Alpha: Climbing Mountains and Taking in The View
DeFi investors have had a wild ride over the last year, jumping on yield farming returns that would make traditional investment managers cry. Liquidity pools, vaults and staking have opened a world of opportunities, not to mention the 10x to 100x performing tokens themselves. But 2020 was only DeFi version 1. Like the first version of a smartphone, it has lots of flashy features that grab headlines, but serious users have noticed some problems that need to be fixed before it is ready for more mainstream adoption.
Formation Fi is leading the way with the next generation of yield farming — Smart Yield Farming 2.0. We are engineering a financial structure that will catch the spectacularly rapid gains of the sector while also constructing better mechanisms to protect against the losses. This will pave the way for more solid long-term growth and open the DeFi asset class to a broader spectrum of investors, who are rightfully wary of the potential risks and hence seek better safeguards before they are willing to enter this fascinating market. 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. Our investment tools and techniques are premised on the fundamental belief that the upside usually takes care of itself. It is the downside that will require most of our attention.
Alpha Index Class: Benefits with Balance
Alpha is a traditional finance term meaning “an investment strategy’s ability to beat the market” (Investopedia). It refers to returns in excess of what would normally be expected from the market. This is achieved, for example, by actively choosing assets that are projected to grow quickly in the short term in the hope of beating the main indexes such as the S&P500. In traditional investing this role is taken by high growth stocks (such as Apple or Tesla). But this is the crypto universe, so we have a much wider and more exciting landscape to explore including the world of advanced yield farming. On the flip side, until now, we don’t have agreed market indices in the crypto space. With the growth of the market this will change over time. For the moment we would see the S&P500 (or the aggregate performance of the top crypto assets as more of an aspirational aim) as the market to beat. The Formation Fi Alpha index class is precisely engineered to exploit exceptional, fast-growing tokens and aggressive yield farming strategies across all the main blockchains (i.e. Ethereum, BSC, and HECO). It is the main driver of the overall performance in bull cycles in the Parity class. It is the bright, hot star in a portfolio. Algorithms, implemented as native smart contracts on each chain, will regularly and automatically rebalance each index to ensure it keeps up with the market and maintains focus on the Alpha goals. The application of sound technical and economic due diligence principles, mixed with the following of strict criteria to filter tokens in and out, will result in the selection of only the absolute best opportunities. It’s not unusual for some of these tokens to achieve stellar growth.
Leverage Amplification with Downside Protection
The Alpha indexes are likely to use a moderate amount of leverage to optimize and amplify gains. Within the Risk Parity strategy, the portfolio is balanced using all four index classes. Though each individual index class will achieve a different rate of return according to the strategy specific risk characteristics. We would also keep the Alpha indexes only moderately levered to boost its rate of return on a given unit of risk. In this way, we can optimize the investment opportunities, making for incredibly attractive risk-reward ratios. Next to diversification within the index classes as a first line of defense, the pitfalls of leverage are further diminished in DeFi by utilizing well designed smart contracts. In DeFi, unlike in traditional finance, leverage is over-collateralized, and the controlling smart contracts will automatically and immediately liquidate the loan if there is a risk of default due to token volatility.
Risk Measurement Plus Asset Management Equals Yield Minus Worry
It’s important to acknowledge that any investment made purely to chase Alpha-level returns carries above-average, or even high, amounts of risk. By definition, the projects are new, often untested in the market and no one knows how they will respond to events such as major market swings, regulation, celebrity tweets and external, environmental events. The risk/reward ratio of some DeFi projects can be extremely alluring but they can also fail spectacularly. This is why traditional investment managers always try to balance out stocks with other assets such as bonds — the role taken by our Gamma and Parity index classes. The wisdom well entrenched in conventional portfolio management is best captured by the old adage which states, “Don’t put all your eggs in one basket”. Implementing this system in DeFi will require a more prudent selection of assets along with the usage of algorithmic schemes that will fine tune the asset weights without incurring excessive gas costs. Within our Alpha index class, we will spread our investments across a wider pool of assets, which have undergone rigorous due diligence checks and careful risk monitoring. Even though the individual assets in our alpha index can be deemed risky when considered by themselves, pooling many of them together in appropriate proportions coupled with automatic rebalancing, delivers the benefit of diversification without sacrificing too much of the yield. Hence, our alpha index will outperform other high yield seeking strategies on a risk adjusted basis.
Risk Measurement + Asset Management = Yield — Worry
Conclusion: Our Recipe for Returns
The Alpha indexes will deliver easy access to a diversified portfolio of extremely high-value DeFi opportunities. They will use high yield coins and aggressive yield farming to capture short term fast growth. They have the highest risk of all the index classes we are creating. But this is a conscious design decision since Alpha will be part of a balanced portfolio (i.e. Parity Index) which will include the Beta and Gamma indexes. Our prescription will then be greater weights allocated towards Alpha for investors with a higher level of risk tolerance and a balanced mix of all *three index classes for the more risk averse investors. More information on the Beta, Gamma and Parity indexes will be released in upcoming articles. Overall, the balanced portfolio will return high gains in good markets and continue to make money, due to being shielded against losses, during times when the rest of the market is down.
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