Can Numerai become the Last Hedge Fund?
Summary
- Numerai sits at the intersection of two megatrends underway in the Fourth Industrial Revolution — Artificial Intelligence (AI) and the Blockchain.
- Goal: Build the world’s last hedge fund, a single hedge fund monopoly to manage all of the world’s money.
- Thesis: Numerai is a data-based protocol disrupting the $8T hedge fund industry with an upside potential of 32,000x+.
- Network Growth: Numerai has built a network of over 10,000 data scientists that actually collaborate, instead of compete, with each other in its stock market tournament. Over $90 million in rewards have been paid to data scientists, and Numeraire (NMR) staked by data scientists on their stock market predictions has grown nearly 300% in the past 12 months alone.
Introduction
This report is the first in a series about the implications of the Fourth Industrial Revolution (4IR) and the Data Economy spanning from the blockchain industry to the future of global societies.
One of the initial projects included in the DATA Index, Numerai innovates at the intersection of two megatrends of 4IR, Artificial Intelligence and the Blockchain, which together define the new Data Economy. Numerai has the longest track record of any crypto-based data economy having launched in 2015. It has also paid more to data providers over its history than any other project, with over $90,000,000 in total rewards so far to data scientists staking its native token, Numeraire (NMR). Given its history and success, Numerai best illuminates the value of the Data Economy and its trajectory in the future.
Numerai is the quintessential blockchain data economy project, an entire ecosystem devoted to unearthing the value of data through onchain coordination and market mechanisms.
Background
Numerai has led to many serendipitous events for the creators of the DATA Index. Thomas Hepner, DATA Index co-founder, earned his first bitcoins competing in the Numerai tournament in 2016 and was one of the first 12,000 data scientists to receive NMR tokens to incentivize the construction of the hedge fund.
In early 2021, DATA Index co-founder Kiba Gateaux created an ETF built on Set Protocol and Ethereum that included NMR. Months later, Thomas independently created a TokenSet that also included NMR. After meeting through Index Cooperative, they realized that both saw the value to people, companies, and society to have systems like Numerai where data and information is free and open for anyone to use, and where everyone is incentivized to collaborate together through open networks.
Numerai: The Last Hedge Fund
Numerai is building the “last hedge fund”, a single hedge fund monopoly to manage all of the actively-managed money in the world, and in the process dominate a $4 trillion global hedge fund industry.
Numerai is built on two foundational premises:
- Stock markets reflect all available information to efficiently allocate capital.
- No hedge fund has ever harnessed network effects.
The first premise is a truism in finance — efficient markets reflect all available information. The second premise is less obvious. Network effects explain why Bridgewater, the world’s largest hedge fund, manages less than 1% of the world’s actively managed money, but Facebook has over 70% market share in social networks. Facebook, the most valuable company started in the 21st century, is built on strong network effects. Every new user that joined made Facebook even more valuable, which in turn attracted more users to its platform, in a self-fulfilling virtuous feedback loop. The opposite is true for the hedge fund industry, which actually has negative network effects. Hedge funds are locked in a brutal, zero-sum competition with each other over the same profits and therefore have no incentive to collaborate with each other.
Numerai will be the first, and last, hedge fund with network effects.
Numerai conjures into existence a network of thousands of data scientists from around the world that participate in its stock market tournament. Incentivized by Numerai’s native token, Numeraire (NMR), data scientists collaborate instead of compete with one another, submitting their models to the Numerai hedge fund to earn NMR tokens.
Numerai then combines every model from every data scientist into a single model, the Meta Model, that predicts future stock market prices better than even the best individual model could alone. Numerai then uses this model to execute the trading strategy of its market neutral quantitative hedge fund. The Meta Model monopolizes intelligence, creating a defensible edge that cannot be copied by any other hedge fund.
In September 2019, Numerai announced that it had achieved Meta Model Supremacy, meaning that as more data is poured into the Numerai system, the Meta Model will always be the best possible model for any given dataset. Meta Model supremacy demonstrates that the Numerai thesis has already been validated. By building the first hedge fund to harness network effects, Numerai has created a better way for valuable information to be incorporated into stock market prices. Instead of having ten thousand redundant hedge funds battle each other in a zero-sum competition, Numerai unlocks the power of a million data scientists and quants to work together to create more efficient capital markets.
Numerai’s Network Effect
Numerai’s growing network effect is built upon the successful execution of its Master Plan and four interlocking components that incentivize collaboration between all participants in the Numerai data economy.
The Erasure Protocol is the backbone of Numerai’s data economy, allowing anyone with valuable data or information to monetize their insights and enabling markets to incorporate previously inaccessible information.
Erasure’s staking mechanism powers two components of Numerai’s network effect: Numerai Tournament and Numerai Signals. Without Erasure, Numerai would be unable to build the Meta Model because it would have no way of gauging the quality of the models and signals submitted by data scientists.
Numerai data scientists have skin in the game because Erasure requires them to put their own capital, NMR tokens, at-risk by staking them to their predictions. Data scientists only earn NMR tokens if their predictions are both original and accurately predict stock market prices, but have their stake burnt, or destroyed, if their predictions are inaccurate. Thus, this mechanism ensures that only high-quality predictions are submitted for inclusion in the Meta Model.
The Numerai tournament is the foundation of Phase 1 of Numerai’s Master Plan: monopolize intelligence. Data scientists stake NMR on their models and earn or lose tokens based on their models’ performance. Since its inception, Numerai has paid out more than $90 million worth of NMR tokens to data scientists staking their models in the Numerai tournament.
There are now over 3,400 models collectively staking more than $27 million worth of NMR. The amount of NMR staked has grown 290% in the past 12 months alone!
With intelligence effectively monopolized after achieving Meta Model supremacy, Numerai set its sights on Phase 2 of the Master Plan, monopolize data, with the launch of Numerai Signals.
Signals enables Numerai to incorporate valuable market information and data from any source, not just the super massive dataset provided by the Numerai hedge fund. By incorporating more data, data scientists will build more diverse and better performing models that feed into the Meta Model, further accelerating Numerai’s network effect.
Numerai has allocated $50 million in NMR rewards to incentivize the creation of original signals, making it the largest financial modeling competition in the world by far compared to just $200k from Kaggle and $180k from Quantopian.
In less than a year since its debut, there are now over 400 models staking more than $3 million worth of NMR on Numerai Signals!
The hedge fund drives Numerai’s data economy and is crucial to Phase 3 of the Master Plan: monopolize money. The hedge fund monetizes the crowdsourced models created by data scientists in the Numerai tournament and Numerai Signals which it then distributes back to data scientists. By trading stocks with the Meta Model, the hedge fund delivers better risk-adjusted returns to investors than any individual model would alone.
So far, the results have been spectacular — since achieving Meta Model supremacy, Numerai’s quantitative hedge fund has outperformed its industry benchmark by more than 29% net of fees!
More crazy still is that Numerai’s US Long only portfolio was up over 98% in the same time period, outperforming the Russell 2000 by more than 46%, likely placing it in the top 1% of all US Long only hedge funds!
Until recently, Numerai’s hedge fund has intentionally limited AUM to just $45 million to develop and prove out its strategies before raising additional funds from investors. Now confident that its strategy has been proven, the hedge fund recently announced that it had raised up to $150 million from a pension fund. Given that Numerai’s quant fund trades at 5.5x leverage, the hedge fund is on a path to control over $1 billion of capital.
Numeraire $NMR Tokenomics
1. Value Capture: Needs Improvement
So if you like the sound of Numerai, it’s time to buy the token right? Why should you want to hold NMR if you aren’t a data scientist staking in the competition?
Currently, the mechanism for long-term value accrual to NMR is dubious. It has mostly been based on staking demand and theoretically any major cryptocurrency like BTC or ETH would function better for staking because they have more value and deeper liquidity. Until NMR’s value is directly tied to the underlying profits of the hedge fund, it’s difficult to determine what the ‘true’ value of the token should be beyond speculation.
Synthetix is an interesting comparison for this argument. ETH and BTC can now be used to mint sUSD and increase economic capacity of the system, and technically the governance token, SNX, was never needed. However, SNX captures value because only SNX stakers receive trading fees and have governance rights even though ETH is the largest source of debt in the protocol now.
That being said, the community behind NMR and their unique domain expertise and network effect is unparalleled anywhere else in crypto or traditional finance. If Numerai succeeds at becoming The Last Hedge Fund, NMR’s speculative value will likely increase substantially even if other cryptoassets cannibalize its utility functions within the Numerai system.
Crypto venture capital firms seem unfazed by NMR’s uncertain value capture mechanism. Since releasing NMR in early 2017, Numerai the company has only raised capital from selling NMR tokens, not company equity, to crypto investors including Paradigm, Placeholder, USV, and Pantera Capital.
In July 2019, Numerai deployed the final contract upgrades to Numeraire which reduced the maximum supply of NMR to 11 million and burned the key meaning that the NMR token contract is no longer controlled or upgradeable by Numerai. Therefore, NMR can no longer be minted, only burned, and the token cannot be modified in any way. However, NMR tokenomics can still be updated using external contracts such as staking modules or integrations in new protocols.
It is also possible that NMR will have significant utility outside of its own ecosystem. For example, Erasure Protocol is somewhat similar to Ocean Protocol as a data and information marketplace so NMR could become a secondary token to stake datatokens in the Ocean ecosystem, thereby further increasing the volume and liquidity of NMR.
2. Regulatory Risk: Very Low
The Crypto Rating Council, established by Coinbase, Kraken, Circle, Bittrex, and Grayscale, uses a points-based rating system to determine whether or not a digital asset falls under U.S. securities law using guidance from the SEC. Cryptoassets are scored from 1.0 to 5.0, where 1.0 is the least security-like and 5.0 is the most like a security. For reference, Bitcoin scores a 1.0, Ethereum a 2.0, and XRP, currently in the midst of a lawsuit with the SEC, a 4.0. NMR received a score of 2.0, the same as Ethereum, which the CFTC has clarified is a non-security commodity.
3. Total Addressable Market: Astronomically High
The world needs exactly one hedge fund with every signal in the world. — Numerai Signals
Globally, hedge funds collectively manage $4.3 trillion in assets. The industry standard for hedge fund fees is a 2% management fee and a 20% performance fee. Between 2019 and 2020, global hedge fund AUM grew from $3.1 trillion to $3.8 trillion, a roughly 19% gain. Assuming the industry standard fees and an 8% performance hurdle, hedge funds raked in an astounding ~$400 billion in gross profits in 2020.
This means that with a relatively conservative 20x price-to-earnings multiplier (the S&P 500 PE Ratio is approximately 34) that the market value of the industry would be $8 trillion.
If Numerai succeeds at becoming the last hedge fund, managing $4 trillion worth of assets, and decentralizes the hedge fund, effectively passing those profits to NMR holders, Numeraire could be worth $8 trillion. Numeraire’s market capitalization today is just ~$250 million. An $8 trillion market cap would represent a 32,000x increase in Numeraire’s current market capitalization!
Despite NMR having the lowest market cap of the DATA Index, representing only 3.4% portfolio weight today, it is conceivable that Numeraire alone could return the value of the entire portfolio many times over.
Conclusion
Ordinarily, it takes decades for a successful hedge fund to build a strong, proven track record and attract significant capital for their trading strategies. Renaissance Technologies, the most successful hedge fund of all time, returned 39% annualized net of fees over a 30-year span from 1988 to 2018 and now manages $165B in assets as of 2021. It took Renaissance 10 years to develop their flagship Medallion Fund, and it was not until 1999, more than 20 years after the hedge fund’s founding, that AUM exceeded $1B.
Barely 6 years old, Numerai has already achieved what no other hedge fund has before. Unlike other hedge funds, Numerai has built a network of data scientists that actually collaborate, instead of compete, with each other. The results of this signature achievement are astonishing: Numerai has now has more than 10,000 data scientists participating in its stock market tournament, and has achieved Meta Model Supremacy, meaning the performance of the Numerai hedge will continue to improve as more data is added and as more signals are created by data scientists. As Numerai’s risk-adjusted performance continually improves, it will attract more and more capital to its hedge fund, making the world’s stock markets more efficient than ever before.
Thank you Alexander Benton and Richard Craib for reviewing and providing feedback!
About Titans of Data
We are a coalition of innovators, operators, and investors in the data economy. We are cultivating a more open, secure, and equitable internet where everyone, including robots, are equals when facing opportunities in Web3. Through our research, we curate innovation to bring the data economy into the mainstream.
About the Data Economy Index
The Data Economy Index is a digital asset index capturing the growth of data-based products and services.
Originally published at Titans of Data on October 12, 2021.
