Investing in CRYPTO: Design powerful and sustainable STRATEGIES (Part2)

It has always been said that the key to investment success is a good strategy. But do you know what the recipe is for an effective strategy that leaves nothing to chance?

We have seen in the first part the first 3 steps to develop robust investment strategies in crypto: the choice of the mechanism of value creation, the timing and the horizon, and finally the choice of the assets that will enter the composition.

In this section, we will look at Step 4, which involves answering critical questions about asset allocation if the strategy is composed of multiple components.

Step 4/10 : Allocation: the best way to allocate assets within the strategy.

Let’s say you have a strategy in mind and know what assets you want to play. Let’s take the example of wanting to create an index portfolio that tracks the top 10 crypto market caps. What is the best way to allocate these 10 cryptos? Well, that depends on the goal and the risk you are looking for; let’s review the 4 possible solutions.

• Equal breakdown: for simplicity, just add 10% to your assets and you will get to 100% with 10 assets. Simple and efficient to manage. If an asset increases in value, you just need to rebalance to return to the initial allocation. The problem? If one of the assets is losing and another one is growing, you will suffer the losses of the losers and will not benefit from the capitalization effect on the winners.
• Proportional breakdown: Let’s say you decide not to distribute the assets equally but to distribute them according to a rule. You can for example weight each asset according to the risk/return ratio (by calculating the Sharpe or Sortino ratio). Let’s take an example to understand with the identified return and risk (here the maximum DrawDown)

> Crypto A: 1Y Return : +30% APR, Max DD : -30% Ratio =0.3/0.3= 1
> Crypto B : 1Y Return : +15% APR, Max DD : -20% Ratio =0.15/0.2= 0.75
> Crypto C: 1Y Return : +50% APR, Max DD : -70% Ratio =0.5/0.7= 0.75
Then we just have to make a rule of three and assign a weight to each asset

Total ratios of A, B and C: 1+0.75+0.75 = 2.5
Weight of crypto A = 1/2.5 = 40%.
Weight of crypto B = 0.75/2.5 = 30%.
Weight of crypto C= 0.75/2.5 = 30%.

So we end up with a portfolio that will outweigh the assets that offer the best risk/return trade-off. The disadvantage is that by minimizing the assets that offer high returns if ever the market is favorable, we can miss out on exclusive returns on investment.

• Square root breakdown: Let’s take the case where you want to play on two assets and weight them in your portfolio according to their capitalization. For example, create an index of Bitcoin and Ethereum (the two largest crypto market capitalizations). You could weigh them according to their market capitalization and implement a rule of three. This would then look like this graph below. Thus the difference of weight between Bitcoin and Ethereum is Delta (∆).

But let’s say you’re not happy with this allocation because overall Ether has more upside potential than Bitcoin and you want to take full advantage of it without giving up a Bitcoin weighting in your portfolio. This is where the square root distribution comes into play. On the chart below we see that by applying the square root to the market cap, the weighting gap ∆’ has narrowed favoring Etherum over Bitcoin, thus exposing the portfolio to greater performance.

That’s it for this post! There are many other ways to create an allocation for your assets, but remember that the allocation process must earn a purpose, in the function of your reward risk management.

If you want to read about the next steps to designing crypto strategies, please follow this link.