Crypto Tokens: Does Security Selection Matter? 


A falling stock market isn’t bad for everyone. Of course, many investors lose as their portfolios decline in value, but those just starting out or underweight stocks can benefit from lower valuations, which tend to offer higher long-term returns.

Of course, equity markets don’t fall for no reason. As the economic environment changes, so do expectations. The positive feedback loop that drives ratings up eventually reverses course and turns negative. But at some point, economic and business conditions stabilize and valuations drop enough to attract new investors and lure old ones back. For example, companies with countercyclical business models can increase their attractiveness by increasing their dividend payout.

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But not all stock markets have the same dynamic as that of variable income. For example, the Italian lira steadily lost value against the German mark for decades before both currencies merged with the euro, and currencies can indeed lose value when hyperinflation sets in.

So what about cryptocurrency tokens? Critics have long raised concerns about its intrinsic value, or lack thereof, and there doesn’t seem to be any relationship between a token’s price and the product it’s supposed to serve as a means of exchange

But with nearly 10,000 cryptocurrencies available, security selection should matter. So, does it? Can chip collectors demonstrate differentiated performance?

Probability of making money in cryptocurrencies

One of the most profitable approaches to cryptocurrencies is to invest in the private seed round of a start-up seeking token funding. The initial price is usually at a large discount to the public sale price, which is comparable to the pre-IPO investment.

But more than four out of five tokens are trading below their initial price, according to an analysis of nearly 10,000 cryptocurrencies by London-based asset manager Jackdaw Capital.

Crypto Tokens: Current Price vs. initial trading price

Bar Chart Showing Crypto Tokens: Current Price vs.  initial trading price
Sources: Jackdaw Capital, FactorResearch

Types of tokens

These odds (less than 20% of an exchange-traded token eclipsing its initial listing price) make investing in tokens difficult. But there are different types of tokens. Certain categories may still offer investors the prospect of attractive returns through stock selection.

To find out, we’ve built a universe of the more than 3,500 tokens being traded today and divided them into 17 categories. The largest category — non-fungible token (NFT) and collectibles — had 585 components, while the smallest — swipe to win — had only 19. These varieties of tokens represent different crypto products that should be relatively uncorrelated.

Type of tokens: according to the numbers

Chart showing census of crypto token types
Source: FactorResearch

Performance of the token

We then created equally weighted indices for each of the 17 witness categories. Most of our categories only have a few years of commercial history, but NFTs and Masternodes date back to 2013 with nearly a decade of history.

Most of these indices generated such abnormally high performance that we needed a logarithmic scale to measure them. This explains much of crypto’s appeal: the potential for 1,000% annual returns can be hard to resist.

Token performance by type

Chart showing token performance by type
Source: FactorResearch

Cryptocurrency volatility

But the crypto market hit a rough patch over the past few months. Its total market capitalization declined from nearly $3 trillion to less than $1 trillion, while bitcoin declined from an all-time high of $69,000 in November 2021 to $20,000 at the time of write this article.

Even so, the 2022 cryptocurrency crash is hardly recorded by the log charts as token indices use average performance and equal weighting for index calculations. The tokens showed such a high positive tilt that the average return was significantly up rather than down. For example, Terracoin (TRC) skyrocketed from $52 to $2,535 in a few days in 2013. The most a token can lose is 100%, but the upside could be parabolic.

Cryptocurrency Volatility: TRC Performance

Terracoin performance chart
Source: FactorResearch

Token performance adjusted to reality

However, since the average investor cannot participate in all token sales, the average return is not an accurate measure of the performance of a token index. Average performance is a better metric. And it tells a very different story.

All 17 types of tokens have lost money for their investors since the indices were created.

Performance between 2013 and 2018 — the peak of the first crypto bull market — differed, even though only a few tokens were traded. Some types of tokens (governance, for example) worked well in relation to, for example, NFTs. From 2017 to 2018, however, hundreds of initial coin offerings (ICOs) took place. Many of these were, at best, speculative; others were scams.

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Since 2018, all token varieties have suffered a steady decline. Despite their ostensible different purposes and business models, all token types followed the same downward trajectory. This implies that security selection does not matter in the crypto space.

Also, our universe is composed of tokens that are still being traded and therefore includes a survivorship bias. Thus, returns are slightly overstated, making the outlook even more negative.

Token performance by type: average returns

Chart showing token performance by type: average returns
Source: FactorResearch

Inflationary vs. deflationists

But maybe these bearish results aren’t as bad as they seem. What if we differentiate between cryptocurrencies with a limited supply, such as bitcoin, and those, such as Ethereum, that have no supply constraints? Bitcoin and other limited supply tokens could have a deflationary effect, especially when the issuer buys back tokens, while unlimited tokens could be inflationary as more and more tokens put downward pressure on the price of token.

We split the 550 DeFi tokens in our universe along these lines and found little difference between these two varieties from 2018 to the present. Supposedly deflationary limited supply tokens performed worse.

DeFi token performance: limited or unlimited supply of tokens

Chart showing the performance of DeFi tokens: limited and unlimited supply of tokens
Source: FactorResearch

Additional thoughts

Fund managers have struggled to create value through stock selection in equities and other traditional markets. Alpha generation has been low to negative over the past few decades. In theory, the complicated new world of cryptocurrencies should offer many information asymmetries that sophisticated investors can exploit.

But unfortunately, theory and reality often collide in the world of investing. All token varieties exhibit the same negative performance trends, making it a difficult environment for security selection.

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The average cryptocurrency hedge fund manager offers nothing but exposure to bitcoin. Investors can efficiently and inexpensively replicate this exposure through exchange-traded funds (ETFs).

The new world is very much like the old.

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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images / Nawadoln Siributr / EyeEm

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Nicholas Rabener

Nicolas Rabener is the CEO of FactorResearch, which provides quantitative solutions for factor investing. He previously founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focusing on real estate across asset classes. He began his career working for Citigroup in investment banking in London and New York. Rabener holds a master’s degree in management from the HHL Leipzig Graduate School of Management, holds the CAIA charter and enjoys endurance sports (100 km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

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