Surviving and Thriving
Dear Friends and Colleagues,
2023 was a defining year for the crypto industry. If the 2020-2022 boom bust cycle represented a false dawn, where crypto assets finally looked, but failed, to gain mainstream acceptance, then 2023 will be remembered as the year which finally paved the way for mainstream adoption with the expected ETF approvals in 2024. Whereas 2022 came as a necessary fire burning through the landscape, destroying many bad actors (FTX, Celsius, Terra Luna, 3 Arrows Capital), 2023 represented a yearlong springtime where the tentative green shoots of an industry rebuilding itself root and stem began to quietly and slowly emerge from the winter. As a fund we remained steadfast in our conviction that events, which many saw as cataclysmic for the industry, in 2022 were neither an indictment of the technology nor of the appetite of the financial industry to see value in this space. We continued to build and invest throughout the bear market and 2023 was the year where we began to realize the benefit of our perseverance.
Macro headwinds at the beginning of 2023 have turned into tailwinds which have propelled the stock market and crypto markets alike. Unsustainably high inflation rates at the beginning of the year have now moderated to a more tenable annualized 3.1% in the US. A feared recession never occurred in the US, and furthermore, economic conditions have softened such that the US Federal Reserve is contemplating rate cuts for 2024. In digital assets, the threat of regulatory overreach was subsequently countered by several significant wins. In a well-publicized summary judgement on the SEC’s Ripple lawsuit, the XRP token was deemed to not be a security. Well-known TradFi asset managers started to make a case for including bitcoin into investment portfolios and several applied to list their spot Bitcoin ETFs including Blackrock, Fidelity, WisdomTree and VanEck. Market expectations are high that most of these will be approved by mid-January, otherwise by the end of this first quarter of 2024.
Indeed, headwinds have turned into tailwinds. But this doesn’t mean that we just went along for the ride. We had to pivot and build, and in the process, we found ourselves not just surviving, but thriving.
We did this by first remaining true to our fundamentals. When we think about our investment and operational processes, we first turn to the generalized fundamental law of active management. Stated verbatim, IR = IC x √(Breadth) x TC [1]. In English, it states that risk adjusted investment returns are a product of one’s skill, breadth of investment strategies or assets, and implementation efficiency. It’s a product because doing two of the three well but performing poorly on the third will still yield poor investment results. Quant managers use it to measure the art of the possible and to evaluate their performance. Discretionary managers with quant training, like ourselves, use this fundamental law to break down the investment levers that we need to design, develop, and deploy. Practically, this has culminated in many investment lessons, some of which we’ve articulated here.
Tangibly, over 2023, here were some of our outcomes.
Our banking partner fell victim to the mid-sized US bank failures in the first quarter of 2023. Our assets were safe, but this led us to search for a stronger partner and we are all the better for it today. Along the way, we found opportunities in the stablecoins de-peg and mis-pricings in co-integrated digital assets to add alpha to our portfolio.
We predicted that a flight to safety during the bear market of 2022 and early 2023 would mean that Bitcoin and Ethereum would outperform their peers. Once the market began to show signs of recovery then alpha opportunities would arise further out the risk curve in newer assets like Solana. This played out as we anticipated. We articulated the difficulties of active management in the depths of a bear market in our article, “Could God Make it in Crypto”. We also took steps to eliminate that risk by widening our research for strategies that can provide alpha over different assets and time horizons. We continue to do that research today.
We remain vigilant on viewing risk with a 360-degree view, encompassing not just price volatility but counterparty and smart contract risks, just to name a couple. We’ve broadened the number of trading partners. We make sure we understand and debate the various layers of risk when better than expected return opportunities present themselves.
Many cryptoasset hedge funds had closed in the beginning of 2023 due to a combination of losses from 2022, being caught up with assets at FTX, or unable to find a subsequent banking partner after the early bank failures of 2023. We’ve been nimble enough to navigate those minefields (we had no FTX exposure!) and survive. Now looking back at the end of 2023, reports such as the November 2023 Crypto Hedge Fund Performance Update posted by Galaxy Digital’s VisionTrack, highlight how our peers are doing. According to that report, BTC had gained 127.5% for the year-to-date (YTD). In contrast, the broad VisionTrack Composite Index of funds posted a 42.3% gain while the narrower Fundamental Index returned +74.7% over the same period.
If those figures indicate what it was to survive, we can say that we thrived. And we are only just getting started.
Ruairi Hanafin
Chief Investment Officer
[1] Portfolio Constraints and the Fundamental Law of Active Management by Steven Thorley :: SSRN