Beta: The Bedrock for Balanced Portfolios Built on DeFi and Web3

In the frenzy of a manic bull market, chasing fast pumping coins and the newest memes may work in the short term but the inherent risks may materialize when a market correction suddenly takes over. A more dependable source of returns is also needed.

Formation Fi is engineering a safer longer-term strategy for investing in DeFi and Web3 that captures the fast returns but, more importantly, maintains steady growth and protects against loss. We are building a sophisticated suite of indexes that will offer a balanced, cross-chain, risk parity strategy: the Formation Fi Alpha, Beta, Gamma and Parity index classes. They will be combined into a single personalized tracking index that provides risk-adjusted returns throughout a whole bull/bear market cycle.

Beta Index Class: Betting on the Market — A Relatively Safe Gamble

Amidst the uncertainty of the financial markets, one of the more certain things about crypto and stock investing is that both markets grow consistently over time with a reasonable amount of predictability in the long run. This long term trend essentially trumps the investment option of holding cash or cash equivalents and collecting interest on it. So, the basic idea behind this tenet is to simply hold ‘the market’ and do nothing (or just wait) as opposed to constant stock-picking (or so called, ‘Alpha’ strategy). The stock market has demonstrated this tenet over 100+ years of trading data as articulated by EMT (Efficient Market Theory). Crypto, though with a much shorter lifespan, has also proven this principle since 2009. So, any long-term investment strategy in crypto assets should incorporate this tried-and-true principle and that is the basis of the Beta index class.

Smart Beta Equals Dumb Alpha

In traditional investing, Beta refers to the volatility or risk of an asset, (such as IBM stocks) compared to the market, such as the S&P 500. We have taken this as the inspiration for the Formation Fi Beta index class. The Beta indexes are geared to outperform the overall market over the long term, supplying the major, long term, solid growth stream of the balanced portfolio. On the stock market, this goal has recently been achieved with thematic ETFs such as those from Cathie Wood’s ARKInvest, so we are taking a similar approach. The Beta index class will have a diversified exposure to the most promising themes within the decentralized blockchain economy.

Indices are typically configured by weighting the individual components equally or by setting the weights based on market capitalization or the price. Many recent innovations in portfolio construction have shown that tilting the index, based on characteristics that can be observed across any group of securities, can lead to significant outperformance. In the stock universe, some such properties are value, size, momentum, profits, revenues, dividends, price earnings ratios and so on.

In chasing alpha, investors can take on excessive risk on individual assets. A more cautious approach would be to tilt an entire portfolio or index towards any factor that can precipitate long term returns along with setting constraints on maximum weights for any security. Assembling such an index, weighted towards a factor that applies across all assets, can be termed a smart beta construction technique. When beta becomes smart, it comes at the expense of alpha that might not have been so carefully chosen. The implication of such a machinery is that investors choosing our Beta set of indexes can follow the mantra, “Select it, Invest in it, Forget about it”.

𝛃smart = 𝛂dumb

At this juncture, we would like to highlight that our alpha index class will consist of more risky assets compared to the securities we select for our beta indices. The risks we take on in our alpha index are the result of a conscious design choice. Despite these risks, which are necessary for superior returns, we have several mechanisms, (not limited to risk based weighting, collateral monitoring, automatic liquidation, thorough due diligence, etc.), to mitigate severe threats and provide downside protection.

Beta Index Class: Thematic Satellites with Periodicity

The blockchain revolution has been determinedly gaining pace since Bitcoin was introduced in 2009. It has grown into a thriving ecosystem and Decentralized Finance is one of the fastest growing sectors as it can generate returns independent of the market direction. To get this far we needed farsighted thinking to comprehend the necessary innovations, the converging technologies and the skills to implement them. This is where the true value in DeFi lies. Just as the internet was built by companies such as Cisco, Google and Amazon Web Services, so DeFi will be built by decentralized organisations such as Ethereum, Chainlink, Uniswap and others that are today still just a spark in their founder’s minds.

Like satellites, which follow circular intended orbits, the Beta indexes will follow the high growth, disruptive innovation projects that are leading their field. They will typically exploit converging technologies and many will be platforms, which will enable further generations of DAOs (Decentralized Autonomous Organizations) to prosper. They will be the infrastructure building blocks of Web3.0 across the main chains, including DeFi schemes (lending/borrowing, decentralized exchanges, derivatives, asset management), Layer 1 protocols, Layer 2 protocols, open data markets, oracles, AI, storage, etc. The selection will be purely thematic and not confined by siloes such as geography or blockchain protocol but with filters applied across market capitalization or other parameters to ensure the quality of the assets picked. Next to the rigorous due diligence process, the key judgment for inclusion, is the early identification of innovators that will help grow the global market for the long haul, wherever they are.

Risk Governance Begins By Seeking Tailored Risks

The Beta indexes are a mix of diversified theme satellites and as such will carry market average risk. The organizations that will be included are long term, healthy, architectural projects which have established that they take their responsibilities seriously and therefore are less likely to be tripped up by the more common dangers facing newcomers. The customary Formation Fi foundational framework, comprising proper due diligence, risk weighted sizing and an algorithmic scheme that will rebalance and fine tune the asset weights without incurring exorbitant gas costs, will be applied. Hence, our Beta index will outperform the market on a risk adjusted basis. The risk of the Beta index class is lower than the Alpha class and higher than the Gamma class within the overall Risk Parity balanced strategy. Subsequent articles will describe the Gamma class and our risk parity methodology in greater detail.

Conclusion: The Formation Fi Formula For Recurring Reliable Returns

By itself, the Beta index class supplies above-average returns for average or market levels of risk. It may not capture the extreme moves made by the very fastest-moving tokens but in a balanced portfolio this is the required blueprint. The most aggressive yields will be caught by our Alpha index class while the Beta indexes focus on sustainable, long term growth, through the ups and downs of the markets, by utilizing a mix of well diversified theme satellites. Suffice it to say that betting on beta is a relatively safe gamble.

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