The 2017 ICO explosion seems completely irrational, an example of crowds gone wild. However, investors may be perfectly rational when they buy a bag of scammy pump-and-dump schemes. Mathematically, it’s possible to trade a bag of crappy, high volatility assets, and build a portfolio that does better than your best asset.
This effect is explained by Adam Fargo and Erik Hjalmarson in their paper on “Compound Returns”.
It turns out that if you hold a portfolio of high volatility assets, the returns in your portfolio will become extremely “skewed”, or dependent on a small number of holdings. Random differences in return add up until a few assets gain greatly in value, and the rest do not, and most of the value is one or two assets. This happened to people who bought BTC or ETH and then saw 100X appreciation.
You might say “That sounds great. Now I am HODLing something really valuable”. However, it is likely that your returns to HODLing will deteriorate. Then you will want to diversify. You may even consider buying crappy new coins.
To see how a narrow portfolio becomes a problem, think about an extremely skewed situation where a bunch of VC investors put $1M into each of 1000 companies, and 999 of them fail, and one of them becomes Facebook or Bitcoin, and returns $10B to its early stage investors. That’s great! That’s $10M for each investment, and a 10X average return. However, if each of the VC investors only has 100 companies in their portfolio (that’s a big portfolio), 90% of them get zero. The effect of skewness is that the most common result ($0) is much smaller than the average result ($10M).
Does this sound unlikely? It’s a realistic scenario for VC investment, where only about 1/3 of funds beat the S&P. It’s also a realistic scenario for investors in normal public stock markets, where over the last 29 years 1.33% of firms accounted for 100% of global wealth creation of $44T. If you buy and hold and you don’t happen to get some of the 1%, you don’t make money. In volatile markets like crypto, this type of skewing happens much faster, in just a few years rather than 29 years.
So, if you want to reliably make money going forward, you would need either:
- A wide portfolio – more than 500 assets in the case of early stage VC
- The one weird trick from Fargo and Hjalmarson — rebalance your portfolio so that you trade out of big winners.
Rebalancing works to increase your chances of profits because it makes your portfolio dramatically larger. It gives you access to potentially “skewed” returns from individual assets that you buy into. It also gives you access to high return scenarios where you bought one asset, held it while it was going up, sold it before a decline, and then bought another asset that started going up. Some of these trading paths result in “skewed” returns that are bigger winners than any individual asset. The probability that you will make these amazingly great trades through your amazingly great skill is low. However, you multiply that low probability by a lot of paths. If you trade out of 5 appreciated assets and into 10 other assets, you create 50 new return paths that are already potentially high return.
This reshuffling can deliver returns that are higher than any single asset in your portfolio. In a volatile market, you can pick assets by throwing darts, and still end up with enough big winners to dramatically change your probability of making money. That’s the weird trick.
Buy-and-hold gives you a portfolio that effectively gets smaller and smaller as a few assets gain greatly in value and the rest fade. Even if the market is gaining value on average, you will get the benefit less frequently. The buy and hold portfolio will have a higher and higher volatility, and a smaller and smaller probability of making money.
How the ICO boom happened
The ICO boom in 2017 took off after appreciation in the price of BTC took it to 20X its price from 2 years earlier, and more thana 1000X its early pricing. At that point, individual BTC holders were sitting on ridiculous gains, and very unbalanced portfolios. Some of these buyers rebalanced into ETH, creating a whole new crop of rebalancers sitting on 100X gains from the ETH ICO. This created more volatility, which drove participants to trade and rebalance into new assets more frequently.
For almost a year, this process actually worked for investors. They picked up enough gains from “to the moon” coin launches to increase returns over their original BTC and ETH portfolios, and realize those returns more reliably. The demand for a wider range of crypto assets overwhelmed the desired to invest in good assets, and this might have been perfectly rational behavior.
This behavior is rational if you assume that crypto owners are forced to reinvest in crypto coins. But why did crypto owners rebalance into crypto coins? Why didn’t they sell some of their coins and buy stocks and bonds with better investor protections? Because as long as they stayed in crypto, they were not reporting capital gains, and not paying income taxes. The boom fell apart quickly when tax authorities such as the IRS started tracking down those gains by asking crypto exchanges to share customer records.
The small-cap conundrum
Crypto portfolios have been busy re-skewing themselves over the past 1.5 years. Bitcoin has gone up, and other assets have gone down. There is probably a pent-up demand for rebalancing. How will it happen?
The behavior of the crypto market has been predictable in one sense. Small capitalization assets have mostly gone down in price. Many of the smaller ICOs are essentially at zero. Many large capitalization assets have held their value. The largest, BTC, has held its value well. Coins that were already $100M+ assets in 2017, or that were able to sell their new coins in offers larger than $100M, such as EOS, have held up almost as well.
My research indicates that small-cap offers, under $100M, are usually bad deals for passive investors. This is true for securities as well as for coins. They suffer from poor investor protections and high sales costs, without delivering the benefits of liquidity. They often have high volatility. This creates a problem in the world of portfolios. In order to reliably make money in a high-volatility asset class, you need a lot of assets to broaden your portfolio. But, if you start splitting the asset universe into smaller-cap deals, the deals become worse on average.
If you want to reliably make money investing in high-return, high volatility, small-cap assets, you have to pull off an interesting trick. You will want to buy them in professionally negotiated chunks, not crowdsourced or public offers, in order to avoid the problems with small cap offers. You will want to roll them up into funds that are big enough to actually trade as large caps and deliver liquidity benefits. And, you will want to be able to reshuffle them in order to have a high probability of realizing the (hopefully substantial) average gains. And you will want to do this while avoiding the cost and regulatory problems of securitizing traditional long-term LP fund interests.
We’re designing a new structure – the Unbundled Fund – to handle these issues. The need for new thinking about small-cap assets in the VC, crypto, and real estate equity categories is driven partly by the challenge of reliably making money from highly skewed returns.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.