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Investing is all about risk not reward — and you probably don’t think like this.
Many investors haven’t heard of the Sharpe Ratio but unlocking its secrets is the key to generating above average returns (also known as alpha) at less risk.
The Sharpe Ratio explained:
The Sharpe ratio of your portfolio is a measure of how much return you’re getting for each unit of risk taken. Sharpe ratios are used extensively by hedge funds but are not typically used by individual investors.
Why should you care? Because a low ratio means you’re almost automatically getting poor returns compared to what you could get if you allocated to better investments.
Typically, the Sharpe ratio is calculated like this:
(Return - Risk Free Rate) / Standard Deviation
A theoretical asset returning 7.5% a year over the risk free rate with a standard deviation of ~15% yields a Sharpe Ratio of 0.5
These numbers aren’t theoretical at all and actually approximate the S&P 500.
This is helpful because it gives us a baseline – your average shmuck can go buy 100 shares of $SPY and get a portfolio with a Sharpe Ratio of 0.5
That’s OK but you don’t settle for OK, you’re a crypto investor after all.
By investing in crypto you get an automatic boost to your portfolio’s Sharpe Ratio: Bitcoin comes in at 0.7 and the CCI30 Index comes in at 0.67
So how do you get it higher?
Improving your Sharpe Ratio
Boosting the ratio isn’t rocket science, it’s actually quite easy and obtainable through diversification.
The best way to diversify in crypto is through research.
In the equities world this could be achieved by buying bonds or screening for stocks that offer higher risk-adjusted returns, but in the crypto world we don’t have those luxuries.
The best way to diversify in crypto is through research. Picking quality projects with expert teams behind them is the key to success. Blindly diversifying in sh*tcoins is not a prudent move given their wild volatility. While that no-name coin may 100x it also has high probability of going to $0. Returns are almost always diminishing against risk, meaning at the extreme, taking on more risk does not mean an equal payout in returns.
What is a good Sharpe ratio?
A quick breakdown of Sharpe Ratio ranges:
0.25 The typical Sharpe ratio of an actively managed mutual fund
0.5 The typical Sharpe ratio of the S&P 500 index over a 10 year period
0.5–0.75 The typical Sharpe ratio of a diversified portfolio of stock and bond ETFs. This is where most well-educated investors are.
0.75–1 Intelligently applied risk parity strategies (see opening line of this post) usually end up here – typical CFA or Investment Advisor territory before fees
1–1.25 Combining risk parity with even better/heavily researched factor investing strategies
1.25–1.75 The level of manager sophistication goes up exponentially from here. Using volatility targeting plus all of the above can move your Sharpe ratio above 1.25. Most hedge fund alpha is attributed to this risk management phenomenon.
1.75–2.25 All of the above techniques are used, plus you need a manager who is competent at investing with futures, mortgage-backed securities, asset-backed securities, interest rate swaps, credit default swaps, and short selling of cash and debt instruments (via the repurchase market) to finance long positions – this is hedge fund territory
2.25+ High frequency trading (HFT) and statistical arbitrage strategies – also hedge fund territory
Building a better crypto portfolio
At a baseline, a crypto portfolio (or just Bitcoin) can be on par with traditional stock/bond portfolio but with some minor tweaks it perfectly reasonable to move into the 0.75–1.25 range.
For example, my portfolio is heavily indexed towards Bitcoin and Ethereum but strategically sized bets in Chainlink and Cardano as well as other coins yielded a 1.0 Sharpe Ratio from 2017–2019.
If you’re willing to invest in non-crypto assets you can push that number even higher. In late 2019 I introduced gold to the portfolio and from that point until today we’ve seen a 1.92 Sharpe Ratio.
While we have seen an increase in the Sharpe Ratio, returns have fallen. Over the 2017–2019 period, the fund averaged a 169% annual return. Post-gold, the fund has averaged an 82% return. There’s no free lunch in investing. While this is in-line with our risk protocol, it does bring up the question of: how do I make money with a high sharpe ratio? The answer is leverage.
Concentration risk vs. leverage
Most investors juice up their returns by taking on excessive concentration risk. This simply means they push more money into fewer bets. There’s nothing wrong with this strategy but at a certain point they begin taking on excess risk without additional return.
It is typically always better to leverage a 1.5+ portfolio vs. concentrate a 0.75 portfolio
More sophisticated investors apply leverage. Managers with access to low interest capital to borrow can leverage a high Sharpe Ratio portfolio and generate excess returns with minimal additional risk exposure.
It is typically always better to leverage a 1.5+ portfolio vs. concentrate a 0.75 portfolio — but the kicker here is that most investors do not have access to leverage. The crypto world is full of leveraged exchanges but often the cost of borrowing is too high to realize any gains over the long-run.
The bottom line
Pay attention to how much risk you’re taking on when building a crypto portfolio. It’s easy to model 10–100x multiples but often hard to understand how risky those assets really are.
If you’re comfortable with the possibility of a big drawdown then a 0.75 concentrated portfolio is no problem. If capital preservation is a goal then look to boost your Sharpe Ratio above 1 and possibly consider leverage.
Additionally, keep an eye on Bitcoin correlation — this market is young enough where diversification’s impact is not yet fully baked.
Have a great weekend, I’ll talk to everyone on Tuesday.
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