Notcoin, a crypto rebalancer

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DataDrivenInvestor

6 min readJan 15, 2021

Bitcoin is up, leaving crypto owners with a Lambo-load of value correlated with bitcoin. This increases the volatility of their portfolio and their risk of losses. They will be tempted to “rebalance”, to sell some of their winnings, and look for new opportunities with new upside.

People do this instinctively. And their instinct is supported by math. Modern Portfolio Theory tells us that we can make more money, with less risk, if we own “uncorrelated” assets. This carries us through times when BTC is going nowhere, but other assets are on average going up.

Are bitcoin HODLers really motivated to sell the best investment in the universe? Yes. Some of it. The last big bump in bitcoin prices drove the ICO boom. Now they are trying out DeFi. As I note in this article, “The 2017 ICO explosion seems completely irrational, an example of crowds gone wild. However, investors may be perfectly rational when they buy a bag of scammy pump-and-dump schemes. Mathematically, it’s possible to trade a bag of crappy, high volatility assets, and build a portfolio that does better than your best asset.”

Maybe we can find better investments. We might be able to find a portfolio of non-crypto securities that is “uncorrelated”, to smooth out crypto returns. This is the goal of our Notcoin project. Notcoin will be a portfolio of securities that has good returns, and is mostly uncorrelated with crypto.

I’m hoping that the DDI community will help us design and build Notcoin. We want convenient packaging, and we need an appropriate portfolio.

On-chain sales and service

We have good news on packaging. We can deliver Notcoin directly to crypto wallets. Take profits by sending crypto for Notcoin, and buy the dip by sending Notcoin to get crypto.

Notcoin will be a security, so we need to comply with securities laws. We’ll make this easier by setting Notcoin tokens to be redeemable, but not transferrable or tradeable. And, we’ll look up a recipient’s qualifications (KYC, AML, accreditation stuff), hopefully with an existing account.

I’m building a machine that I call “Redeemer” to deliver simple on-chain sales and service.

Portfolio design challenges

We need to find uncorrelated assets for a Notcoin portfolio. Finding uncorrelated assets is hard. Getting “efficient frontier” returns is hard. Getting them with reasonably priced leverage is hard. I’m hoping that the Data Driven Investor community can help out by making some suggestions. Some of you might even be interested in joining the project.

Modern Portfolio Theory (MPT)

MPT tells this story: Investors will bid on assets until expected returns are equivalent. Investors can buy high volatility assets, or they can buy low volatility assets and then use leverage (borrowing) to get approximately the same return and volatility. In this situation, it may be difficult to improve returns by selecting assets.

However, investors can improve their risk adjusted returns by using diversification. They can buy a portfolio of assets that have returns that are uncorrelated. Then they will experience situations where asset A (for example, bitcoin) is going nowhere, but asset B (for example, an S&P 500 ETF) is on average going up.

Money drives correlation

A simple way to think about a portfolio is to sort it into “risk” assets that people buy when they think the economy and money supply will grow, and “risk off” assets that people buy when they think economy or money supply problems are coming. This is the idea behind a portfolio with 60% stocks and 40% bonds. People buy stocks to invest in growth (risk on). They buy bonds when they want to guarantee that they will get money back (risk off). Putting them together gives smoother returns.

The problem with this approach is that every asset is affected by the macro availability of money. When the money available for investment is increasing (and this is has been happening for a LONG time), then every asset gets pricier — stocks, bonds, crypto. Their prices are somewhat correlated. The problem becomes worse when money availability shrinks. This tends to happen in panics like 2007, when everyone cancels loans and issues margin calls. Then asset prices become even more correlated and go down. It’s a truism that in times of stress, assets go to a correlation of 1.

Finding uncorrelated assets is hard.

Negative hedges don’t increase expected return

Under these circumstances you can hedge. You can buy short futures that go up when your other assets go down. This negative correlation has the effect of getting you out of the market and reducing your risk. However, it also reduces your return by getting you out of the market. It does not give you the effect of an uncorrelated investment, which stays in the market and (on average) earns alpha.

We want large-cap liquidity

Notcoin will be an open-ended fund that people can buy and redeem whenever they want. We want to build it from securities that we can easily buy and sell because they have a liquid market.

Correlation moves around

The measured correlations between crypto and other assets change. The approach proposed here will only work if there are longer-than-random periods of low correlation. If correlations are somewhat durable, but move move between high and low correlation, then we will want active management to switch between the regimes.

We need high volatility

Crypto has a high volatility. You might not even notice a change in risk adjusted returns if you put it together with lower volatility assets like most securities. To effectively decorrelate crypto, we need high volatility. So, we will be looking for unusually volatile assets, or more likely we will be looking for inexpensive ways to leverage assets to boost their volatility.

And, crypto buyers WANT high volatility. Their goal with crypto investments is high risk and high return.

Waterfalls can deliver higher volatility

I considered a lot of ways to get high volatility, and one method jumped out for its low cost and flexibility: Waterfalls. We can use waterfalls to divide investment returns into a low-risk tranche, and a higher risk tranche that takes losses and also gets extra returns. In the crypto world, we can even call the lowest risk tranche a “stablecoin”. Please feel free to go crazy with this evergreen idea.

For example, the Halgo Jefferson fund in a waterfall

I presented this challenge to my friend Francois d’Hautefeuille of Halgo. His Jefferson fund checks the boxes for liquidity, consistent performance, leverage, and active risk management. We haven’t calculated the correlation with BTC yet (maybe you can help with that). Securities indexes have reported correlations as low as 0.13.

He provided this backtest of Jefferson (blue) divided into two tranches (grey/stable, and orange/volatile).

The following view includes 50% bitcoin in the blue line. BTC juices the returns a lot. In this carefully selected time period (buying at the last peak in BTC), the return is higher when mixed with the securities fund. So in this period there is a “free lunch” from decorrelation.