A Crypto Narrative Violation

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Introduction

In their August 2020 monthly investor letter, the good folks at Bitwise took aim at active management in digital assets while making “The Case for Indexing in Crypto”. This led to a friendly exchange between our two firms that addressed both the content of their letter as well as the philosophical differences between our respective approaches.

What follows is an expanded version of our side of that exchange, which we are publishing in an effort to publicly contribute to the passive versus active debate in digital assets.

As a quick caveat, we respect the efforts of Bitwise and appreciate the work it has done to elevate the dialogue in this emerging market. What follows is not meant to serve as commentary on the Bitwise team or any of its offerings. Our intent is instead to engage with a crypto investing maxim that often goes unchallenged.

Challenging a Crypto Status Quo

When it comes to sources of third-party exposure to digital assets, the prevailing wisdom says that beta is all one needs and therefore passive investing is the only game in town.

The majority of research advocating for crypto exposure illustrates how small buy-and-hold allocations to bitcoin can improve the risk/return profile of a standard 60/40 portfolio. For example, CoinShares recently published a report suggesting an allocation as high as 4% could be beneficial.

In addition to the expected commentary from index providers themselves, many prominent voices in digital assets have also made public remarks against the idea of active management. (It should be noted that this sentiment only applies to liquid sources of active exposure since venture capital seems to be universally embraced as a force for good.)

This narrative has clearly won the day as Grayscale lights the fundraising world on fire with its various trust products and Bitwise is more the household name than any digital asset fund manager. Even those with relatively good brand recognition such as Pantera and Polychain have only a small portion of their assets allocated to liquid trading strategies.

But beta isn’t the only game in town. Quite the opposite in fact. As we’ve discussed in detail before, the digital asset market is a bonanza of alpha potential. Given its fragmented microstructure and dearth of professional traders, this is a marketplace that must be considered among the most conducive to active management. Yet attempts at capitalizing on that opportunity are routinely denigrated.

The pursuit of alpha in crypto therefore represents a narrative violation, one that we seek to promulgate at Dalpha. Similar to the Bedrock founders who coined the term, “we constantly question popular narratives in search of hidden truths…this is especially useful in [digital asset] investing, where capital tends to be dramatically over-allocated to startups that align with the strongest market narratives.”

In Response to Bitwise

While we disagree with several assertions made in this month’s Bitwise letter (e.g., the correlation section draws conclusions we consider to be spurious), the section entitled “Picking Winners is Hard, Maybe Impossible” will serve as our focus here. We cite specific quotes from the letter below that are followed by commentary of our own.

The universe of active crypto asset managers is full of thoughtful, articulate, experienced, well-informed, professional investors … who constantly disagree on how things will play out.

The section starts by implying that disagreement among investors on what the future may hold is evidence that picking winners is hard. But disagreement is precisely what makes a market. If we all agreed tomorrow that one bitcoin was worth $25,000, then many of us would be newly unemployed and that rumored Coinbase listing would suddenly look much less interesting.

We naturally agree that nobody can predict the future, a reality that applies not only to crypto fund managers but also to firms providing unidirectional exposure to an entirely new asset class. This is doubly true for those offering idiosyncratic exposures — such as CoinShares, Grayscale and Bitwise with their single asset tracker vehicles — to which an allocation would represent, in essence, the picking of a winner.

Seventy such firms shut down last year, driven by poor track records and the inability to raise capital.

The section continues by referencing recent crypto fund closures. This shouldn’t come as much of a surprise to anyone familiar with alternative investing. Attrition is the name of the game for most asset management businesses, traditional as well as alternative. Building a successful hedge fund is particularly difficult as evidenced by the fact that most of them fail.

For every Bridgewater Associates, which currently manages upwards of $130 billion, there are hundreds if not thousands of sub-$50 million hedge funds living on the edge of extinction. Given the immaturity of the asset class and many of its practitioners, the crypto hedge fund lifecycle will surely be truncated, especially in these early years.

This part of the Bitwise commentary echoes the Schadenfreude we often see on “Crypto Twitter” with each passing fund failure. We suspect this is partly due to observer bias, which suggests that we see what we want to see when preconceptions influence our interpretation of events. Having witnessed the general failure of active management in other asset classes — and perhaps having their own directional, beta-oriented businesses to support — the crypto commentariat rarely passes on the chance to revel in fund shutdowns.

What appears to be lost on many is that the battle for investor mindshare is best fought from without rather than from within. We all need investors to gain comfort with this space. The more successful digital asset funds become, the more attention the space will receive, and the more legitimate its exposure will begin to feel.

There is some truth to the idea that a rising tide can lift all boats here. To paraphrase Jeff Bezos, competition isn’t zero sum when the potential opportunity is big enough.

Moreover, crypto hedge funds collectively account for a tiny portion of total assets allocated to the space. Surely they do not represent any real competition in terms of client capital or attention. We therefore suspect that time would be better spent focusing on beta market share rather than sub-$5 million crypto funds with short half-lives.

Successful multiyear track records are hard to find: For example, the median crypto hedge fund returned 30% in 2019, according to PWC, trailing the Bitwise 10 Large Cap Crypto Index by more than 20% (BITX rose 51.8% in 2019).

Here we have a reference to multiyear track records immediately followed by the selection of a single arbitrary data point — calendar year 2019 — to illustrate the relative underperformance of digital asset hedge funds. The framing of this statement is suboptimal in terms of definitions, measurement periods, and metrics.

Definitionally, we should start by understanding that crypto funds are not monolithic, just as their traditional counterparts are not singular in their respective approaches. We appreciate the need to quote average returns for the sake of convenience, but there are clear distinctions between long-only funds that often promote beta masquerading as alpha and multi-strategy, quantitative trading, and arbitrage funds designed to exploit the myriad inefficiencies on offer within the space.

With regard to time frame, those familiar with professional investing know that performance is measured over market cycles that ideally encompass multiple regimes. This is typically defined over a period of three-to-five years. Rarely are judgments made on the basis of just one.

So yes, the average crypto fund underperformed the Bitwise 10 Index last year. But that fails to account for the substantial relative outperformance witnessed during 2018 and the inline performance generated this year through June (per data from Crypto Fund Research). And if we drill down into the various sub-strategies, those numbers begin to look all the more interesting.

That being said, the foregoing is largely irrelevant since, in their purest form, hedge funds are NOT meant to relatively outperform any particular benchmark. They are instead designed to maximize absolute and risk-adjusted returns in relatively uncorrelated fashion. The risk-adjusted part is of particular relevance here.

Professional investors are attempting to solve for several things when they make allocation decisions. In the world of alternative investing, risk-adjusted returns are the key focus for most. This is especially important in the context of crypto, where volatility is the primary gating mechanism for investors.

(Note: The risk-adjusted return of an asset effectively explains how much risk is required to achieve a certain level of return. If two assets provide the same level of return, then the asset with lower risk will have the better risk-adjusted return.)

For a proper treatment of this issue, we recommend a Cliff Asness post on the topic entitled The Hedgie in Winter. By no means an apologist for hedge funds, Asness points to the flaw in comparing hedge fund performance to indices, which by definition represent a beta of one.

Comparing hedge fund returns to industry benchmarks is a common mistake. It is most often committed by journalists who lazily view relative underperformance of hedge fund hotshots as good headline fodder. It is therefore unsurprising that many crypto observers take a similarly simplistic approach when assessing fund performance. After all, most operators in this space have limited — if any — asset management experience.

Which brings us to another point about crypto fund attrition. The vast majority of the earliest digital asset fund managers had no prior experience managing capital. Many such funds were led by former technologists who personally profited from stratospheric price action in 2017 and thereafter fancied themselves professional money managers.

These individuals are not the first to fall victim to a narrative fallacy that equates luck with skill, and surely they are plenty intelligent and capable people. But it takes a certain chutzpah to extrapolate one phenomenally good punt into qualification to manage fiduciary risk.

We are reminded of a quote from Michael Lewis’ Liar’s Poker when contemplating this phenomenon, “Never before have so many unskilled twenty-four-year-olds made so much money in so little time. There has never before been such a fantastic exception to the rule that one takes out no more than one puts in.” (A crypto version of that book would be epic, by the way.)

Similar to the opportunities they seek to exploit, crypto hedge funds are in their nascency. In addition to navigating a volatile asset class and uncertain regulatory backdrop, these fund managers are attempting to build businesses in the cutthroat world of high finance. We can be certain that failures will continue apace, but we view this as a natural clearing of the underbrush that will make way for increasing numbers of experienced investors to rise in their stead.

If you’d asked well-informed crypto investors in January 2015 — “Do you think Ethereum will launch and be worth 4x bitcoin’s current market cap in a few years?” — how many do you think would have said yes? Not many.

Here the author makes a rather random assertion that not many fund managers would have anticipated Ethereum’s rise back in 2015. Having lived through it ourselves, we know the same could have been said about Amazon during one of its massive post-bubble dips. But how does speculating about what folks may or may not have been thinking in 2015 help make the case against active management?

The average monthly dispersion between the best and worst performer is a whopping 60.71 percentage points. The smallest difference was 22.95 percentage points in March 2020, which is still significant in a single 30-day period.

Elsewhere in the letter, the author inadvertently makes the case for active management by highlighting dispersion statistics that are commonly used to demonstrate opportunity for most fund managers. Meaningful differentiation between winners and losers is a prerequisite for any successful active management strategy. And the fact that league tables turn over the way they do means there is potential value in security selection. Execution is of course another piece of the puzzle, but the data shown in the below table are the same that get active managers excited about their strategies. The case for indexing is actually strengthened when there is persistence among winners and losers.

Crypto is Ideal for Active Management

We fully agree with the sentiment that active management is hard and in most conventional cases value destructive. We believe passive investing makes great sense for deep, liquid, and developed markets that have been made mostly efficient by the proliferation of professional traders. It is here that we concur with Charles Ellis — whom the authors cite just as we have in prior posts — that indexing is preferred when focusing on liquid traditional markets.

However, the digital asset market is a much more attractive place for active managers given its inherent inefficiencies and general lack of competition. Studies have shown that active management is not always negative sum, that it can add value in obscure markets where a lack of attention can lead to abundant opportunities for alpha generation.

For example, active fund management has historically proven effective when focused on emerging markets, high yield, and small-caps, all areas that are relatively less trafficked when compared to their blue-chip counterparts. There are also pockets of structural inefficiency where alpha generation is real and persistent, namely in private credit markets where asset managers can fill funding voids created by regulation-inspired bank retrenchment.

The beauty of crypto is that it is both under-followed and structurally fragmented. As David Swensen once noted, “In less efficient markets, active management produces potentially sizable rewards…[that] tend to reside in dark corners, not in the glare of floodlights.”

Closing Thoughts

The primary benefits associated with traditional index investing mostly involve matters of efficiency. Index products are largely designed to reduce cost, complexity, and risk (through diversification). There is a democratizing element to index funds for the average investor in that they provide a way to gain broad exposure to an asset class in a diversified, liquid manner at a lower price point than the average active alternative. These products also solve for the paradox of choice given the thousands of mutual funds from which investors have to choose.

Generally speaking, crypto index products have not been created in the image of their traditional counterparts. With annual expense ratios reaching as high as 2.50%, they are much more expensive when compared to the 0.09% average for equity index funds. Access has not necessarily been made easier since many of these products (at issuance) are only made available to accredited investors. Granted, this is a regulatory burden that must be borne by crypto index providers through no fault of their own, but the point remains. Instead of offering better liquidity, these products often carry lockups and generally do not allow for daily dealing. And by our math, the Bitwise 10 Index Fund has actually underperformed bitcoin in gross terms since its inception while at the same time experiencing higher volatility. (Note: We use bitcoin for purposes of comparison here since it is the default beta proxy for many in this space.)

As we have addressed elsewhere, volatility is a critical concern for many allocators when it comes to digital asset investing. It is axiomatic that crypto index funds should not be expected to assuage that concern, calling into question the merits of a passive approach when it comes to attracting institutional capital.

It is our view that crypto index products are arbitraging complexity (e.g., which trading venues to onboard with, custody issues) and governance (e.g., investors who want exposure but can only invest in fund form) with a dash of regulation (e.g., the SEC’s continued refusal to approve the creation of digital asset ETFs). In that sense, there is certainly value in the access index providers can offer for those seeking to solve for exposure in as familiar a construct as possible. But we believe there is a better access point for those investors willing to pay proper fees in an effort to maximize the quality of that exposure.

There is more than one way to skin a cat, to be sure. And plenty of room exists for passive as well as active approaches to serve different investor needs. We are all on the same team in the battle against the allocator status quo when making the case for digital asset exposure. But the crypto status quo also needs challenging, which is a cause we seek to advance at Dalpha.