Institutional investment in crypto assets creates the need for benchmarks. However, widely accepted investable crypto benchmarks do not yet exist. In this article, we highlight the reasons for the lack of institutional-grade benchmarks and the options available to investors.
Material impact
The choice of a crypto benchmark makes a material difference in assessing investment performance. The chart shows the year-to-date impact of choosing between various commonly used options.
Year-to-date performance of various crypto benchmarks, rebased
Source: CoinMarketCap, S&P Global, CCi30.com
The performance differential between Bitcoin and the S&P Broad Crypto Market Index was 12.5 percent. The difference is even greater vs the CCi30 which is up only 34 percent year-to-date, only about half of Bitcoin’s performance.
The challenges in creating crypto benchmarks
The key reason for the lack of consensus on crypto benchmarks is the limited institutional presence in the crypto market and the lack of established active investment strategies.
Benchmarks describe the returns the investor would earn from a passive strategy in order to measure the success of the active strategy, and at this point, there are no active investment strategies that a substantial number of institutional investors pursues.
Defining the investment universe is another challenge, as the investability criteria vary greatly based on the investor’s jurisdiction, regulatory status and internal policies. These factors determine the tokens, custody solutions and counterparties that are acceptable or allowed, and this will limit some investors more than others in terms of the tokens they can invest in.
Crypto hedge funds with active long-only strategies in the crypto market do not have the same needs for benchmarks as traditional institutions as they often define their investment objective as generating a positive absolute return through the selection of tokens and giving a greater weight to high-conviction positions relative to an equally weighted portfolio. To the extent that they reference benchmarks, they may choose ones that are more equally weighted versus market capitalisation–weighted indices.
Crypto hedge funds are also cautious about using market capitalisation–weighted benchmarks, as those will be very strongly driven by Bitcoin’s performance, Bitcoin being the largest crypto asset, with about half of the total market capitalisation.
A further difficulty is that most crypto indices apply somewhat arbitrary rules to constituent selection. The indices may be labelled as ‘fully transparent’ and ‘using objective criteria’, but the detailed index guides usually include subjective decisions about constituent selection.
The great divergence in the returns of various crypto indices even over a relatively short period, such as year to date, shows how widely the index methodologies vary.
Hypothetical versus investable benchmarks
The crypto benchmarks available currently will often leave a gap between what is included in the index versus what is actually investable by the institution. This will mean that some of the out or under-performance will be beyond the investor’s control.
This will almost certainly be the case when a broad benchmark is used, but it may happen even with narrower benchmarks.
Using a benchmark that is narrower than the actual investment universe that the institution is targeting will also mean that there will be a random component to the out or under-performance versus the benchmark. For example, if a large-cap benchmark is used, but the investments are selected from a broader universe, then the returns among the small/mid-cap versus large-cap segments will drive part of the relative performance rather than just the token selection.
Options and solutions
It is near impossible at this stage to find a benchmark that perfectly fits an investor’s targeted investable universe and investment strategy.
The best option is to clearly define the investment universe and select a reliable index that comes close to reflecting the chosen universe while being conscious of the gaps between the index constituents and the investor’s actual investable universe.
If a broad index is chosen, such as the S&P Broad Crypto Market Index, it is important to understand which constituents of the index are uninvestable and how much of the performance divergence relative to the benchmark they are responsible for.
If a narrow index is chosen (such as using Bitcoin or a top-ten index as a benchmark), but the investments are selected from a larger universe, then it is important to recognise that the drivers of the relative performance will not be limited to the selection of the best projects. This includes market regimes – in certain market phases, large caps lead, while in others, the small caps tend to outperform.
It is also important to recognise Bitcoin’s dominant weight in market capitalisation–weighted indices, especially as Bitcoin’s performance is driven not only by the success of the protocol but also by global macro events.
The decision to select a market capitalisation-weighted benchmark or a differently constructed one (such as square-root-of-market capitalisation or equally weighted) should be driven by what the investor defines as their passive exposure.
Another option is to create a tailored benchmark (in-house or outsourced) that exactly reflects the investment universe and the passive strategy that the investor’s performance needs to be compared to.
Benchmarking crypto yield and market-neutral investments
Crypto investment strategies that are not built around a long exposure to the market require different benchmarks and comparisons.
Crypto yield strategies are best compared to fiat money market investments while recognising the additional risk. Market-neutral strategies in the crypto market should deliver positive absolute returns with high Sharpe ratios.
When investments are outsourced, the managers’ performance should be evaluated similarly to the above by comparing it to the most reasonable benchmark while recognising the gaps between the index and the actual investment universe that the manager will have no control over.
When comparing managers, it is important to understand the differences between their investment strategies and the token universe that they invest in. Due to the significant diversity in investment strategies, comparisons can be difficult – some managers will have a greater illiquid venture component, others will have none; some will be targeting absolute return versus relative performance compared to the market, some will optimise for risk-adjusted return, others for performance; while some will build the strategy around maximum drawdown targets.
Summary
Currently, the great diversity of investment approaches and the varying limitations on the acceptable and investable token universe mean that the available crypto benchmarks do not exactly reflect the passive alternatives to the active strategies that most investors could pursue. It is important to recognise where relative out or under-performance is beyond the investor’s control. Alternatively, tailored benchmarks may be created. As active institutional investment in the crypto market emerges, benchmarks will be created that correspond to the common investment strategies.
Read more about crypto assets from Sygnum here.
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