Crypto factor investing. Really

Not everyone loves factor investing. Many see it as a silly marketing gimmick gussied up with fancy maths to give often muddled results a thin veneer of scientific respectability.

However, even if you don’t invest money using factors — and most people shouldn’t — factors are still a flawed but decent framework to understand financial markets. As the statistician George Box said, all models are wrong, but some are useful.

That said, this is just deeply silly:

Over the past fifteen years, crypto has matured into a full-fledged asset class with hundreds of liquid tokens. However, most crypto allocations are still 100% Bitcoin. We believe proper asset-pricing models can help investors seeking to diversify beyond Bitcoin. Adapting traditional equity “factor investing” to crypto, we build a Four-Factor Model with crypto market, size, momentum and intangible value factors. These factors exhibit historical excess returns and can be implemented in simple long-only crypto portfolios.

Here Alphaville has to pause and shout into the void . . . 

PLEASE CAN WE ALL STOP CALLING CRYPTO AN ASSET CLASS IT’S JUST A COLLECTION OF ABSOLUTE BULLSHIT

. . . OK. With that out of the way, let’s return to the actual report. It’s written by Sparkline Capital’s Kai Wu. He’s a smart guy who actually does produce interesting research, some of which underpins a $32mn value ETF that incorporates intangibles. Wu used to work at GMO, where he presumably picked up the value bug.

But surely he didn’t pick this up over at GMO:

On Jan 10, 2024, crypto achieved a milestone in its journey to becoming a mainstream asset class. On this day, Bitcoin exchange traded funds (ETFs) were approved for listing on US stock exchanges. In the weeks that followed, $50 billion in shares were traded, resulting in $5.2 billion in net inflows.

Bitcoin ETFs broaden access to the asset class, enabling spot crypto ownership in the comfort of a traditional brokerage account. These products are helpful not only for retail investors, but also for highly sophisticated financial advisers with stringent custody and reporting requirements.

In addition, the Bitcoin ETF marks a symbolic embrace by the financial establishment. Many of the largest and most important players in the traditional financial system, such as BlackRock, Fidelity, JPMorgan, and NYSE, are involved in the issuance of these products. Crypto is now for adults. 

It’s incredible that this needs to be spelt out, but the only reason why the likes of BlackRock, Fido, JPM and the Big Board have gotten involved is because they are in the money extraction business.

Sure, there will be some muppets true believers at each institution, but the “adults” are involved only because a mix of regulatory fragmentation, lethargy and incompetence means the money they can make now outweighs the risks (or in the case of Franklin, a Hail-Mary pass was needed to fend off irrelevance). Dealers don’t “believe” in crystal meth, they’re just supplying something people will pay a lot of money for. If it was legal, you could probably tweak at your local wealth-management office.

Back to the paper. Like a lot of smart quants, Wu seems to think that everything that trades can, should and must be systematically categorised. Here is his attempt at shoehorning useless hopium into a useful but flawed framework from equity investing:

Wu sets aside mainstream factors like (traditional) value and quality because:

Cryptocurrencies are highly intangible, deriving their fundamental value from intellectual property, brand equity, human capital, and, perhaps most importantly, network effects. As such, they lack meaningful book value. We also set aside the quality factor, as most of these early-stage projects do not yet have well-defined profitability metrics.

Somehow this doesn’t lead him to question the entire premise. Is there one single crypto token with a “profitability metric”, or any sort of clear value beyond what someone else is willing to pay for it? We might as well come up with a factor framework for rare stamps. (And unlike crypto, stamps have a clear use in day-to-day life.)

Does it work though? Wu finds that his own intangible value factor is the best performing “crypto factor”. After that are the market factor (buying all of the coins) and then “small-caps” — what we might otherwise call the shitcoin factor:

Of course, what Wu really shows is this: of thousands of made-up digital widgets sold to the desperate, the feckless and the greedy, some have gone up in “value” since 2017. And if you make some enormous assumptions, ignore all the obvious caveats and feed the data into a factor framework, you will discover that some “factors” perform better in crypto.

With all that said, Alphaville is sure that the first “smart crypto beta ETF” 🤮 is in the works.