA algorithm seems as an attractive alternative to using lending services. Though with inherently higher risk, potential long-term returns are in multiples higher than 5–10% p.a. received from lending out their Bitcoin (BTC)s.
Diversification to more Altcoins in a highly correlated crypto market is a myth. Decreasing portfolio risk while keeping upside potential with conservative long-term FPA strategy on Bitcoin may do the trick.
Venturing away from Bitcoin when considering long-term investing or speculation is a hot topic for us Bitcoin (BTC)ers. We think there’s misconception about Bitcoin’s fundamentals (monetary focused) being approached from technologist perspectives of blockchain projects (features focused) which makes people compare apples to oranges. There’s an interesting take on this topic of Altcoin Valuations from Jimmy Song. Leaving strictly asset management hat on, there seems to be less risky way for creating competitive returns. FPA strategy seems to fit the bill for crypto funds seriously aiming to beat Bitcoin benchmark.
Let’s say a multi-asset long-term fund may allocate 20–30% to spot Bitcoin and 20–30% to major Alts like Ethereum, Litecoin, etc. It may further allocate some 10–20% into staking coins and 10–30% into tail and illiquid digital assets. As these portfolio allocations are of long-term character (asset agnostic, it’s allocation) and anything other than spot Bitcoin bears higher risk than Bitcoin itself, FPA strategy becomes a legitimate alternative. In fact, from strictly investors’ value creation perspective relative to risk/reward we may argue it’s more logical way to create alpha in 70–80% of non-Bitcoin allocation of this hypothetical portfolio. Why?
More probable alpha
Because most multi-asset long-term crypto funds are in our view caught in trader/investor dilemma pushing them to risk/reward dead end street. We’re purposely staying away from Bitcoin vs Alts fundamental discussions and focus only on risk/reward probabilities.
Looking at past two Altseasons where~80% of Alts did 3x over Bitcoin, one may conclude returning 3x is just as easy as being generally exposed to Alts and waiting for the tide to lift all boats. 2018/2019 detox has hopefully showed it’s no longer the case, picking winners with sober mind, timing alt windows and executing on trades make this a whole lot different game. As a result, funds being pushed toward more active trading would have to step up their skills to beat 90% of market participants. That’s a tough call.
Funds with long-term (3+ years) investment thesis may be hitting the same wall just from different angle. A data driven look at Alts indicates most Alt prices have over long-period of time either depreciating or oscillating tendency (just few of them). Sustainably profiting on either of those groups pushes funds to more active trading and it’s inherent risks again. And since the same data suggests holding on Alts positions over long-term period is probabilistically a guaranteed loss, long-term Altcoin funds fall in the trader/investor dilemma as well.
FPA strategy aiming to create alpha over Bitcoin is also pushed to more active trading, but has in contrast 2 key assumptions different.
Firstly, the asset choice. Bitcoin monetary fundamentals suggest long-term appreciation, recently quantified by experimental Stock-to-flow model. There’s simply much less market cycle unknowns, future value risk or technology failure risk when we deal with the cryptocurrency with so far the strongest Lindy effect.
Secondly, the execution. FPA algorithm prevents market timing and emotional bias risks. It needs to know just one asset well, make use of its unique characteristics and compound value over long-period of time.
For a lot less risk
On top, crypto-funds dealing with Altcoins must mitigate more than asset or market risks while most of them are non-existent or substantially lower in Bitcoin ecosystem.
- counterparty risk — what are the odds of Bitcoin (BTC) defaulting versus a small yet promising blockchain team?
- technology risk — what probability of fatal bugs might be expected from ultra conservative Bitcoin (BTC) core team versus “move fast, break things” mindset common to most predominantly technology oriented blockchain teams?
- portfolio risk — how much correlated risk funds add to their portfolio in their quest to find the winners? Crypto markets are highly correlated, the lowest risk denominator in crypto is Bitcoin (BTC) as uncorrelated assets lie outside of crypto sphere. Thus, to decrease crypto portfolio risk while retaining upside potential funds must allocate more to Bitcoin (BTC) strategies, not less.
- custody risks — how much more operational risk funds take on themselves to manage several coins when almost 50% of funds do self-custody?
- fraud risk — what due diligence can funds effectively in practical terms apply to remote distributed teams to prevent fraud or scam risks?
FPA strategy, being an algorithm on Bitcoin futures derivatives, does have it’s inherent risks such as counterparty risks and position liquidation risks. But these are, in our view, relatively better manageable compared to vast array of Altcoin related risks.
As a result, considering a decent portfolio size, it seems more operationally feasible and from risk/reward perspective more probable to return 3x multiple over Bitcoin with FPA strategy than with actively traded Altcoins.
FPA strategy was built for long-term Hodlers no matter we help them directly in our fund or indirectly via another fund. The more Hodlers accumulate, the more decentralized and resilient Bitcoin becomes.
We’re using the term Hodler not as strictly as many may interpret it. For us, it’s anyone wishing to hold Bitcoin, the longer the better. Eventually even those holding Bitcoin via funds will “hodl” them, hopefully, in their cold-storage. And as managing one’s own keys induces questions and curiosity around Bitcoin itself, there’s a higher probability that those investors will search to understand it’s monetary innovation beyond mere profit. And that perspective is exciting.
Published at Tue, 07 Jan 2020 10:31:18 +0000
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