I freely admit to being agnostic about only two things in life – God and cryptocurrencies.

In my more cynical moments, I sometimes wonder whether wildfire like the growth of crypto is positive proof that there cannot really be an omnipotent being lurking in the heavens, but in reality, I am perfectly content that both are very real and very meaningful to lots of people. And where there is obsession and devotion, there is investment potential – just ask the papal indulgence sellers of the Middle Ages.

These weighty questions sprang to mind after pondering a new range of products from innovative Australian ETF issuer Zerocap, which is building a whole new product category: structured products for crypto.

The Zerocap Smart Beta Bitcoin is the latest fruit of the firm’s labours. Here is the description for this fascinating product: “Zerocap managers will deploy proprietary models that rebalance the high volatility of bitcoin to lower levels, in line with risk profiles of equity portfolios. The objective of Zerocap Smart Beta Bitcoin is to reduce and balance risk while actually improving risk-adjusted returns, all while providing exposure to bitcoin. Similar risk parity strategies are common and effectively deployed in other asset classes, and Zerocap believes this risk parity and risk reduction approach is well suited to bitcoin, given its ingrained volatility and high-risk characteristics.”

The play here is obvious I suppose. The crypto space is one of the few markets in the world that continually has a higher implied volatility ratio when compared to realised volatility. According to Zerocap, this means that options are priced at a premium – these yields can vary between 20% annualised to as high as 40%, depending on market conditions.

What powers this is also obvious. Harvesting cryptos significantly increases the volatility over equities, a seven to eight times increase. And Zerocap is not alone in this approach – the IDX Crypto Opportunity index (COIN) was recently launched and is designed to “opportunistically allocate between cryptocurrencies and fixed income ETFs by exploiting short-term momentum. The index seeks to provide a risk-managed allocation option for investors who seek to use robust factor techniques to harvest attractive risk-adjusted returns from a volatile asset class”.

Momentum at play

These fascinating product launches, all built around volatility harvesting, prompted me to ponder whether there might be any more classic ‘factors’ or ‘style’ premia at work in the sexiest part of the financial markets – crypto. Hedge funds seem to think so. Nicolas Rabener, founder and CEO of FactorResearch, recently released a paper that suggested that there might be one obvious factor at work: momentum. His analysis revealed the hedge fund industry is aggressively muscling in on the crypto space, looking to make huge profits from volatile trading.

Rabener said: “Essentially all classic hedge fund strategies are being deployed in the space, with quantitative ones leading (37% of hedge funds), followed by discretionary long-short (28%), discretionary long-only (20%), and multi-strategy (11%).”

Cryptocurrency hedge funds were estimated to manage close to $4bn, as at the end of 2020, according to a PwC survey. That is a reasonably big number, but I suspect it might be even bigger if most investors looked at recent performance data from these hedge funds. Using data from the 17 crypto hedge funds in the Eurekahedge Cryptocurrency Hedge Fund index, Rabener reckons the index has returned 11,967% since inception in 2014 versus a mere 135% for an index composed of the largest 50 hedge funds and 267% for the S&P 500.

One can only imagine the fees being charged for all this masters-of-the-universe wizardry, except that one other number stands out. The correlation to bitcoin was 0.88 between 2015 and 2021.

Essentially, Rabener suggested: “This means that these funds represent crypto-currency beta rather than alpha.”

Another key measure shows that the correlation of cryptocurrency hedge funds to the S&P 500 and top 50 hedge funds, was just 0.03 and 0.22, respectively, between 2015 and 2021. So, hedge funds are not really harvesting any alpha here, but they are providing some diversification, courtesy of momentum.

Are there any other possible factor premia that could be harvested in the future as crypto moves ever more mainstream and decentralised finance rises from the VC funded incubators? What might ‘crypto smart beta 2.0’ look like once it has moved beyond volatility harvesting and the obvious liquidity fuelled momentum trade?

To ponder this, it might help to think through what underlying forces produce classic equity and bond factors. I would suggest that three motors stand out as relevant. The first is a behavioural bias among investors to overlook certain assets in favour of others. This produces asymmetries of information that can produce pricing differentials that persist over time (the size factor and value premia). Another driver could be market-based inefficiencies that favour liquid trades and hinder fewer liquid trades or obstruct the arbitrage between the two. The last might be a regulatory arbitrage where central policy – or lack of – acts to warp markets and pricing.

In each of these, we can begin to see some green shoots of factor emergence within crypto. In the behavioural bias space, because absolutely everyone and their dog believes all cryptocurrencies are super correlated to bitcoin, there must be a chance that we are all collectively missing the underlying fundamentals of some smaller currencies that could produce future outperformance.

Distorting market liquidity

In the liquidity-based space, the overwhelming dominance of just a few crypto whales on trading activity will likely distort market liquidity and provide some space for factor premia to emerge.

And lastly, regulatory opportunity is already obvious in yield harvesting where the income-based returns from lending into volatile markets have produced a rich harvest that can be used to produce new products.

If we are honest, this yield farming is in effect an arbitrage on the fact that regulators have not clamped down on this activity to date. They might continue to ignore yield farming, allowing investors to fool themselves into thinking for instance that their stablecoin yield farming is in effect a form of money market fund. Or maybe the regulators will finally act and shut down this DeFi-based activity. However, so long as the yield is in existence, we can certainly envision evermore complex ways of taking those cash flows and dicing up returns.

And of course, I have ignored the elephant in the room – the obvious existence of momentum as a factor, powered by liquidity flows, in the crypto space. Perhaps, over time, as crypto markets mature, we will begin to see ever more complex hedge-fund-inspired derivations of managed futures and risk parity strategies emerge into the mainstream – ‘crypto smart beta 2.0’!

David Stevenson is strategic adviser at ETF Stream

This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.

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