Continuous Versus Binary Investing
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Data have different definitions in statistics. For example, discrete-binary data have finite values and limited potential outcomes. Conversely, continuous data can fall anywhere on a continuum and therefore contain infinite possibilities.
Binary is yes/no, on/off, zero/one. Something either happens or it does not. Continuous includes those binaries as well as every possibility that might lie on the spectrum in between.
We use this idea of continuous versus binary thinking to describe the various approaches one can take to digital asset investing.
The below illustration helps bring this to life.
The square represents directional buy-and-hold approaches achieved via “flat pricing”. Outcomes dictating performance are linear. Bitcoin can rally, fall, or tread water. So an investor’s outcome can be good, bad, or unchanged. This is a largely binary approach that affords no room for alternative outcomes other than straightforward ones. This type of passive exposure can be achieved via outright purchases of crypto or through various tracker products.
The cube represents the venture capital (“VC”) approach, which begins to introduce greater variability in outcomes. In digital assets, this typically involves allowance for exposure to projects that extend well beyond just bitcoin. And it often allows for more than just one type of exposure since venture investments can often take the form of tokens or equity. It also involves more than one path to payout. That is, with a “squared” approach to bitcoin, “number go up” is the winning formula, whereas with venture capital, a “win” can take multiple forms (e.g., merger, acquisition, management buyout, secondary sale, public listing).
A binary calculus, however, continues to underpin any path to success with venture capital: Blockchain as a technology must take hold and achieve greater adoption. Crypto as a broadly-defined concept must mature and advance. The digital asset class as a whole must develop and evolve to the point of institutionalization. Entrepreneurs must execute in the midst of it all and generate liquidity events for their backers.
A relatively more liquid hedge fund approach to digital assets is quintessentially non-binary. It is like a tesseract, where zeros and ones can go off in all directions to create a multitude of possibilities. Here managers can capitalize on an infinite combination of exposures, instruments, trading venues, time horizons, and strategies to successfully navigate myriad market backdrops and outcomes. Picture a barbell where opposite ends represent binary scenarios, and the bar that connects contains a multiverse of potential outcomes that would be missed by focusing only on either side of the extreme. This allows for a diversity of approach — and potential outcomes — that can combine at a portfolio level to present investors with an all-weather way to access an emerging new space.
Alternative Approaches to Crypto
We believe “squared” approaches to crypto are some combination of: poorly structured (e.g., expensive tracker products leveraging regulatory arbitrage); logistically difficult (e.g., require exchange selection/onboarding and custody decisions); or suboptimally designed (e.g., do not solve for volatility or maximize quality of return).
We therefore prefer a more active approach to digital asset investing, particularly for those investors seeking to maximize risk-adjusted returns.
The “cubed” venture capital method currently represents the conventional way for institutional investors to gain active exposure to crypto. We estimate there are 10x more hedge funds than venture capital funds focusing on the digital asset space. Yet the bulk of the fanfare and fundraising success has flowed to the less liquid approach thus far.
It is easy to understand why institutional engagement has been largely confined to venture strategies. Since crypto can generically be characterized as an emerging technology, the innovation budget for allocators often defaults to venture capital. Crypto can in some ways be considered the next killer app and the total addressable market could be massive when using traditional markets as a guide. It therefore makes sense that venture would seem the logical first engagement point for sophisticated investors.
We should also recognize that we are currently in a golden age of sorts for venture capital. Despite the pandemic, venture capital exit activity just reached its second-highest level ever. We are also on pace for a record fundraising year for the strategy. This all comes at a time when venture capital darlings were among the best-performing stocks of the past decade and led the market’s rebound out of its pandemic-induced trough. Some of that VC shine spilling over into crypto should therefore be expected.
Venture capital’s collective hold on the investing public consciousness has even resulted in some of its practitioners achieving minor celebrity status as modern day philosophers. Top VC “influencers” now have hundreds of thousands of Twitter followers. There has even been a book written about the collected wisdom of AngelList cofounder Naval Ravikant, whose Twitter following is currently listed at one million (double that of Ray Dalio, head of the world’s largest hedge fund). This is evidence of what Scott Galloway has referred to as the “idolatry of innovators” and “founder fetish”.
There might also be some of what economist Richard Zeckhauser calls blame aversion at play here. Given their 7–10 year horizons, judgment day is a long way out with venture capital funds and the periodicity of their performance reporting might be more a feature than a bug. As Cliff Asness has pointed out, infrequent marks and easy window dressing allow venture capital funds to smooth their return streams. This can have a soothing effect on investor psyche, especially for those concerned with reputational damage that might arise from a negative outcome resulting from any crypto foray.
Crypto and venture capital therefore make good bedfellows: the former is long on potential and volatility but short on experience and credibility, while the latter is long on capital and risk appetite but short on paradigm-shifting moonshots. This reminds us of a quote from an excellent feature on venture capital in the The New Yorker from earlier this year:
Venture capital has offered a path into the market for unsmooth operators and bizarre ideas.
Many of the earliest vintage crypto hedge funds were really long-only venture type funds that tried to shoehorn themselves into liquid constructs. The idea of “liquid venture” quickly took hold during a period when everything looked like a rocket ship and liquidity appeared abundant. This probably seemed like a good idea at the time, but at some point so did the NFL’s decision to subject America to a Detroit Lions game every Thanksgiving.
The directionality of these funds conspired with severe asset-liability mismatches to doom many in the bear market of 2018. This resulted in a general distaste for crypto-focused hedge fund strategies. We agree that investors should be wary of paying for beta masquerading as alpha. And to be fair, there remains plenty of that type of exposure on offer. However, the crypto hedge fund universe has matured significantly in the past couple of years, with increasing numbers of experienced practitioners entering the space. A good portion of these new entrants do not view the simple act of hedging as evidence of value-add but rather engage in genuine pursuits of alpha.
The reality is that financial markets are complex adaptive systems. Outcomes are often nonlinear, particularly when they involve the birthing of an entirely new asset class. The future of crypto is thusly highly uncertain, which makes a more liquid trading approach worth considering.
That VC-funded custody provider may or may not be one of those acquired by traditional incumbents looking to expand into crypto. That VC-backed trading venue may or may not be able to participate in the inevitable consolidation to come.
But what we do know is that this is a tradeable asset class in the here and now. Inefficiencies abound whether they be structural (e.g., fragmented market microstructure), regulatory (e.g., GBTC arbitrage), or idiosyncratic (e.g., defi). These opportunities all exist in real time and thusly do not require contemplation of theoretical future states of the world. They can be accessed in relatively liquid form with return potential that genuinely mirrors that of “liquid venture”. They have auditable track records serving as tangible proof of concept with significantly more transparent price discovery when compared to their venture capital counterparts.
The struggles faced by traditional hedge funds to justify their fees over the past decade-plus have been well documented. Venture capital has largely avoided such scrutiny despite not covering itself in glory on the same account. But hedge funds used to have no problem justifying their fees on the back of the alpha that existed in less-trafficked markets and strategies. While traditional markets have grown increasingly efficient over the years, the digital asset landscape — despite its many risks — presents us with a potential alpha bonanza upon which savvy practitioners can capitalize amidst limited competition.
Birds and Frogs
Mr. Dyson’s speech focused on complementary species of mathematicians, but the distinction he drew is useful for our purposes as well.
Birds fly high in the air and survey broad vistas…out to the far horizon. They delight in concepts that unify our thinking and bring together diverse problems from different parts of the landscape. Frogs live in the mud below and see only the flowers that grow nearby. They delight in the details of particular objects, and they solve problems one at a time.
Birds — like hedge funds — operate from a higher perch to survey the vast landscape below. They are opportunists who thrive on episodic sniping resulting from the breadth of wildlife on offer and their ability to deftly navigate air, land, and — in some cases — sea.
Frogs — like venture capital funds — go deep into a specific situations. They focus on idiosyncratic opportunities strictly within their core competence and patiently allow them time to play out.
There is a symbiosis that exists between these two approaches. Hedge funds benefit from the funding that venture capital provides to build the infrastructure upon which they trade. Venture capital benefits from its portfolio companies having a native client base eager to use their services.
We also believe that these two approaches can coexist in complementary fashion for allocators looking to build a robust digital asset portfolio. Here we paraphrase Mr. Dyson by replacing his reference to mathematics with investing.
[Investing] needs both birds and frogs. [Investing] is rich and beautiful because birds give it broad visions and frogs give it intricate details. [Investing] is both great art and important science, because it combines generality of concepts with depth of structures. It is stupid to claim that birds are better than frogs because they see farther, or that frogs are better than birds because they see deeper. The world of [investing] is both broad and deep, and we need birds and frogs working together to explore it.
Just as Mr. Dyson saw progress in mathematics coming from mathematicians avoiding the urge to fly too high into abstraction or sink too deep into detail, we believe a similarly balanced view could prove effective with alternative approaches to digital asset investing.