Gamma: The Calm Center Within The Swirling Gyre
DeFi has had a good run during 2020 and in the first months of this year. Double or even triple digit returns were becoming the expected norm. Aside from a few notable hacks, rug pulls and protocol implosions, the system had largely worked well. Crypto investors were making more money than they ever thought achievable in the traditional investing world. All this, however, has happened in a bull market which suddenly turned around between the middle of April and May. In fact, the main driver of crypto prices, Bitcoin, which more or less had consistently gone up from March 2020 until April 2021, started correcting from the middle of April. DeFi was able to resist this fall initially and rallied for another month before it also experienced a serious correction or perhaps even a bear market. One thing is sure: corrections and bear markets will always come and when they do, they are usually brutal.
Formation Fi is leading the way in building a new generation of DeFi investments that supply high growth in the good times but also bring solid, consistent returns in market downturns, whenever they come. 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 central philosophy, which applies in equal measure even for the decentralized investment terrain, emphasizes preparedness by constructing robust portfolios which can withstand, and at times even take advantage of, the unexpected when it does end up happening.
Gamma Index Class: Safety Net with Upward Mobility
The Gamma index class is designed to supply reliable returns from safe and/or uncorrelated sources that will protect a portfolio against losses during dips, corrections, crashes and bear markets. Its purpose in a portfolio is to balance out the risks inherent in the other index classes. In traditional investing, this is accomplished by balancing different classes of assets that react in opposite directions to the same events, so called uncorrelated classes. This protects the combined investment so that there should always be growth or income — e.g. stocks vs. bonds and commodities.
The Gamma indexes are the dependable foundation, the body or the core portfolio, upon which to build higher risk/reward investments using the Alpha and Beta index classes, which are the rising stars and satellites (LINKS: to Alpha and Beta articles here). In the crypto universe, the assets we have selected in the role of bonds are cross-chain interest-earning stablecoins. The lending platforms will be chosen according to a strict filtering policy, including sound technical and economic due diligence principles, to ensure the highest levels of operational excellence and reliability. The assets will include interest-bearing assets (e.g. stablecoins and governance tokens) from DAOs such as Compound, Aave, Cream and others across the main blockchains. Typically, these will allow a stable return target of 3%-8% APY so that they can deliver partial protection against losses for a balanced portfolio. Considering the yield for the 10-year U.S. Treasury is considerably lower (e.g. 1.35%) in today’s inflationary market condition; this is a highly attractive range of rates. If these return profiles change significantly then the smart contract attached to each index will rebalance the index weightings to attain a better total APY concurrent with the goal of maintaining asset diversification across many networks. A judicious use of liquidity mining in stablecoins could be included in this index class, as we aim for modest returns while trying to minimize the possibility of impermanent loss. This will be carefully designed to achieve our target which will be above the inflation rate.
In addition to this return target, Gamma will also provide low to negative correlation to the market which can be a tricky challenge in the crypto market. Obviously, the market is fast evolving but at the moment we see two ways to solve this problem. First, we will use part of the cash flows we generate with this index class to buy optionality on the decentralized derivative exchanges. Second, we will look at the old markets and add decentralized commodity-backed stablecoins like for example gold-backed or other commodity-linked stablecoins. These innovations will furnish long-term confidence whatever the markets are doing.
Risk Control Requires Strict Tolerance Limits
The Gamma indexes carry a low level of risk due to the reliable nature of the projects and tokens included. Dollar pegged stablecoins reduce the yield volatility further and the use of lending platforms across multiple chains reduces the reliance on individual or specific technologies. The addition of decentralized optionality and commodity backed stablecoins provide the critical negative correlation to optimize the index. The customary Formation Fi foundational framework, consisting of proper due diligence, risk weighted sizing and an algorithmic scheme that will rebalance and fine-tune the asset weights without incurring exorbitant gas fees, will be applied.
Sticking to our guiding tenet, of mitigating the downsides, will mandate an overall asset allocation that relies on reading the prevalent environment and assessing anticipated market conditions. Among the arsenal of metrics, our automated systems will depend on, a key indicator will be the volatility of individual assets and groups of securities. Clearly, combating the uncertainty of the markets will demand an iterative and continuous improvement model, wherein we will start measuring historical volatility and supplement that with incremental forecasts where appropriate. Given that all predictions come with a certain degree of inaccuracy, our specialized algorithms will be calibrated to work satisfactorily under a wide range of measurement and forecast errors. The level of volatility (both, past and anticipated) will become a crucial decision aid that will enable us to suitably adjust the weights across all our index classes. When rough weather sets in, or is expected, Gamma will receive a bigger chunk of the funds. As The Going Gets Grim, Then Gamma Gets Going.
Gamma Allocation ∝ Volatility
Gamma Allocation will be Proportional to Volatility. In other words,
↑Volatility ⇒ ↑Gamma Allocation
Higher Volatility implies Higher Gamma Allocation
Hence, our Gamma index will provide a stable return and become a safe-haven amidst times of turbulence. The risk of the Gamma index class is lower than those of the Alpha class and the Beta class within the overall Risk Parity balanced strategy. Subsequent articles will describe the Risk Parity class and explain why Gamma, this lowest risk class, would have the highest allocation in the balanced portfolio and act as the essence of the Risk Parity class.
Conclusion: The Formation Fi Foundation For Higher Returns and Lower Risks
The Gamma index class supplies a reliable return when the rest of the market cannot or is in retreat. It is an important, highly weighted and compulsory component of Formation Fi’s balanced Risk Parity strategy as it enables the other index classes to work at higher risk levels when market conditions allow them to. 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. Whereas the Gamma index will supply the long-term safety component of a well diversified high yield portfolio with low to negative correlation to the market. Simply put, Gamma is a necessity when gearing up for a bumpy ride.
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