Raising the Bar for Portfolio Performance Measurement: The Concentration Risk Indicator

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Executive Summary

• CRI (the concentration risk indicator), modified and adapted from the Herfindahl-Hirschman (HH) index, is a novel risk measurement measure we have developed. Supplementing the CRI with other metrics allows us to gauge how our portfolios are performing and to compare them to the wider set of crypto investment opportunities.
• Our asset selection guidelines, due diligence process, risk management oversight and our VVV weighting methodology take care of monitoring the many other factors that dictate whether an asset makes a good investment.
• Continuous innovation, inspired by how world class athletes deal with new record settings, is the hallmark of our investment management approach.

Bringing Risk Parity to the Defi Party has been the impetus for numerous innovations that we are designing and implementing in the blockchain environment. These novel techniques will create an unparalleled platform for wealth generation accessible by anyone. We are introducing these concepts in the Eiffel Release Plan series of articles [LINKS TO ARTICLE ONE, TWO, THREE, FOUR AND FIVE].

In this sixth article, we will discuss a new metric we have developed, termed the concentration risk indicator (CRI), that will allow us to gauge how our portfolios are performing and compare them to the wider set of crypto investment opportunities. This metric is focused on the current facet of the decentralized terrain, wherein the majority of the wealth is restricted to a small number of tokens. Our new measure, when supplemented with other well known portfolio measurement yardsticks, will give a complete picture of how well our machinery is working.

The crypto landscape has many individuals who invested early in projects such as Bitcoin and Ethereum, when they were up and coming prospects. These holdings have grown significantly to become fairly large positions. From a portfolio perspective, their wealth is heavily concentrated in a few names. This is also the very nature of the crypto markets, where bitcoin and ethereum command more than 60% of the total market capitalization.

The number of tokens listed now on major data providers, such as coinmarketcap, is around 19,500+. This figure has more than doubled within the last one year. With a trend where several tokens appear, and an equal or greater number disappear, choosing the right investments is an arduous task. Our earlier articles discuss the due diligence and research procedures we will utilize, based on several decades of insights, for forming portfolios.

Having the right selection methodology is crucial and, once a selection is made, evaluating the corresponding performance is equally important. To address drawbacks with prevailing methodologies, and to supplement existing methods, we had to come up with the CRI.

The concentration risk indicator is meant to indicate how diversified the holdings in a portfolio are. This is a modification of the Herfindahl–Hirschman (HH) index: (Reference: [Herfindahl–Hirschman index]), which is widely used as a measure of the size of firms in relation to the industry they are in and an indicator of the amount of competition among them. We tailor the HH-Index to the crypto markets based on the following two features: 1) the larger the market cap of an asset, the lesser the risk of holding it; 2) the more volatile an asset, the higher the risk of holding it. The amount of money invested in an asset as a fraction of the overall wealth held by an investor, which is also the weight of the asset within the portfolio, is also factored in this metric.

The concentration risk indicator can be calculated for individual assets and for portfolios of assets as well. When comparing two investments, the lower the concentration risk, the better the investment from a diversification point of view. If two assets have comparable market cap then the asset with lower price volatility would be preferred. Instead of using the raw market cap values, we normalize and express it as a fraction to the total crypto market cap before including this factor in the concentration risk indicator. Similarly, if two assets have comparable levels of volatility, the asset with a greater share of the market would be preferred.

As an illustration, given a choice between holding BTC or ETH, if we need to isolate the effect of size on our investment, BTC with its higher market capitalization would seem as a better alternative. Likewise, SOL, XRP and ADA have a similar level of market share and hence their price volatility determines how concentrated an investment in these assets would be. This simplified example is meant only to illustrate the influence of size and volatility. Clearly, ETH has many other features that could potentially qualify it as a more desirable investment than BTC. An argument can also be made that tokens with higher market cap will have lower volatility than the ones with lower market cap.

The first draft of this article originally included LUNA along with SOL, XRP and ADA in the above example. But the events of the past few weeks are a wake up call to all players in the Crypto landscape. Better risk management, stress testing and checking numerous seemingly unlikely scenarios are an absolute necessity. The recent LUNA / UST episode on the Terra network, from May 8 to May 13 2022 and beyond, is a demonstration of the risk of holding concentrated portfolios.

We have been developing and testing our new metric for several months now. The creation of this measure was to have a numeric score to show people that no concentrated holding is safe even if it is as large as BTC or ETH. Clearly the recent events have not been easy for many of us. But it affirms our long held belief that nothing can be taken for granted in crypto, and for that matter anywhere, and suitable risk mitigation plans have to be made even for rather extreme scenarios. These beliefs are encoded in the risk management guidelines that our investment teams have to adhere to. Going beyond just this new metric, a rigorous approach to investing and risk management is what investing on blockchain needs. Risk parity and the whole suite of tools we are bringing are exactly the need of the hour.

While the CRI metric gives preference for larger and more stable assets, smaller and newer assets will be the drivers of growth. Hence, adding a greater number of smaller assets can compensate for the risk they bring in terms of size. Our asset selection guidelines, due diligence process, risk management oversight and our VVV weighting methodology take care of monitoring the many other factors that dictate whether an asset makes a good investment.

We are deeply cognizant of the delicate necessity that to keep improving the performance of our portfolios, our tools to assess performance need to keep improving as well. Volatility, returns and other metrics are generally more meaningful when evaluated on a comparative or relative basis. Since Crypto investments are deemed riskier, to perform a proper comparison for risk and returns, we will try to incorporate benchmarks external to the crypto world. Initially, we will display returns, volatility and the concentration risk indicator, over different time intervals, comparing our main funds Alpha, Beta and Gamma with several other prominent crypto assets.

At a later stage, we will compare the volatility of our funds to an external benchmark such as the VIX volatility index (Reference: [VIX Volatility Index, CBOE Website]). Also our returns will be benchmarked against returns from other asset classes outside the crypto landscape. External indices across asset classes such as stocks, bonds, commodities and so on could be useful for this purpose. There are further improvements we are planning to the CRI, so that it will take into account the proportion of assets invested on different chains. Similar to the basic CRI discussed earlier, the enhanced CRI will reflect the diversification benefits of amounts invested across multiple chains.

A big part of crypto investing, and also perhaps many other aspects of our lives, is dealing with uncertainty and our struggle to overcome it. Sergey Bubka is our Icon of Uncertainty. As a refresher, he broke the pole vault world record 35 times (Reference: [Sergey Bubka, Icon of Uncertainty]). Pole vault is a simple sport, where you use a long pole to jump over another long pole, which is placed on top of two other long poles.

Applying the central idea from pole vault to the crypto landscape, we can view the introduction of any new trading strategy or innovation or even regulatory change as equivalent to the raising of the bar in the game of pole vault. Once a new innovation starts becoming popular others imitate it or come up with other wonderful ideas, and we need to find ways to better ourselves. Each time the bar is raised the spirit of Sergey Bubka, whom we admire a lot and who is a huge inspiration for us, will help us to reach higher and find a way over the raised bar.

This anecdote, about Sergey Bubka and overcoming uncertainty, forms our fundamental belief that galvanizes us to constantly innovate and find better models, metrics, trading strategies and ways to generate wealth for all our participants.

Where to Find Us?

Website: https://formation.fi

Telegram: https://t.me/FormationFi

Twitter: https://twitter.com/FormationFi

Medium: https://formation-fi.medium.com