Alfa Leak: What is Alpha?

Level 3 - Virgin DeFi Analyst

Welcome Avatar! Today, we cover a term we see thrown around liberally in the crypto world. The often misunderstood and even more elusive - The Alpha.

No, not like this:

Here you see a dominant silverback gorilla in his natural habitat. He must lead the group’s daily travels and activities, keep the group cohesive, and defend the group from outside intruders.

We’re talking about this:

Sweet, sweet alfa

Alpha, in textbook terms, is a measure of the performance of an investment when compared to a representative benchmark. In traditional financial markets, the S&P 500 is a commonly used benchmark to compare against stock or fund performance.

Why is it relevant?

If a passive investor in the S&P outperforms your actively managed investments, then you were better off in the S&P. Alpha was invented to measure excess returns. An example:

• Investor A buys the S&P and earns 10% return

• Investor B buys 3 tech stocks and earns 12%

• Investor B generated alpha of +2

If you’re a believer of the efficient market hypothesis then you believe generating alpha consistently is impossible (doubt that’s anyone reading this, otherwise you wouldn’t be here!).

Of course, returns are only as good as the risk taken to achieve them. There are plenty of cowboys in the investment world who run it up hot with excessive leverage and risky gambles that crash and burn when a trade turns against them in a big way (Melvin Capital & Gamestop being a famous example).

Beta

That brings us to the next item - beta. Beta is the volatility of your investment or portfolio relative to an index. A beta of 1 means the investment’s volatility on average performs exactly in line with the index. In the case of the S&P, stocks like Walt Disney, Google and Visa have a beta of close to 1. Negative beta would mean the investment moves inverse to the index, and zero beta means no correlation. Higher beta in absolute terms (yes, it can theoretically be negative) means higher volatility and theoretically higher risk.

Fun question: what is the beta of a coin flip? Let us know in the comments below.

Relevance for Crypto

There are two primary ways alpha and beta can be applied to crypto. The first is understanding crypto’s risk/return profile relative to equities, and the second is understanding the risk/return profile of alternative cryptoassets relative to a crypto benchmark.

Our view is that BTC (and perhaps ETH in the future) should be compared to equities, and alpha and beta for cryptoassets should be measured against BTC. If you’ve been a long time reader, this is probably not news to you.

If your crypto portfolio is up 10% against BTC when the market is strong due to buying higher beta altcoins but you end up down 20% against BTC when all is said and done, that’s negative alpha. That’s why in the long run, you need to understand what you’re buying (or take profits liberally!).

Generating alpha over requires that you understand crypto, DeFi and the nature of what it is you’re investing in. You may get lucky on some trades following along on Twitter, but sustained outperformance requires an edge.

On Correlation

In general, crypto tends to be quite correlated within the asset class. BTC-ETH in USD have been highly correlated since Q1 2018, as you can see below:

Autist note: correlation and beta are not the same thing. Correlation tells you the strength of the linear association between the two variables. Beta tells you the *size* of the effect.

According to research from quant fund Two Sigma, they found Bitcoin’s beta to global equities to be 0.74, but with a much lower correlation at only 18% from January 2015 - March 2021. The higher beta was due to differences in volatilities (~15% annual volatility for Equity and ~73% for Bitcoin).

They also looked at the rolling 60 day correlation and found that the correlation was higher for much of 2020 and Q1 2021.

Since June 2021, the correlation between BTC and the S&P 500 has continued to increase. This makes sense intuitively. As BTC becomes more widely owned by all kinds of investors it will become more correlated with tech stocks, which make up an ever increasing proportion of traditional benchmark indices. Is there a case to be made for BTC “decoupling” in the future? Sure. However, we do not see that today.

Summary

• Alpha is about generating excess returns relative to a benchmark

• Alpha can be both positive (outperformance) and negative (underperformance)

• Beta is a measure of volatility relative to a benchmark

• Beta can be positive, zero, or negative

• Our opinion is that the two key benchmarks to monitor for crypto are 1. BTC and 2. BTC-S&P

  • Potentially ETH in the future

• BTC and thereby crypto more broadly is becoming more correlated with equities

We hope you enjoyed that lesson on alpha and beta. If you haven’t already, join our community of DeFi enthusiasts below for more.

Until next time…

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Disclaimer: None of this is to be deemed legal or financial advice of any kind and the information is provided by a group of anonymous cartoon animals with backgrounds in Wall Street and Software.