2020 Investor’s Guide to Crypto

This guide has the purpose to provide crucial information to investors about bitcoin & crypto-assets. As we move away from an era of liquidity to an era of diversity, crypto-assets becoming essential in the portfolio of the modern investor.

TL:DR

Institutional demand for crypto-assets comes from the customer-side. Crypto-assets, becoming a trend, makes large investors jump on the bandwagon to benefit from both alpha generation and diversification.

Backtesting performances over the past 6 years, a portfolio of global 60/40 + 5% crypto-assets would benefit from a 95% Sharpe ratio improvement, and 215% cumulative return increase, vs. a portfolio without crypto-assets.

Specialised crypto hedge funds have increased in popularity, characterised by high YoY fluctuations ranging from -60% to +2,278%. Investors are faced with a tough choice: gaining in terms of USD, or accumulating BTC.

Table of contents

A New Asset Class: Crypto-Assets

Era of Diversification

Digital Scarcity

Gold 2.0

Crypto Funds Overview

Crypto Hedge Funds

Crypto Hedge Fund Performance

Case Study: Polychain Capital

Investor key determinants

Gaining USD vs. Accumulating BTC

A new Asset Class: Crypto-Assets

Blockchain technology was publicly introduced in 2009 as Satoshi Nakamoto’s response to the lack of trust and transparency in the central banking system. Blockchain brings this trust back to the people by allowing decentralized, transparent, and immutable transactions. At that time bitcoin was the only crypto-asset, while today there are more than 2,500 crypto-assets which are divided into the following categories: currencies, utility tokens, security tokens, crypto commodities, and stable coins.

Crypto-assets, as a new asset class, has started gaining traction in 2017 with the increased involvement of institutional investors. Bitcoin, dubbed as digital gold, is undergoing a slow and steady institutionalisation, as seen in figure 1:

Figure 1: Bitcoin becoming a new asset class [1]

Bitcoin has proven to be the world’s best performing asset of the decade, with an increase of 9,000,000% in 2010’s. Despite this meteoric rise, crypto-assets are only a fraction of the world’s money and markets, as seen in figure 2. Blockchain technology is increasingly being implemented in more industries including healthcare, supply chain, banking and financial services. The technology is shifting on the adoption curve, from the early adoption phase to the early majority phase.

Figure 2: Digital Assets Into Perspective

Era of Diversification

According to the BofA, the 2020s will be an era of diversification, changing from the previous 2010‘s era of liquidity. The era of liquidity was created by central banks who have cut rates more than 799 times since the Lehman Brothers collapse and bought more than $12 trillion of financial assets. This has created a “liquidity supernova”, causing the longest and almost the greatest equities bull- run in history.

The Fed has created a liquidity trap, in which it risks a recession if it stops quantitative easing. As QE continues, bubbles will continue to grow. This low-inflation environment benefits US equities while disadvantaging commodities and other disinflationary assets. BofA estimates that the liquidity era will last another 3–6 months, after which we will see a top in the prices and higher inflation will start as a result of global negative interest rates. From this point, the diversity era will start, where disinflationary assets will outperform today’s QE gainers [2].

Figure 3: Correlation Matrix September 25, 2013 — August 13, 2019 [3]

Crypto-assets, being a disinflationary asset class, can be what institutional investors need to reach their future performance targets, while decreasing their portfolio risk.

Figure 4: Crypto-Assets in a Traditional Portfolio [3]

They have proven to be uncorrelated to any other asset class, and are also imperfectly correlated amongst themselves, as seen in figure 3. The inclusion of crypto- assets in traditional investment portfolios decreases the portfolio’s overall risk because of diversification. A small allocation of crypto-assets helped the performance of traditional investors over the last six years, shown in figure 4. The total return and sharpe ratio significantly increased with the inclusion of crypto-assets.

Digital Scarcity

Bitcoin is hard-coded to decrease block rewards for mining by half every 210,000 blocks, a phenomenon called the Bitcoin halving. The block reward, part of the PoW(Proof of Work) consensus, is the number of bitcoins a miner receives when successfully mining a block of bitcoin.

The current block reward is 12.5 bitcoins and will decrease to 6.25 bitcoins in May 2020. The halvings will occur until the maximum 21 million supply of bitcoin will be mined, out of which 18.2 million have already been mined.

The decreased mining rewards will increase bitcoin’s digital scarcity, as shown by the stock-to-flow(S2F) model, graphed in Figure 5. The S2F model is considered to be a bitcoin valuation model based on the stock-to-flow ratio.

What is Stock-to-Flow Model? The stock-to-flow ratio measures the flow of new supply produced by bitcoin miners in relation to the outstanding stock of bitcoin – showing the number of years required, at the current production rate, to achieve the total supply.

In May 2020 the S2F ratio will double, to 50, thus increasing the scarcity of bitcoin. According to the model, Bitcoin’s price should reach 100,000 $ due to this increased scarcity. The model has been accurately predicting bitcoin’s price, with an R2 correlation of 95% [4].

Furthermore, the model also has a high correlation when testing it against gold and silver. As bitcoin’s stock-to-flow ratio increases to 50, it gets closer to Gold’s stock-to-flow ratio of 62. This indicates that Bitcoin’s market cap should move towards gold’s market cap.

Figure 5: Bitcoin’s S2F Model [4]

Previously, increased digital scarcity has led to Bitcoin reaching new highs. This can be seen in figure 5, where the halving is represented by the shift of dark blue dots, to dark red. This is because miners are forced to sell their mined bitcoins to cover their costs, creating a constant selling pressure on the market.

Starting from May 2020, they will only be able to sell half of what they previously could. Specifically, they currently sell an approximate of $400 million per month, which will halve after May’s halving. Assuming that demand remains the same, this will tip the scales relative to supply and demand and cause a surge in bitcoin’s price.

Gold 2.0

Bitcoin is often referred to as Digital Gold. Gold has proven to be a store of value and Bitcoin is increasingly being considered as one.

For now, trust in Bitcoin is larger than the one in gold. This is because it is exactly known how many bitcoins are in existence and how the inflationary rate will evolve in the future. As of gold, nobody knows exactly the amount of gold mined, the size of global natural gold reserves and the future production rate. However, gold has proven itself as a store of value for thousands of years, which bitcoin has not. In time, blockchain technology will have the opportunity to prove itself.

In terms of portability, bitcoin is not a physical asset. Therefore one bitcoin can be divided as one sees fit. On the other hand, it is insecure to make large gold payments and it is hard to divide it into the equivalent of small sums which you need for daily activities. Furthermore, bitcoin’s transactions are immutable and private.

The barriers of entry and exit are smaller when entering crypto-assets in comparison to gold. You are not required to purchase any minimum amount and you are able to sell it whenever you want with very low fees of doing so.

The largest difference between bitcoin and gold is decentralization. Bitcoin is not governed by any central bank or government body.

Crypto Funds Overview

The growth of the crypto ecosystem along with increased international regulatory framework allowed for a variety of funds to enter the market. Over 800 various crypto funds have been created, including hedge funds, venture capital funds, and index funds. As crypto-assets started outperforming traditional investments, crypto- funds have grown, as seen in figure 6.

Figure 6: Launches of Crypto Funds [5]

The crypto fund launches peaked around 2017’s bull-market, aided by an increased investor’s interest. In 2019 the industry was midway through the ‘crypto winter’ and experienced a decrease in investor interest and thus it is estimated that 90 funds have closed during that year.

The main funds in the industry are outlined below, in figure 7. The field is dominated by the hedge fund model, while some choose a hybrid hedge fund — venture capital model. Hedge funds and index funds are liquid, with 12 month lock-up periods, and they also accept additional capital into the fund. On the other hand, venture funds have a 10-year lock-up period, and they generally don’t accept additional capital.

Figure 7: Main Competitors [6]

Crypto Hedge Funds

Starting from 2018, hedge funds have been moving away from a generalized strategy to these specialized strategies: fundamental, quantitative and opportunistic [7]. These strategies have the following dominance within the crypto hedge fund market:

Fundamental — 19%

These funds are only long and are investing for the long-term. They invest based on the asset’s intrinsic value.

Quantitative — 37%

Funds that are either directional or market neutral and have a quantitative approach which includes: market-making, arbitrage, and high-frequency trading.

Opportunistic — 44%

This strategy takes advantage of o opportunities created by the shift in long-term trends. They have hybrid strategies that may include mining and early-stage investing.

Figure 8: Redemption Terms by Strategy [7]

According to PwC’s early 2019 report, there are around 150 active hedge funds which together have around $1 billion AuM. Crypto hedge funds have an average team of 7.5 individuals, with an average investment management performance of 3.5 years per person. Interestingly, 25% of the crypto hedge funds have independent directors on their boards. This indicates the lack of crypto expertise in global senior management. As traditional investment will merge with the crypto ecosphere, these numbers are expected to grow.

The median crypto hedge fund in Q1 2019 had $4.3 million AuM and only 10% of the hedge funds are managing over $50 million.

Median AuM in 2019 has a year-on-year growth of 358% from 2018, and it is expected to increase further in 2020 as the market matures.

The median fees coincide with traditional investment managers, with a 2% management fee and a 20% performance fee [7].

This data shows a consistent growth of the crypto hedge fund niche even through a long bear market. It proves that investors are willing to experiment with this new asset class and that they believe in its long-term potential. In time, the gap between traditional investment and crypto-assets will be bridged and this will increase crypto-asset adoption within existing traditional investment managers.

Crypto Hedge Fund Performance

Figure 9: Median Returns by Strategy [7] * Based on estimated returns

Crypto-assets are known to have massive fluctuations in price. Hedge funds have the ability to use their know-how to turn these fluctuations into their favor and increase alpha generation for their clients.

Depending on the strategies of the hedge fund, the returns vary, as it can be seen in figure 9 and 10:

Figure 10: 2018 Median Returns [8]

Depending on an investor’s preferences, he or she may choose a hedge fund which suits their needs. The 2018 median returns show that fundamental and opportunistic funds decrease the downside potential of the asset, but still have negative returns in a bear market. On the contrary, quantitative strategies are market neutral and can be profitable in all market conditions. In 2018, the median quantitative fund was negatively correlated to the market, with a beta of -2.33.

Crypto hedge funds limit their risk exposure during high volatility periods. Thus, hedge funds with fundamental and opportunistic strategies over-perform against the underlying asset in bear markets, and under-perform during bull markets. This decreases their risk, consequently increasing their sharpe ratio.

Case Study: Polychain Capital

Polychain Capital is one of the leading crypto-asset hedge funds. It was founded in 2016 and reached close to $1 billion assets under management in early 2018. Analyzing its performance over the years allows investors to gain a better understanding of what to expect when investing in crypto-asset hedge funds.

Figure 11: Polychain Capital Yearly Returns [9]

The hedge fund’s ROI since inception netted a positive performance of 1,332%, as detailed in figure 11.

Their fund’s yearly returns mirror the high fluctuations seen within the crypto-asset ecosystem. In order for investors to be profitable, they had to cope with these high fluctuations on the long term. For example, during the worst six months between July and December 2018, the hedge fund lost 47.6% [9]. Thus, depending on the period when an investor entered the fund, he could have either made large gains, or large losses.

Investor Key Determinants

In order to obtain a better understanding of the investors within this market, it is important to understand their psychology and the reasons that determine institutional investors and retail investors to enter this new asset class.

When discussing with Chris Tyrer, the head of Fidelity Digital Assets Europe, he stated that institutions are entering the market because of increased demand from the customer-side. Crypto- assets have become a trend, causing more awareness, which in turn makes more investors jump on the bandwagon. Family offices are hearing about it and are starting to ask institutions about the possibility to trade within these markets. Thus, institutions are reacting to customer demand and entering these markets. According to him, investors are interested to enter crypto-assets for both alpha generation purposes, and diversification. Companies like the low, steady, yields generated from crypto lending and are also benefitting from diversification. For instance, according to GSR, a HongKong based firm with crypto services such as market making, OTC trading, and structured products, institutions want to diversify 0.5–1% of their portfolios into crypto-assets.

Another reason why institutions will be entering the market is that companies and banks made large profits in the past 12 years US equity bull market and will need to invest their money elsewhere, in a new asset class.

On the retail side, the key determinants vary. According to BitPanda, a leading European digital exchange, retail portfolios vary between 20,000–50,000 euros on average. One of the reasons why their portfolios are so large is because more than half of them are early adopters into crypto-assets and were able to buy these assets at much lower prices than the current ones.

Figure 12: Retail Investors Key Determinants

According to my research, I found that these are the key determinants for retail investors, and their respective portfolio allocations, as seen in figure 12.

Investors who are solely focused on alpha generation are typically the ones who are ‘riding the hype’ and are investing mainly because of the fear of missing out. They lack financial market knowledge. Investors interested in diversification have the highest financial markets knowledge out of the three and are investing in bitcoin and blockchain technology for the long term. On the other hand, diligent investors only invest a very small amount of their portfolio for experimentation purposes. They want to learn more about blockchain and how the crypto-asset ecosystem works.

Gaining USD vs. Accumulating BTC

In my opinion, retail investors should define a clear strategy before they start investing in crypto-assets. They should either focus on gaining USD in their portfolios or accumulating BTC. This will impact the way they trade and which trading pairs they will use. The ones interested in making profits in USD should trade on direct fiat pairs. If they will trade altcoins on bitcoin pairs they will subject their portfolio to the added volatility of bitcoin.

On the other hand, there is a trend of retail investors who don’t necessarily want to make profits in USD, but their goal is accumulating as much BTC as possible for the long-term. These traders will engage in altcoin markets and trade them to gain satoshi. Satoshi is a unit of measurement of Bitcoin, and it represents a one-hundredth millionth of a single bitcoin: 0.00000001 BTC.

Retail investors should begin by researching basic chart analysis indicators and trading techniques in order to understand trends and how to efficiently build their positions. These include RSI, moving averages, dollar cost averaging and position laddering.

About the author

My name is Roland Roventa and I have entered the cryptocurrencies ecosystem in early 2017 and have been trading based on fundamentals ever since. I am excited to see the cryptocurrencies evolving as an asset class, merging with the traditional world of finance.

References:

[1] Sfox. “The Slow but Steady Institutionalization of Bitcoin.” Medium, SFOX Edge, 21 Jan. 2020

[2] Harnett, Michael, and Tommy Ricketts. “Global Investment Strategy — The Biggest Pictures.” BofA Global Research, 12 Feb. 2020.

[3] “Grayscale Investor Deck.” Grayscale, Sept. 2019.

[4] PlanB. “Efficient Market Hypothesis and Bitcoin Stock-to-Flow Model.” Medium, 26 Jan. 2020, medium.com/@100trillionUSD/efficient- market-hypothesis-and-bitcoin-stock-to-flow-model-db17f40e6107.

[5] Crypto Fund Research, cryptofundresearch.com/.

[6] Crypto Fund Research, cryptofundresearch.com/.LetKnowNews. “Top 10 Crypto Hedge Funds.” Medium, 12 Oct. 2018, medium.com/letknownews/top-10-crypto-hedge- funds-5479df56b4a3.

“Grayscale Digital Asset Investment Report.” Grayscale, Oct. 2019.

Chandler, Simon. “Biggest Crypto Hedge Funds and What They Tell About the Market.” Cointelegraph, 19 Aug. 2019, cointelegraph.com/news/biggest-crypto-hedge-funds-and-what-they-tell-about-the-market.

[7] PricewaterhouseCoopers, and Elwood. “2019 Crypto Hedge Fund Report. ”Crypto Fund Research, cryptofundresearch.com/.

[8] PricewaterhouseCoopers, and Elwood. “2019 Crypto Hedge Fund Report.”

[9] Hui, Ada. Investors in Polychain Capital’s Crypto Hedge Fund Saw 1,332% Gains — If They Stomached the Dips. CoinDesk, 30 Mar. 2020