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Original title: “Are there any deviations between AAVE’s current risks and returns? How to evaluate DeFi investment portfolios?”
At present, the traditional financial market investment model has changed from active to passive. As of the beginning of 2020, the assets under management of index funds exceed 10 trillion US dollars. This change is also very likely to occur in the current digital currency market that is dominated by active investment.
In other words, ETFs and other index funds are very worthy of attention. In addition to DeFi Pulse Index , Index Cooperative, Synthetix and PieDAO have also released their own DeFi indexes. At present, more than 24 million US dollars of funds have been invested in DeFi assets through DeFi Pulse Index. in. There may be more ETF indexes in the future, and a rating mechanism similar to the “Morning Star Rating” of traditional financial fund ratings is also needed.
So how to evaluate the returns and risks of a digital asset portfolio more scientifically? This article gives two dimensions, combining the two dimensions can even design an automated “Morningstar rating” suitable for blockchain assets:
Uncorrelated assets : the smaller the correlation between the component assets in the portfolio, the higher the expected return value of the portfolio as a whole;
Equal risk bearing : The proportion of the risk brought by the component assets to the overall risk of the portfolio. Compared with the proportion of the component assets in the portfolio, whether there is a large deviation, the greater the deviation, the higher the overall risk.
In the past decade, the investment model of the traditional financial market has rapidly shifted to passive investment. As of the beginning of 2020, the assets under management of index funds exceed US$10 trillion , which is driven by low fees, wide market exposure, and diversification. However, depending on how the index is constructed, concentration risks may occur and reduce diversification, thereby increasing the overall risk of the tool.
Index funds and the transition to passive investment
An index fund is a mutual fund or exchange-traded product (ETP) whose purpose is to provide direct exposure to financial market index returns. Many investors use index funds because they eliminate the complexity of active management (the process of selecting individual stocks to invest in) and simplify access to a given market by providing broad market exposure. Diversified investment portfolio. In addition, index funds tend to follow passive investment strategies, which incur lower fees than actively managed funds.
For these reasons, investors’ preferences have shifted from active management to passive management. In September 2019, as more and more investors realized the difficulty of “outperforming the market”, the scale of assets managed by passive U.S. stock funds exceeded that of active U.S. stock funds.
Given the practicality and popularity of index funds in traditional finance, it is not surprising to see the emergence of this financial primitive in the crypto ecosystem. Protocols such as Index Cooperative, Synthetix, and PieDAO have established their own DeFi indexes so that cryptocurrency investors can easily access DeFi without being an expert in the field. As the crypto ecosystem transplants all possible financial products in traditional finance to the crypto network, the index is ready for rapid growth, especially in DeFi assets.
Concentration risk
Despite these benefits, index funds still inadvertently bring concentration risks. This applies in particular to market capitalization-weighted indexes, because the index concentration of each company is determined by multiplying the price of the outstanding shares. For example, in the past few months, the S&P 500 Index has been more concentrated in the top five technology stocks (Apple, Microsoft, Amazon, Facebook, and Google) than during the Internet bubble.
Since April, the concentration of the S&P 500 has only increased a little, and the concentration of the top five companies has reached 21.95%. Although this behavior can be expected in an index that follows the market value structure framework, understanding how position concentration affects product risk and diversification helps investors understand what to expect in different market environments.
The only free lunch in investment
Nobel Prize winner Harry Markowitz once said: ” Diversity is the only free lunch.” The core idea is that by diversifying investment, investors can reduce the risk of their investment portfolio by sacrificing a small portion of the long-term expected return. Diversification has always been the key selling point of index products, so it must be considered from different perspectives. Although there are several ways to assess portfolio diversification, the most important related to this are:
- Diversification of unrelated asset forms
- Diversify in the form of equal risk
“Uncorrelated assets” refers to the correlation between the underlying assets in the investment portfolio, while “equal risk exposure” refers to the contribution of a single asset to the total risk of the investment portfolio.
Diversification: unrelated assets
The most common tool for assessing the relevance of assets is the correlation matrix. Correlation is a kind of statistics used to measure the relationship between one variable and another variable, and the correlation matrix is a table of pairwise correlations of a group of variables.
Modern Portfolio Theory (MPT) was proposed by Harry Markowitz in the 1950s. It uses diversification as a portfolio allocation strategy to minimize special risks by holding assets that are not completely positively correlated. In other words, the more irrelevant assets a portfolio holds, the higher the return on diversification.
Compared with other asset classes such as gold, crude oil, stocks and bonds, crypto assets such as Bitcoin and Ethereum have the lowest correlation. As shown in the figure below, the data for the three years as of October 28, 2020.
Investors who want to increase the rate of return by adjusting the risk of asset classes will inevitably need to include crypto assets such as BTC and ETH in their investment portfolios.
Diversity: equal risk-taking
When building an index or portfolio of assets, there are obviously restrictions on diversification. However, investors can obtain a marginal return from the diversification of their investment portfolio.
Evaluating the contribution of marginal risk (MCTR) of each asset in the portfolio can measure the contribution of a single asset to the overall risk of the portfolio. Ideally, the risk contribution of each asset should be evenly distributed in a portfolio. If compared with other assets in the portfolio, the risk of an asset accounts for a large proportion, then reducing the allocation of such assets can increase the diversification of the investment portfolio.
Take the famous 60/40 portfolio as an example-a portfolio consisting of 60% stocks and 40% bonds. One of the biggest disadvantages of this portfolio allocation is that in most markets, more than 90% of the risk comes from stocks. Therefore, a 60% investment portfolio brings 90% risk. In other words, the risk contribution of each asset is inconsistent with the asset allocation of the portfolio.
Why is this important? Simply put, the stock yield determines the yield of the 60/40 portfolio. When stocks rise, the 60/40 portfolio is likely to also rise (but the increase is slightly smaller). Similarly, when stock prices fall, 60/40 may also fall. In short, stocks determine the future of the 60/40 portfolio.
For the sake of clarity, this article refers to risk as the “standard deviation of asset returns.” The standard deviation can be regarded as the range of uncertainty. The higher the standard deviation (risk), the wider the interval, and therefore the greater the uncertainty of short-term asset returns.
Although the principles of diversification have been well applied in traditional finance, in the field of encryption, investors ignore these principles when constructing investment portfolios.
Well-known crypto investors (such as Chris Burniske of Placeholder Ventures) have begun to advocate for beginners to easily obtain multiple DeFi assets by investing in the DeFi Pulse Index (DPI). Although investing in DeFi indexes sounds like a good practice for beginners, DPI may not be able to achieve its claimed diversification to meet the needs of more sophisticated investors.
Diversified and largest DeFi index
DeFi Pulse Index (DPI) is a market capitalization weighted index used to track the price performance of DeFi assets on Ethereum. DPI is updated monthly and does not include tokenized derivative products, synthetic assets, or tokens linked to physical assets.
DPI on “irrelevant assets”
Now, let us examine DPI from the perspective of “irrelevant assets” and “equal risk-taking” in the diversification framework.
The correlation matrix of DeFi Pulse Index shows that, with the exception of UNI, most assets are highly correlated. Although the correlation between UNI and other DPI assets such as REN or REP is close to zero, UNI and DPI assets still maintain a positive correlation.
The combinability of DeFi protocol assets, the application of Dai in many basic markets, and the potential correlation with Ethereum are all potential risk concentration points.
DPI on “Equal Risk-taking”
Combining the above correlation matrix, we can use asset covariance and total portfolio variance to estimate the MCTR (Marginal Contribution to Risk) of each asset to evaluate the overall risk of the index in detail.
According to the current DPI allocation, the total portfolio risk is 122.48%. MCTR by assets shows that UNI (16.53% of the index) accounts for approximately 26% of the total portfolio risk.
In addition, 77% of the total DPI risk is mainly driven by 4 tokens (UNI, YFI, SNX, and AAVE), and the return of the DPI index will become extremely sensitive due to the price fluctuations of these 4 tokens. Like our 60/40 portfolio, the small number of assets in the DeFi Pulse Index portfolio brings a lot of risk.
Increase the diversity of DPI
Simply adding more DeFi assets to the DPI portfolio will be counterproductive, because all DeFi assets move the same, especially in a strong bull or bear market.
One potential way to generate better risk-adjusted returns is to create a configuration that spreads risk more evenly. For example, moving to a portfolio of equal weights and rebalancing weekly or monthly may produce higher returns, while also reducing the overall portfolio risk. But it is worth noting that a shorter rebalancing time period may cause additional transaction gas costs.
Final thoughts
It is often said that the market is the embodiment of randomness and chaos. Index portfolios like DPI are designed to control the randomness and chaos of the digital currency market that trades continuously. “Irrelevant assets” and “equal risk-taking” are two valuable methods for controlling investment portfolios in response to market fluctuations. Building a portfolio of encrypted assets based on these two principles can reduce overall risk and increase returns. In the next 10 years, as DeFi gradually swallows the traditional financial market, it must also absorb the effective strategies of the traditional financial community.
