Digital Alpha for a Digital World

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Summary

A shifting investment landscape may require that investors adopt a more exploratory mindset to achieve their target returns going forward. Digital assets have the potential to play a productive role in helping investors address the challenges of late cycle valuations and diminishing value add from conventional sources of active management.

Most arguments in favor of digital assets use macroeconomic theories and potential return asymmetry to justify directional exposure. But the digital asset class is the definition of inefficient and can offer investors differentiated sources of alpha through actively-managed fund vehicles.

A multi-strategy approach focused on relatively liquid investment strategies could allow investors to capitalize on those inefficiencies in a familiar construct that does not demand conviction in the underlying that is otherwise a prerequisite. All that is required is intellectual curiosity and open-mindedness to differentiated sources of return.

The Case for Exploratory Investing

On the morning of D-Day, Winston Churchill gave a speech to his generals that ended with the following admonition: “Flexibility of mind will be one of the decisive factors. Risks must be taken.”

Our current state of affairs is not nearly as dramatic as that fateful day in 1944. But the ground is shifting on myriad matters economic, geopolitical, and cultural, which makes for an uncertain investing landscape going forward. Add to this peak valuations, dwindling yields, and diminishing alpha, and the need is greater than ever for investors to adopt exploratory mindsets in search of creative solutions to their asset allocation challenges.

About fifteen years ago, Harvard economist Richard Zeckhauser published a paper entitled Investing in the Unknown and Unknowable. The piece examines how certain legendary investors “have earned extraordinary returns by investing in the unknown and unknowable”. These “UU” situations describe a condition of general ignorance where the future state of the world is unknown and the probabilities of potential future states are unknowable (i.e., there is no historical precedent upon which to base future projections).

Zeckhauser adds that some UU situations deserve a third U for uniqueness. These are situations where there is a dearth of professional investor involvement and such inattention can lead to significant mispricings. Return outcomes for UUU investments can sometimes be “extreme”, particularly when complementary skills allow for the application of “unusual judgment” that can result in extraordinary value capture from less-trafficked investments.

The digital asset class today is the quintessence of UUU investing. The future of blockchain and digital asset adoption is largely unknown; we cannot reasonably assign probabilities to outcomes given the novelty of the technology; and the relative immaturity of the space — combined with regulatory uncertainty — has sidelined most professional practitioners. We therefore have a recipe for “remarkably powerful” returns when investors can combine the complementary skills of technical proficiency and trading capability.

The Current State of Play

Most arguments in favor of digital asset exposure — and bitcoin (BTC) in particular — focus on asymmetric risk/return potential and notions of sound money. Added to these are other beliefs in the possibility that BTC could one day achieve reserve currency status and evolve into a frictionless, censorship-resistant payment rail. This has combined to give rise to a legion of strident supporters, many of whom are willing to hold BTC with low time preference and little price sensitivity (also known as HODLERs).

Justifications for getting long digital assets are compelling for more than philosophical reasons. Great work has already been done by the likes of Grayscale, Bitwise, Pantera, and others who have made eloquent beta cases for BTC. Given its potential return asymmetry and historical lack of correlation with other risk assets, a small allocation to BTC within a traditional asset allocation program has been shown to both increase a portfolio’s expected return as well as reduce its expected risk (diversification effects work their magic here).

Unfortunately, this has proven to be a mostly academic exercise since digital asset investment activity continues to be dominated by retail traders. Potential return asymmetry and a compelling inflation narrative have attracted macro investors like Mike Novogratz, Dan Morehead, and, more recently, Paul Tudor Jones. But the amount of institutional capital invested in the space today is estimated at just $10-$20 billion. This is small relative to a roughly $350 billion market capitalization for the asset class as a whole (per CoinGecko as of August 1, 2020) and minuscule in the context of the more than $100 trillion in institutional assets under management globally.

While multiple variables may explain the lack of institutional participation thus far, we believe security and volatility play central roles. Great strides have been made on the security front, both with digital asset native offerings from the likes of Anchorage and Bitgo, and with legacy institutions such as Fidelity and BNY Mellon developing solutions of their own. Significant work remains to bring about the level of comfort seen with traditional assets, but we are well on our way to seeing security become a substantially mitigated risk.

That leaves volatility as the primary gating mechanism in our estimation. Tremendous upside has proven real with digital assets but so too have peak-to-trough drawdowns on the order of 70%+. As Kahneman and Tversky’s prospect theory tells us, investors are reluctant to consider an investment with such significant potential for loss no matter the theoretical upside. If we learned anything from the Global Financial Crisis (“GFC”) — and are relearning with Covid-19 — it would appear that volatility is so bad we must do everything in our power to avoid it.

A Pragmatic Alternative

Digital assets are locked in a battle for hearts and minds that involves subjective as well as objective truths. The subjective is defined by a contest of ideas where the asset class is making thematic progress. The objective involves a competition for capital where asset allocation decisions need to appeal from a portfolio construction standpoint.

Contemplating those objective truths allows us to focus on a topic whose urgency is clear and present. It speaks to a real world use case — speculation — rather than to the potential promise that digital assets could perhaps one day fulfill. This is the conversation that needs to be had with investors since it eliminates conviction in the underlying as a prerequisite. It does not ask for belief in BTC’s potential to change the world; it only requires an open-minded desire to maximize one’s risk-adjusted returns in a familiar fund construct.

This involves a reframing of the investor conversation away from theoretical future states of the world and towards the reality of now. Proper contextualization here requires some degree of inversion: Instead of making the case for digital asset exposure, we should try instead to understand why investors are avoiding it. Doing so reveals an entirely new attack vector that addresses an investor need that has yet to be recognized as a want.

There is a concept in military strategy called escalation, which manifests across vertical, horizontal, and political dimensions. Vertical escalation involves employing new types of weapons to attack new categories of targets. Horizontal escalation involves widening the geographic theater of conflict.

We believe that conventional arguments used to justify digital asset exposure are too narrow and aspirational. They require willingness to stomach extraordinary volatility as well as subscription to some combination of: 1) the idea that inflation may someday return and the theory that BTC will perform as a hedge; 2) the belief that we could be in for a collapse of the global fiat system that will see digital assets rise in its stead; and 3) the potential of blockchain technology to deliver on its revolutionary potential.

Viewing things through the lens of an allocator, these are all big asks individually; collectively, they form a near impossible thesis for most investment committees. We therefore suggest an alternative approach that embraces vertical as well as horizontal escalation in the competition for allocator capital.

Vertically, we aim to focus on the less-discussed of the Greeks in digital assets: alpha. Indeed, we believe the potential for alpha generation within this space is remarkable. Lost in the hysteria over mark-to-market price action is the fact that we have been presented with an entirely new asset class that is the definition of inefficient. People can argue about use cases, valuation metrics, adoption curves, and long-term price targets. What we have in the meantime is a small but tradable asset class that is dominated by retail flow and supported by developing but fragmented infrastructure. The resultant opportunity for alpha generation is extraordinary, allowing investors to not just participate in significant upside potential but to do so in a way that could also maximize risk-adjusted returns in uncorrelated fashion.

Horizontally, we aim to shift the focus towards actively managed fund vehicles as another credible method for gaining quality exposure to digital assets. Several avenues exist for investors to gain directional exposure to the space, ranging from outright ownership to relatively less liquid tracker products to illiquid venture capital vehicles. While each approach has its pros and cons, all of them are beta plays whose only ability to dampen volatility might come in the infrequency of their performance reporting (more on that later). But less discussed are the many other types of investment strategies that are less sensitive to directionality and potentially capable of generating attractive risk-adjusted returns.

For example, volatility is normally considered a good thing for hedge funds, and BTC’s historical monthly trading range has been upwards of 30% since 2014 (even higher if we go back to its formative years). It is also not uncommon to see basis trades between futures and spot markets annualizing at over 30%, and the proliferation of new instruments spread across multiple exchanges can see pricing vary wildly during periods of heightened volatility. And, unlike traditional markets, one has the rare opportunity with digital assets to gain access to market-making strategies in fund form.

Arbitrageurs, quantitative traders, and liquidity providers may not be built for speed in bull markets, but their ability to consistently generate attractive risk-adjusted returns — with little-to-no leverage — is virtually unmatched in today’s global asset markets.

The digital asset class is one of the rare remaining opportunities for investors to extract alpha from highly inefficient and relatively liquid — albeit capacity constrained — markets. And it has arrived at precisely the right time in the investment cycle for traditional investors. As David Swensen told us in his seminal work, Pioneering Portfolio Management, “Emphasizing inefficiently priced asset classes with interesting active management opportunities increases the odds of investment success.”

Status Quo Bias

In his piece, Zeckhauser noted the following when advocating for UUU investing: “Some substantial losses are inevitable, and some will be blameworthy after the fact. But the net expected results, even after allowing for risk aversion, will be strongly positive.”

The first step towards capitalizing on an opportunity is being open to it. Unfortunately, we live in a risk-averse, follow-the-leader world of investment management that typically does not reward independent and creative thinking.

For example, the most common — and consequential — question among venture capital investors is, “Who is your lead?”. Signaling is a word often repeated in investment circles and speaks to the lemming-like investment habits we have developed. As Paul Graham once observed, “The biggest component in most investors’ opinion of you is the opinion of other investors.”

WeWork was able to raise extraordinary sums of money not because of its attractive economics but because the Vision Fund had allocated so much of its own capital. Bridgewater has become the largest hedge fund manager in the world not thanks to its stellar performance but because of the inertia that develops around institutional capital flows.

The idea that money makes money has never been truer.

In this environment, we have witnessed a steady decline in value-add amongst investment funds and allocators alike. Charles Ellis, the founder of Greenwich Associates, wrote a paper for the CFA Institute in 2012 that examined The Mystery of Underperformance. The piece lamented the persistent failure of institutions to achieve their investment objectives, and Ellis was generous in placing blame at the feet of all parties involved — fund managers, consultants, investment committees, and allocators themselves.

We’ll put aside for now the self-serving motives of investment managers whose survival depends upon asset accumulation and focus instead on the decision-makers directing capital their way.

Ellis paints a picture of consultants motivated by the notion of diversification in order to avoid any potential for consequential decision-making. Their agency interests are focused on retaining as many customers as they can for as long as possible, where average performance effectively qualifies as winning. To paraphrase Warren Buffett, diversification protects jobs while concentration destroys them in this context.

Much the same can be said of allocators themselves, whose frontline professionals find little upside in contrarian or outside-the-box thinking. Capital preservation at the client — and therefore firm — level is the primary motivation, leading to unoriginal analysis and decisions driven by risk-averse groupthink. Their own efficient frontier mentality has them sequestered in the known and knowable.

The result has been a lack of curiosity amongst investors and allocators that follows the Principle of Least Effort. An information-seeking actor typically opts for the path of least resistance and stops when minimally-acceptable results are found. Nobody gets fired for hiring Och-Ziff (now Sculptor) for its hedge fund exposure or Blackstone for its private equity allocation — the alternative investing equivalent of an equity fund manager making Apple a core holding. And nobody gets fired for sticking to the same old 60/40 allocation model that their firm has used for years.

Per Ellis, “Fund executives are almost always staff-minded processing people who must often feel ‘caught in the middle’ between investment committees with too little time and investment managers with too much skill and experience at selling.” Along with their artificial time constraints, investment committees are often populated by non-investment personnel (in the case of pensions) or executives led by outdated beliefs whose own existential calculus involves maintaining the status quo.

What we are left with are portfolio constructs that essentially all look the same. This allows big investment managers to get bigger while returns suffer in the negative space created by complacency. Mistakes are repeated and lessons are rarely learned. Firms hire managers after their best years and fire them after their worst, a deeply-ingrained heuristic that somehow persists despite continued underperformance.

What Zeckhauser lamented as “blame aversion” is the psychological barrier standing in the way of digital assets. The unwillingness to expose oneself to the possibility of being wrong — even if the analysis ex-ante justifies the action — is the driving force behind our pervasive intellectual incuriosity as investors.

Pull the Goalie

AQR cofounder Cliff Asness coauthored an essay in 2018 called Pulling the Goalie: Hockey and Investment Implications. The piece draws parallels between investing and the practice of pulling goalies for losing hockey teams near the end of games. This is a fairly common strategy employed in an effort to momentarily give losing teams a numbers advantage in terms of personnel. So instead of five attacking players with one goaltender between the pipes, pulling the goalie gives a team six attackers while also leaving their defenses exposed by way of an empty net. This is typically done with less than a minute remaining in regulation.

Not surprisingly, pulling the goalie is a negative expected value move in terms of goals; in fact, the probability of being scored against quadruples while that of scoring only doubles. However, as the authors point out, coaches should not be solving for expected goals. Rather, it is standings points that should matter more. A team down by a point in the waning seconds of a game gains a lot by scoring and sacrifices little by being scored against. The analysis goes on to show that pulling the goalie is indeed a positive expected value event from a standings perspective, and often should be done much earlier than is customary.

The most basic lesson is to make sure you are thinking about the right risk. Pulling the goalie always increases the volatility of numbers of goals scored, and is a negative expectation in terms of the score. For those reasons it is often used as a metaphor for a high-risk, desperation move. However, the point of hockey is not to maximize the differential between the goals your team scores during the season and the goals it gives up (if it were, no one should ever pull a goalie). The point of hockey is to maximize the number of standing points — a team down by a goal with short time remaining gains a lot by scoring, and loses little if the other team scores — which argues for a different measure of risk and return. As we have shown, pulling the goalie actually reduces the risk of losing the game — it’s an insurance move — and this is the proper risk measure.

Despite the mathematical logic, hockey coaches have proven indifferent to the report’s findings. The authors speculate this is because — like investment managers — coaches are not actually rewarded for winning games. They are instead more interested in simply being perceived as being good. If they do everything in a manner that embraces conventional wisdom, then they meaningfully reduce the probability that they will be blamed if things go wrong.

When you play not to lose rather than play to win, “sins of commission are far more obvious than sins of omission.” The authors make good use of John Maynard Keynes’ famous quote here: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

Those of us not named Jim Simons operate in a world of mostly efficient markets where active management routinely fails. Even in those rare instances of value-add, there is not much persistence to any outperformance that may momentarily exist. This is true for traditional as well as alternative investments. According to HFR, average hedge fund returns have fallen from 18.3% in the 1990s to 6.4% in the 2000s to 3.4% in the 2010s.

Consequently, investors are understandably opting for greater amounts of passive exposure for their traditional allocations. And they are increasingly being pushed into private investments to compensate for the alpha decay in their liquid alternatives portfolios.

Even the world’s largest money manager — BlackRock — is adapting to the impact of more efficient markets. Per Mark Wiseman, the firm’s global head of active equities, “With public markets becoming so efficient it has become difficult to produce returns in excess of market gains, so institutional investors are looking to private markets to generate alpha.”

Similar to its public market counterparts, though, private equity has underperformed and alpha generation has virtually disappeared over the past few decades. This is particularly true when one accounts for the illiquidity required and leverage employed. Also similar is that even in those limited instances of outperformance, there is no persistence to it.

Investors are venturing out on the liquidity spectrum even though history says that doing so is unlikely to help them outperform. Nor do current market conditions elicit confidence: Nearly $2.5 trillion of dry powder needing to be deployed, already record levels of corporate debt, extended valuations, and an economy rocked by a pandemic and social unrest should not elicit excitement for the most illiquid and leveraged part of asset management.

So why have investors been flocking to private equity? We refer again to AQR’s Asness, who ventures a guess of his own in a recent blog post entitled The Illiquidity Discount?.

In the piece, Asness wonders if the attraction to private equity is less about its potential for relatively better returns and more about the fact that the infrequency of its performance reporting has a smoothing effect on portfolio returns and a soothing effect on investor psyche.

What if illiquid, very infrequently and inaccurately priced investments made them better investors as essentially it allows them to ignore such investments given low measured volatility and very modest paper drawdowns?…[private equity’s] big time, multi-year illiquidity and its oft-accompanying pricing opacity may actually be a feature, not a bug!.

Asness is admittedly having some fun with this idea, but his point serves as a gut punch to the allocator community: Fear of volatility is so strong that investors are willing to sacrifice returns and liquidity so they can avoid ever having to see it.

Past struggles with active management are unfortunately not being offset by strong forward-looking expectations. Nearly $15 trillion worth of quantitative easing following the GFC and now Covid-19 has ushered in — and sustained — the longest bull market in history. Yet we inexplicably still have a multi-trillion dollar underfunded pension problem even while unrealistically assuming annualized net returns of 7%. Nearly all of the 200 largest defined-benefit plans in the S&P 500 are underfunded. Estimates for prospective equity returns over the next decade hover around 4%. Negative real yields and global deleveraging spell doom for risk parity. High equity valuations and historically low bond yields see prospective returns of a 60/40 portfolio at sub-3%.

America’s largest state pension fund, Calpers, recently announced its intention to employ leverage in order to increase its private equity and debt allocations. The fund’s CIO, Ben Meng, reckons doing so will give him the best shot at meeting pensioner obligations going forward. With a targeted return of 7%, declining equity premiums, and the 10-year at sub-1%, we sympathize with Meng’s desire to get creative. He was quoted in a December interview with the Financial Times saying that “…I need to look at all corners of the world where I can earn that additional 1–2 percent.” We applaud Meng’s exploratory mindset but suspect his team has left at least one stone unturned in its search for that incremental return. (Update: Just prior to this article’s publication, Mr. Meng resigned from his role amid conflict of interest allegations associated with his personal private equity investments.)

Calpers serves as a harbinger for investors of all stripes. In a world of diminishing alpha that is awash with liquidity, risk appetites should increasingly allow for small exploratory allocations. This would require some “pull the goalie” thinking about risks that are perhaps being wrongly considered. It would also need consultants, investment committees, and other gatekeepers to rediscover a sense of curiosity and open their minds to alternative sources of return. This would mark a shift away from a perfunctory, tick-the-box allocator mindset to that of a creative, independent investor mindset where fees are justified and value is genuinely added. In this day and age, we agree with Howard Marks that it is much better to be “…an intelligent speculator than a conventional investor.”

There is plenty of historical precedent where unconventional thinking has been rewarded. The sports world is especially rich with examples. In baseball, we have the practice of bullpenning and the use of sabermetrics popularized by Michael Lewis’ Moneyball. In basketball, we’ve seen the successful implementation of the D’Antoni system that favors three-pointers and high pick-and-rolls in a spread-out, fast-paced offense. American football saw a transformative innovation of its own with the West Coast offense devised by coach Bill Walsh in the 1970s. Each represented differentiated thinking at inception but evolved into standard practice given their effectiveness. As Lewis observed in another of his classics, Liar’s Poker, “Any astute trader will tell you his best work cuts against conventional wisdom.”

The Hedge Fund Investment Case

There was a time when traditional hedge funds delivered on their original promise of maximizing absolute as well as risk-adjusted returns in uncorrelated fashion. They were able to do so because a lack of competition combined with emerging instruments and strategies to result in significant inefficiencies upon which to capitalize.

Where we are today with digital asset hedge funds is reminiscent of the early days of their traditional counterparts: regulatory uncertainty; general opaqueness; information asymmetry; limited track records; underdeveloped risk management programs; operational deficiencies; and potential for significant volatility.

Just as during the late-1990s — when hedge funds really began to gain traction as investable options for institutional investors — we are now witnessing the rise of a differentiated risk/return profile with vehicles designed to maximize absolute as well as risk-adjusted returns.

Hedge funds performed a critical role in those early days by providing institutional investors with entree to what were once highly effective but still fledgling investment approaches. Similarly, there is today a clear need for a professional “jungle guide” to help investors navigate this new space. History does sometimes rhyme.

There are multiple strategies being deployed by digital asset funds that span the liquidity spectrum. Given its nascency, we believe this is a market better suited for speculation than investment. In our assessment, the greatest potential for consistent alpha generation lies with the traders and arbitrageurs. We also appreciate there are instances where fundamental analysis can prove effective, and it is our hope and expectation that more thematic approaches will prove worthwhile over time. This is why we believe that the most successful digital asset investors will gravitate towards a multi-strategy approach as they mature and evolve along with the market.

A diversified, opportunistic portfolio seeking to extract value from inefficient emerging markets strikes us as very compelling indeed. And doing so in a relatively liquid fund construct that allows for continuous rather than binary thinking makes for a good complement to the current digital asset product mix.

Zeckhauser suggested that “individuals with complementary skills enjoy great positive excess returns from UU investments”, and investors should “make a sidecar investment alongside them when given the opportunity.”

Selecting the right “sidecar” in this space is a critical piece of the puzzle.

This is the value we seek to provide at Dalpha.