Crypto Horse Race: Using Data Analysis to Separate Winners from Losers
With the Kentucky Derby in the books, horse race fanatics are setting their sights on the upcoming Preakness and Belmont Stakes–the two summer races completing the Triple Crown.
We’ve been thinking about horse racing too, albeit less about pedigrees and stride lengths, and more about evaluating performance. Specifically, in the race to generate positive returns on crypto investments, how can one analyze past performance?
Backtesting performance is nothing new to investing. In traditional markets (i.e., non-crypto), investors measure portfolio performance in two main ways. First, by looking at absolute performance, a measure of how much a stock appreciates or depreciates over time. This is most often done by looking at standard deviation, a common metric for a stock’s volatility.
Second, investors consider relative performance. Looking at performance on a relative basis essentially means comparing a stock’s rise or fall to that of a similar stocks or group of stocks (e.g., an index like MSCI). Tools such as tracking error and the information ratio are common ways investors measure relative performance.
It’s obviously important to know a stocks absolute performance, but relative performance is really what provides insight into whether there is value add in a stock-picking process. The return that is generated over the index return–aka alpha–is how portfolio managers demonstrate they are picking the right stocks. Alpha, when generated within an investor’s risk constraints, is how portfolio managers prove their worth.
But how can we measure relative performance in the crypto space?
It goes without saying that measuring crypto asset performance is far less developed, but there are tools emerging that allow investors to determine how their crypto picks are performing against the broader markets. For example, Coinbase has a market cap weighted index fund that gives investors exposure to the assets listed on its exchange, and Bloomberg recently launched their own benchmark index that will compare the performance of ten digital assets.
While these indices are helpful, we’ve been concerned that there really is a lack of sophisticated approaches to actively invest in crypto assets. Technical analysts in the stock market look at historical price and other factors and then use quantitative tools determine a stock’s trajectory, and we think the same type of rigorous research should happen with crypto. In other words, what if we apply serious technical analysis to the available data, and see which digital assets come out on top?
The HorseRace BackTest
Which brings us back to the racing analogy. The sum of our thinking over the last several months resulted in a backtesting methodology we call the “Horse Race Backtest.” Here’s how it works:
We first observe the potential range of returns for our baskets of crypto assets by considering three investment alternatives: holding BTC over the long-term; holding a market cap-weighted investment in the Coinbase Index; and holding an investment in the 10 largest crypto assets.
Next, we evaluate each of these three alternatives against the performance of our own portfolio over a 70-week period. The reason we use this time period is in part due to the increasing breadth of cryptocurrencies that have emerged and developed track records in 2017. In addition, we wanted to capture performance of these alternatives through the bear market in early 2018. Not surprisingly, even going back just 70 weeks the crypto landscape looks dramatically different–a factor we took into consideration as we developed our methodology.
Finally, we document rolling average monthly returns for our portfolio and the three alternatives. It’s probably also worth noting here that even when using this type of technical analysis, we focus heavily on the fundamentals of an organization when choosing crypto investments.
Here are the performance results from running the backtest shortly after May 1st, 2018.
We fully appreciate that this time period has been unique in the short life of cryptocurrencies. With all the crypto-promises being made and broken out there, we want to emphasize that these eye-popping numbers need to be viewed through a prism of reality that takes into consideration this being a very new asset class that’s untested in many ways (i.e., no need to fire your stock market portfolio managers). And as with any type of backtesting, previous results never guarantee future performance. But you knew that.
What’s more important to remember here is that by sifting through all of this data, opportunities to separate the crypto winners from the losers do exist. This isn’t a new development–technical analysis and quantitative principles are applied to actively managed stock portfolios all the time–but there is no doubt a lot being learned in real time about the behavior of the crypto markets.
Unlike an actual horse race, which of course is very speculative, with the right tools it is possible to make some sense of the crypto markets and ensure that you’re not left completely guessing about where to put your money.
