Episode 16: Beating the Market
A Game of Geeks and Greeks
“The curious task of economics is to demonstrate to (wo)men how little they really know about what they imagine they can design.” — Friedrich von Hayek
I have $100 today. I want to invest it, so that my $100 will enable me to buy at least the same basket of goods that I could buy today at some point in the future. The rate at which the price of goods increases is known as inflation, and let’s say its 2%. So I know I need an investment that returns at least 2%. How do I choose what to invest my $100 in?
This is the precise challenge that investors of all stripes must find an answer to. As with everything else, the choice is relative. What’s your appetite for risk? How much of your net worth does that $100 represent? How long can you afford to keep that $100 invested? These are all questions that determine how people think about investing.
After you’ve made that choice, then the question becomes — how do you measure if you’re any good at investing? How do you figure out if you made the best choices possible in picking stocks, bonds, or crypto assets to buy? This question has been explored by some of the most celebrated minds in the domain of economics and mathematics over the last sixty years, and has led to a much deeper understanding of the relationship between risk and reward in markets.
As we’ll explore in this episode, defining and measuring performance is as much an art as it is a science. In fact, some investors have made performance theater out of their efforts to measure performance and justify why they should get paid billions to lose money for their investors (more on hedge funds later). But as with all things in life, in investing, performance is everything.
Why Performance Matters
For retail investors, the performance of their investments may determine whether they will enjoy a comfortable retirement, whether they will have enough money to send their children to university, or whether they can afford their dream holiday. Likewise, the pension plans, foundations, and other institutional investors want to monitor the performance of their investments to ensure that the assets will be sufficient to meet their needs.
In fact, Moody’s estimates put the US public pension shortfall at over $4 trillion. That means that government workers in the US are relying on pensions that simply aren’t there (yet), and the managers overseeing these portfolios have to generate a much higher rate of return with the time remaining before the pensions are due to be paid out.
For professional investors, the performance of a portfolio or a fund determines how much they get paid. Assets under management, or AUM, typically defines the management fee paid by an investor.
For a simple strategy, like an ETF or index fund, investors pay 0.40% of the total value of the portfolio to the manager. For more “cutting edge” strategies, like a bitcoin ETF, the rate is as high as 2.5 or 3%.
And for more actively managed strategies like a hedge fund, private equity firm, or venture fund, the rate is 2% of assets under management paid per year, plus an additional 20% of every dollar of return generated after the initial amount invested is repaid to investors. So slight differences in how performance is calculated can have a massive effect on how much money investors get back, and how much money managers earn for managing these portfolios.
If investors use performance measures to reward money managers, then money managers have an obvious incentive to manipulate their performance scores.
One of the most fascinating concepts confirmed in the twentieth century was that time — and the measure of its passage — was not universal, but in fact relative. Hours, as measured by clocks, are only relevant as a benchmark by which to measure the passage of time. Likewise, distance is relative to a fixed (well, actually moving) point in space. Space and time is relative to how our planet, earth, is moving through space compared to all of the other points in space. The first two minutes of this National Geographic segment provide a helpful, if somewhat dramatic, explainer.
Markets and performance also rely on something called relative performance. After all, money is also a measure that was created to enable trading of relative value. If one sheep is worth one hundred chickens, that’s a relative value. If one Bitcoin is worth $5,000, that’s an absolute measure, since dollars are a base unit for measuring for people who spend in dollars. Luckily for us, most things in the world are priced in dollars.
Absolute return is simply whatever an asset or portfolio returned over a certain period. A familiar term to most investors, values can be quickly found in stock and mutual fund prospectuses, simple to calculate. This measure does not take into consideration the fact investors have choices, relies on investors to compare returns when researching alternatives.
Relative return gives investors with insights into the performance of an investment relative to a benchmark. If the benchmark chosen is the rate of inflation, it provides investor with growth of money in real terms. The challenge is that relative return requires more work to calculate, and requires investors select a benchmark.
Unless the benchmark chosen is the rate of inflation, relative return still does not provide the investor with an indication of real growth. For example, the relative return could be 10%, but the absolute return of the investment might be -20%, and the absolute return of the benchmark -30%.
Benchmarks and Reference Rates
There are a few widely used benchmarks or reference rates that people use, like fixed points when measuring distance, to determine how something is performing.
As we’ve discussed in the episode on debt, the interest rate varies on the length of the loan and the risk of the loan, so the standard interest rate used is typically the federal funds rate. This is an important benchmark in financial markets, and is often called the risk free rate or Rfr, since US government debt is considered to be a riskless asset.
Another important interest rate is LIBOR, or the London InterBank Overnight Rate — which is set by a handful of british banks, and was famously manipulated in a stunning display of modern day cartel behavior
Market Rate of Return
Another way to measure performance is to look at what you would have earned invested in a generalized market index. In the US, the most common market benchmark is the S&P 500, which is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE, NASDAQ, or the Cboe BZX — 3 different exchange venues.
Industry Specific Benchmark rates
For less liquid asset classes without easily accessible benchmarks, the best method to evaluate relative performance is to define a list of peers, which could include a cross section of traditional mutual funds, equity or fixed-income indexes and other hedge funds with similar strategies.
For specific asset classes like hedge funds, PE, or VC, industry bodies like Preqin, Morningstar, Zephyr, and others publish (expensive) benchmark rates by strategy and market. So if you’re an investor in a global macro fund that deploys a long short strategy, you can compare the performance of the fund you’re an investor in to the aggregated performance of all managers deploying that strategy.
Lastly, for individual funds, there’s a special metric called the Sharpe ratio indicates the amount of additional return obtained for each level of risk taken. Basically, it determines if the additional risk a manager took with their investors’ money was rewarded with higher returns. It’s use and significance is a hot topic, but Sharpe himself offers some sage wisdom here.
Good god, the greeks!
Since part of this podcast is explaining If you’ve been around a financier, you’ve likely heard terms like alpha and beta thrown around, and perhaps delta, theta, gamma, rho, vega, and more! If you want to sound like a bonafide financier, you can refer to these things as the Greeks — since these are all Greek letters. Each Greek measures the sensitivity of the value of a portfolio to a small change in a given underlying parameter.
For the purposes of this conversation, let’s introduce just two Greeks, the most widely used two — so you can be a financier too (no Patagonia vest needed)
…is the excess return an investment or a portfolio of investments generates above and beyond a market index or benchmark that represent the market’s broader movements. So basically alpha is your ability to “beat the market.”
For example, say you want to buy bitcoin, but you typically invest in an S&P 500 index. If the S&P index typically returns you 7% per year, or $7 per $100 invested, and bitcoin returns you $7 per $100 invested, the alpha of your investment is 0 — because it perfectly tracked your reference index. Now say bitcoin generated $7.70 per $100 invested. It’s alpha would be 10%, because every $100 invested returned 10% more than the standard market rate.
If the alpha of a portfolio is zero, then its returns matched the market. This means that investment manager has neither added or lost any value.
…measures volatility, or how much the price of an asset or portfolio fluctuates, in relation to the overall market, to help investors determine how much risk they’re willing to take to achieve the return for taking on said risk.
The baseline number for beta is one, which indicates that the security’s price moves exactly as the market moves. So if someone says an asset has a beta of 1, that means when the market goes up 1%, that asset also goes up 1%. It moves the same way the market does.
Investors looking for low-risk investments might gravitate to low beta stocks, whose prices will not fall quite as much as the overall market drops during downturns. However, those same stocks will not rise as much as the overall market during upswings. More aggressive investors tend to seek out high beta investments, where they take more risk for the potential of higher reward. Investors can use beta figures to determine their optimal risk-reward ratios for their portfolios.
A quick overview of alpha and beta and the types of investors who deploy these strategies here.
Crypto Performance: More Art than Science
OK — so why does this matter? Who actually cares?
To explain this, I’d like to introduce a fun experiment called The Potato Fund. In January of 2018, I was in the office at 4 am, as crypto markets were going crazy, and I decided to spend a little bit of bitcoin on a fun little experiment. It was a bad idea in hindsight, but I wanted to run the experiment to see how it would perform.
So — I picked 10 coins based on logos and hype and a number of other silly factors and constructed a portfolio. I then tracked the performance of that portfolio in absolute USD terms, BTC terms, and ETH terms over a 300 day period, and ultimately sold the assets for a tax loss at the end of 2018. RIP Potato fund.
Here’s what the potato fund demonstrated. At certain points, I was gaining value in USD terms, but losing value in BTC terms. At other points, I was outperforming ETH, but not BTC. Because most of these coins were priced in BTC, what was the right benchmark to use? Was it worth the risk of buying these coins for so little gain, or would I have been better off buying and holding bitcoin? Or an index? Or ether?
Here’s a more cogent example. Say you invest US dollars in a crypto fund at the start of 2018. At the end of 2018, that fund has lost 30 cents of every dollar. So in absolute USD terms, you have lost money. But say the fund accounts for performance relative to the price of bitcoin, and in BTC terms, the fund is up 40%, because its portfolio is worth more in bitcoin than it was at the start of 2018 (because the price of bitcoin is 75% lower now).
Is that a good investment? Or say, in an event more extreme case, the fund accounts for performance relative to the price of ether, and in ETH terms, the fund is up 70%, because the price of ether is now 90% lower than it was at the start of the year. What’s the right way to view performance?
No benchmark is going to be perfect — ever — and just like hedge fund managers play games with performance is the legacy finance world, you can expect crypto fund managers to do the same in crypto.
So how does one actually begin to define a benchmark for the crypto market?
Risk Free Rate
This one is really tricky, but it’s probably bitcoin or cash (ie no return, 0%). Maybe it’s the fed funds rate because that’s the closest riskless asset. Or maybe it will be some digital US treasury note in the next decade?
We don’t have LIBOR, but we have DIPOR or decentralized inter-protocol offer rate as an open finance version of LIBOR.
With crypto lending markets, like our sponsors at Celsius, we have interest rates but they’re not risk free. And moreover, many of these aren’t interest rates, but rather inflation rates. You need to earn a staking reward to preserve your pro-rata share of the network.
Market rate of return
Bloomberg teamed up with Galaxy to create the BGCI, and Bitwise has the HOLD10 index which many funds use as a benchmark. There are nearly as many indeces as there are markets, and of course every crypto platform sells its own “basket” product.
However, I am skeptical of most index funds — buy them at all if all assets have a beta of 1? Crypto is highly correlated, and we don’t yet have distinct asset categories that behave differently enough to achieve some sort of diversification. According to our research, current strategies to “index” or create a market basket fall short of the goal of diversification. Most index products are inadequate as a “smart beta” tracker.
Given that crypto asset management is a nascent industry (and as someone who runs strategy for a crypto asset manager, these challenges are front and center in my mind all the time!)
In terms of peer benchmarking, a Fund of Funds called Vision Hill has begun to initiate tracking. Preqin and other traditional investment industry tracking services have carved out a separate sub-section for crypto fund reporting.
Interestingly, without industry consensus on the risk free rate and the market rate, many financial engineering problems are impossible to solve. For example, options are priced using a number of inputs including the risk free rate and interest rate.
Similarly, the optimal capital structure of a firm, as defined under CAPM — a 1960s innovation that led to numerous Nobel prize awards — is impossible without these inputs. So you can imagine that there is much at stake when attempting to define an industry benchmark.
Listen to the rest of the episode for more discussion on crypto alpha generation strategies, mark to market pricing challenges, and why all of this valuation work will someday matter more than we can imagine!
Check out Steven Strogatz’s new book, Infinite Powers. If you were never that excited about calculus, I promise this book will change your mind.
I highly recommend the CFA Institute as a starting point for understanding valuation and performance. It covers Sharpe ratios and other key concepts that are crucial to understanding how performance can be evaluated both in absolutes and relative terms.
Here’s a brief primer on the Greeks in the context of options trading from the fine folks at E*Trade (along with extensive disclaimers about the risks of options trading).
Here’s a brief primer on investing styles, which connects concepts of liquidity, risk, and other factors discussed during the episode with the ways investors might thematically deploy capital.
Practically *everything* Cliff Asness and the fine folks at AQR, one of the hedge funds that have pioneered the realm of quantitative (or math-driven) investing, publish is excellent. The 20 for Twenty is a great (free) eBook highlighting their top 20 research pieces, and I recommend it for those curious about financial mathematics and various asset classes like fixed income, liquid alternatives, and more.
Lastly, if you’re thinking about valuation, performance, and benchmarks, I host periodic CFO roundtables to discuss the evolution of the crypto finance function. You can sign up here for future sessions.