By Zava Aydemir
DAOs have had an incredible run the past couple of months. There is not a week that passes by which sees the launch of new DAOs. Their purpose and reason for existing are as manifold and diverse as human interests and activities can possibly be. Some were founded to allow its community members access and co-ownership to otherwise unaffordable NFTs (SharkDao), others were created as a media platform (ForeFront, Bankless), some operate as a research and early-stage investment platform (Global Coin Research) or they were initially launched to buy a copy of the US Constitution (ConstitutionDAO). Many earlier DAOs, and today the largest ones so far, are protocol DAOs in the DeFi space (Uniswap, MakerDAO, Compound to name just a few).
Equally impressive, this proliferation was accompanied by a surge in the amount of funds held in DAO treasuries (see link). As diverse as the current DAO landscape presents itself, there is one common aspect that almost all DAOs share: their treasuries are mainly composed of the native token. This concentration, however, comes with certain risks that can potentially challenge their viability in the future.
This article will address the challenges of treasury diversification in three steps:
Our conclusions from this analysis:
One powerful concept behind DAOs is that its community members are at the same time also its owners. This governance structure helps align the interests of the DAO and its members. In addition, remuneration of contributors with native tokens, especially in the early stages, lets community members gradually build equity to then participate in the upside and future success of the DAO. This remuneration structure is reflective of the successful implementation of compensation schemes in traditional startups (link) in the past.
At the same time, however, native tokens are exposed to general market volatilities and are not immune to strong sell-offs during bear markets. It is in such circumstances that the daily operations and functionality of a DAO can be disrupted due to the lack of cash reserves for its regular funding. Partially compensating a core group of team members in terms of a fixed salary in stable coins that is responsible to maintain daily operations and even to continue to build its network and develop during episodes of market stress becomes instrumental for the viability of a DAO. It is therefore important that part of the Treasury is diversified in low risk/safe payoff assets such as stable coins.
Selling native tokens against stable coins, however, is easier said than done. The dilemma that DAOs face is that the markets may fail to smoothly absorb the supply of native tokens due to the lack of liquidity leading to a sharp drop in its price. Furthermore, a sale of native tokens by the DAO itself can lead to a negative perception in the marketplace and among community members even though such a sale is in the best long-term interest of the DAO.
DAOs can resort to several non-disruptive strategies to raise cash in exchange of native tokens without directly intervening in the marketplace. These strategies center around three broad categories of managing a Treasury:
How much should a DAO treasury hold in cash and how much in native tokens? If we have the longevity and long-term success of the DAO in mind, this question goes even deeper: What should a DAO Treasury that is set it up for its long-term success and viability look like?
To answer this question, we will look at the composition of portfolios of organizations that have similar goals to those of a DAO but that have been around for a long time as organizations and stood the test of time through numerous crises. The aim is that inspection into such organizations will then help us delineate a Treasury composition for DAOs.
We think good examples of traditional organizations that have similar goals to DAOs are family offices and university endowments. Their goals can be broadly categorized along these principles:
If we succeed to distill portfolio features that are characteristic to such organizations that distinguish them from average portfolios, then we can as a subsequent step start to think about how to translate such portfolios from traditional finance to a crypto-based counterpart.
But first things first. Inspection into the composition of the portfolios of family offices and endowments reveals that they invest their funds very differently from the average household in the United States, whose majority of wealth is mostly parked in pension funds. There are two distinctive features that are worth highlighting in this comparative analysis:
Family offices and endowments hold about a quarter of their portfolio in low-risk assets such as cash or absolute return in comparison to only 7% of average American households. Similarly, the exposure of family offices and endowments to very high risk and/or highly illiquid asset classes –alternative investments – such as VCs, PE, leveraged buyouts or real estate is significantly higher at 45% in comparison to only 19% for the average American households. On the other hand, US households hold a massive 75% of their wealth in stocks and bonds compared to only 29% with family offices and endowments.
Considering these findings, the portfolio composition of family offices and endowments can be best described as a barbell strategy. Theoretically, ex ante, every investment can be located on a risk spectrum that ranges from risk-free to highly risky. Between these two extremes, you have a large middle ground where risk is moderate.
Now imagine this risk spectrum as a barbell. On the far-left side, you will have cash and absolute return investments; on the very right side, you will find PE, VC, real estate and other alternative investment vehicles that are associated with big payoffs and high risk. The wide middle part of not so safe, small payoff and medium risk is populated by traditional assets classes such as equities and fixed income.
Now in analogy of a barbell, the best way to lift this risk barbell is to hold it at both ends, never in the middle. More concretely, the main characteristic of the barbell strategy is that capital is not evenly distributed across the risk spectrum. Instead, a very large share of the funds is allocated to the one extreme, very low-risk assets. That way, family offices and endowments protect their business and wealth from potential ruin, but also ascertain that they can enter new investments at very attractive levels during periods of financial distress. At the same time, a barbell strategy allocates funds to the other extreme, to very high-risk investments. This way it exposes the portfolio to few volatile opportunities that can lead to massive paydays. In other words, the barbell strategy makes uncertainty your friend.
Allocating funds to moderate risk-taking, in contrast, is the least attractive strategy: the upside is never high enough to produce life-changing gains and the downside is often large enough to keep you up at night. But this is predominantly the investment strategy of pension funds and thus of a vast majority of households in the US.
There are nuances in structuring the barbell portfolio strategy, of course, and the differences in the outcomes manifest themselves mostly in the risk level of the long-term performance (if we accept volatility as an appropriate risk measure, which typically is not a good idea). Endowments and foundations often follow a similar investment strategy as family offices and Ultra High Net Worth households but are characterized by higher volatility in their performance. What unifies them however is that, on average, they outperform pension funds by 1% to 1.5% annually often with the same, or even lower amount of risk. This may not seem to be a big difference, but it starts compounding in the longer term: 5x vs 6x after 20 years, 11x vs 17x after 30 years, 24x vs 42x after 40 years.
See KKR report for assumptions to generate this graph.
One important conclusion studying the long-term performance of family offices and endowments versus pension funds is that the pursuing of the barbell investment strategy over time will lead to superior returns at much lower risk. The central question for a DAO in this context then becomes: what is the digital counterpart to the barbell strategy in the traditional financial world? We try to address this question by mapping the real-world investment strategies that is associated with each section of the barbell in today’s family offices and endowments to its digital counterpart. A possible answer to this question is summarized in the table below.
We’ll next discuss the individual assets separately for each sleeve of the barbell strategy:
Safe / Low risk:
Not Safe / Medium Risk:
Big Payoff / High Risk:
On barbell investment strategies:
Nassim Taleb, The Black Swan, 2007.
Master Your Business Risks Using the Barbell Strategy.
On investment strategies of family offices and university endowments:
Yale Investment Office, Yale’s Strategy.
KKR Insights, The Ultra High Net Worth Investor: Coming of Age, May 2017 .
On discussions of DAO treasuries:
Bankless Newsletter, April 2021.