“The wheels on the bus go round and round” - the average 12 y.o. crypto investor chants, while being chauffeured around in a Lambo.

Just a heads up: This post is just for education, and this post is not financial nor traveling advice. Data and information were gathered from CoinMarketCap, Shrimpy.io, and Beethoven-x. However, this is not sponsored post.

Narrative waves

The crypto market seems to be chaotic and turbulent at a first glance. Piercing the surface of the market, you’ll find that the game revolves around shifting narratives and psyops warfare. For bonus reading material on market dynamics, I would highly recommend A very degenerate thesis by @knowerofmarkets, as well as The Game of Deception by Josh McGruff.

Or as aptly summarized by @bigd_intern:

Ideally, we want to formulate a plan that could take advantage of these narrative waves, and without us having to be trading savants or on-chain detectives.

The Rebalancooor

Ahhh I’m rebalancing!

Let’s imagine we are in the following scenario, it’s late December 2020. We are gathered with la familia for the holidays. We have not invested in crypto, yet we keep hearing “crypto” pop up around the dinner table. Apparently, there are rumours that a bull run is about to start. We make our New Years Resolution to put $5K into crypto and see how it goes. We’d like to think of ourselves as a tad more sophisticated than the average investor, and we know that portfolio rebalancing is a suitable strategy for capturing the average stock market returns. Could we apply rebalancing to crypto with similar success?

The key to catching all the waves is to be simultaneous in all the places.

To take advantage of the waves and pumps, let us construct a portfolio rebalancing strategy. We will be allocating a total of $5000 into a portfolio containing 10 coins, each weighted at 10% of the portfolio. As the prices move up and down, the weights will shift. We can set our rebalance threshold at 10%, meaning we will sell a coin is it becomes 11% or more of our portfolio, and buy a coin if it becomes 9% or less of the portfolio. The numbers in bold are parameters that can be modified, but in the following scenarios, we keep them the same to make things comparable.

The idea behind rebalancing is that we rotate our profits from tokens that have gone up into tokens that have gone down.

Our benchmark

First things first, let us define a benchmark to measure our performance against.

From the period between JAN 1st to DEC 1st, 2021. The total crypto market cap did a 3.5x. Just as a reference, BTC did a 2x, while ETH did a 6.3x.

A “good” strategy should track or outperform the total crypto market cap. A “bad” strategy will underperform the total crypto market cap.

Large cap portfolio

Let’s say we chose our portfolio by taking the top 10 coins by market cap in JAN 2021. I’m using the backtesting tool from Shrimpy.io to generate the data below.

If we look on the rightmost panel, we can see the tokens in our portfolio and their weights. The chart on the left tracks the performance of the Rebalancing strategy (red) versus HODL-ing the tokens without rebalancing (grey). The middle panel shows us the final performance on the end date of DEC 1st, 2021.

Observation: Looking at the chart, Rebalancing tracks HODL closely, but HODL takes a slight lead. The final performance of Rebalancing and HODL both beat our benchmark of 3.5x by a little bit.

Why did Rebalancing lose to HODL?

The reason seems to be that we rebalanced into several coins that did not recover their highs after the May crash (LTC, LINK, XLM, XRP).

Large cap with a little twist

Let’s say instead of going with the top 10 crypto, we picked just the top 9 and added Solana (a little cherrypicking here, but I do have a point to make). Luckily for us, Solana had one of the biggest gains seen in the crypto market this year.

Observation: Looking at the chart, we wee that HODL and Rebalancing were pretty close up until August. Starting September, Rebalancing severely underperformed HODL. And at endpoint, Rebalancing is close to a 2x to the total market cap benchmark, and HODL is close to a 5x to the total market cap. We can consider the difference between Rebalancing and HODL to be the impermanent loss.

Insight: If our portfolio contains a big “winner”, then (in hindsight) the optimal strategy would be to HODL, because we do not want to sell the “winner” to buy the “losers”. But even if we rebalanced, having just one “winner” lifts up the entire portfolio’s performance.

DeFi bluechips portfolio

Let’s say we assumed after DeFi Summer 2020, many of the DeFi tokens will make a come back in 2021, so we added some DeFi bluechips to our portfolio. Unfortunately, DeFi bluechips did not have the best price performance in 2021.

Observation: Looking at the chart, Rebalancing started to outperform HODL early on, and the gap widens throughout the year. At endpoint, HODL is at 0.75x of our market cap benchmark, while Rebalancing is at 0.92x of benchmark.

Insight: Even though we didn’t get any big “winners” in our portfolio, rebalancing has worked in our favour.

Why did the gap between rebalancing and HODL widen?

The likely explanation was that the DeFi tokens are all highly correlated with each other, and any price differences between the DeFi tokens tend to revert back to the mean. Rebalances are very good at capturing these temporary differences (the quants gave it a fancier name, statistical arbitrage or “stat arb”). Another way to see it is simply that DeFi tokens are highly correlated assets so they have lower impermanent loss.

Synthetic TriCrypto

Let’s say we want to be extremely conservative with our crypto exposure. We can copy the weights of Curve’s tricrypto token: equal exposure to BTC, ETH, and a stablecoin.

Observation: Looking at the chart, HODL and rebalance are pretty close in the first half of the year, and HODL steadily rises above rebalancing in the second half of the year. At endpoint, HODL is at 0.6x of our market cap benchmark, while rebalancing is at 0.47x of benchmark. Unfortunately, rebalancing underperformed even the BTC maxi portfolio (100% BTC HODL).

Insight: a tricrypto-style rebalancing portfolio is a “bad” idea in a bull market. Likely reason is that it has too much uninvested cash, and the rebalancing makes it sell the BTC and ETH too early. On the flip side, I’d imagine tricrypto-style to be hit the least hard in a bear market, but we will see how that pans out.

Some thoughts

Rebalancing is passive, conservative, and makes few assumptions about the market. Rebalancing means we will not show up on the trader leaderboards for the biggest gains, but it will also prevent us from showing up under biggest losses.

Rebalancing gives us a narrower range of outcomes, centred around the average market returns. And with lower uncertainty, we can make better plans around the other parts of our portfolio.

What percentage of the portfolio should be in rebalancing? While NFA, I’d personally lean heavier on the heavier side. I have full confidence that if we zoom out to yearly candles, the crypto market cap will be diagonally up to the right. Having constant exposure to the market (even when the bear hits, because losses are impermanent) is my attempt to capture the most upside passively.

Even if you are trader, you may want to keep a passive, lower risk portfolio separate from the active trading portfolio. Dedicating a portion of the trading profits to DCA into a rebalancing portfolio may be an interesting alternative to keeping the gains all in cash.

If our portfolio is well diversified and mostly large caps, rebalancing should give a close approximation of general market returns. This could be useful at the start of a bull run, as we have a good chance of outperforming the overall crypto market cap, BTC maxi, and tricrypto.

If our portfolio contains more “low-cap, high-risk gems”, rebalancing might be a bad idea. These portfolios are similar to early stage VC funds, where the general advice is to hold (or even double-down) on the winners, instead of selling winners to buy losers.

If our portfolio is concentrated in one sector, rebalancing should beat HODL thanks to capturing the “stat arb” opportunities as they arise.

Knowing all these facts and quirks about the performance of rebalancing, we may conceive of more complex meta-portfolios. For example, we could group tokens by their sector, and only rebalance within each sector. We could also put our low-cap bets in a separate basket that is not rebalanced. Of course, we could also introduce machine learning and other data sources to optimize our portfolio parameters, but the general principles don’t change.

DeFi portfolio rebalancing

Centralized solutions to portfolio rebalancing carry several costs, including spread and trading fees on an exchange, not owning our tokens, and 3rd party portfolio management software fees (unless you rebalance manually yourself).

An exciting future for portfolio management lies in DeFi, where we can join a pool, receive trading fees, own our tokens, and collect token rewards. So, pretty much the cons under CeFi become pros under DeFi. A few names if you want to look dig in further: Beethoven-x (more below), IndexCoop, BasketDAO, Cook Finance.

One major downside in DeFi solutions is that all the desired assets must exist on the same network. E.g. if I wanted a basket of 20 different L1 tokens, there’s no DeFi method to get them to coexist together, although I hear several X-chain projects are working fast to make that a reality.

Beethoven-x

I have been playing around with Beethoven-x, a Balancer fork on FTM. And one of their pools in particular, “The Magic Touch by Daniele”.

Near the top you see the tokens in this pool. There is MIM, a stablecoin, and wMEMO, a rebase coin. As we’ve seen in the previous article on levered LP-ing, adding a stablecoin lowers the volatility of the overall pool.

The wMEMO is also particularly interesting. If the other tokens go up in price faster than wMEMO rewards, wMEMO keeps accruing rebases. However, if other tokens stay constant or fall in price, the wMEMO rebases are “redirected” to buy the other tokens (we will probably re-visit the idea of yield redirection in a separate article).

Observation: in the line chart, we can see that the HODL performance (grey) vs pool performance (green) track each other very closely. The pool is relatively new, so we don’t yet have enough historical data to draw firm conclusions. We see that as of the time of writing (Dec 9, 2021), the pool is doing slightly better than HODL.

Observation: Near the bottom, you will also see that the pool has an APR of around 60%, which is rewarded in $BEETS tokens. And of course you can use an auto-compounder like Grim or Reaper to get an APY of around 80%. Note: the rewards are not included in the performance line chart.

Insight: Without rewards, several of our hypothetical portfolios earlier experienced impermanent loss. Now that we can collect a juicy yield on our portfolio, the yield should outweigh impermanent loss except in extreme situations.

Insight: With DeFi platforms, we can start constructing complex portfolios as well. For example, here we saw the introduction of a rebase token into the portfolio, which allows us to stack yield on top of yield. We could also introduce interest-bearing tokens and staked tokens into the portfolio. Taking it to the next level would be adding tokenized strategies (receipt tokens from other DeFi platforms, such as a-tokens, y-tokens, c-tokens, or even levered LP tokens 😉) into the portfolio.

A secret, for those who made it to the end

A little known secret, is that this article only contains half the magic. The other half of the magic needs to come from you, dear reader! I just know that we would have a blast when our ideas collide! Come @ me on twitter. Would love to see it!