Is Your Portfolio Ready for a Market Correction? Comparing Hedge Funds and Self-Managed Investments (SMIs)

Given the shakiness of current markets investors may be taking a second look at their portfolios to check they are ready in case of a significant market correction.  In doing so they may wish to consider a new asset class called Self-Managed Investments (SMIs).  Built on blockchain technology SMI’s can be considered a tokenized hedge-fund.  In theory the same investment strategy, for instance, a long/short equity strategy can be packaged as a traditional hedge fund or as an SMI.  However that may be where the similarity ends.  Even based on the same underlying strategy a hedge fund and SMI have very different risk profiles for the investor.  Indeed the original motivation for SMI’s was to enable a return to Genuine Portfolio Diversification (GDP) by eliminating the unavoidable systemic and counterparty risk of the traditional hedge fund.  In this article we look at the pros and cons of each approach.

The Pros and Cons of a Hedge Fund

The purpose of a hedge fund is to give investors access to the expertise of the manager in order to provided returns not otherwise available.  Investors place funds with the manager for them to trade on their behalf.  In return for this service managers generally charge a 2% annual management fee and a 20% performance fee based on returns above a high water mark.  The hedge fund may only be available to certain “accredited” or “sophisticated” investors.  There may also be a lock-up period before funds can be withdrawn.

Hedge Funds Carry Counterparty and Systemic Risk

Because the manager trades various financial instruments a hedge fund is necessarily exposed to the risk of the failure of their broker, clearing house, bank or other counterparty required for the trade.  This risk can be managed with the proper due diligence but cannot be eliminated.  Perhaps more importantly for the investor looking at the robustness of their portfolio in the event of a market correction, the need for counterparties also exposes them to the systemic risk of market collapse. 

Systemic Risk is the Result of Dependencies in the Financial System

Systemic risk goes to the heart of the problem for the investor.  When markets collapse the correlation of assets tends to approach 1.  That is to say, they all fall together.  The reason for this is because they are all part of the same fiat financial system.  Under normal conditions each asset in a portfolio may look uncorrelated with others.  However during a market event the interconnected dependencies of the financial system reveal themselves through the general fall in prices.

This inter-dependence can also be viewed from a design perspective – the way today’s fiat system is actually built.  The dependencies of the system are the result of the overwhelming majority of assets being derivatives.  Derivatives are any financial instrument whose value depends upon another instrument.  The low end estimate of the size and scope of the global derivative market in 2017 was $544 trillion on a notional contract basis.  By way of comparison, the GDP of the United States is around $20 trillion a year.

“In my view derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Warren Buffet

Because the value of derivatives depends upon the value of another asset, this creates dependencies between institutions.  The solvency of banks, insurers, brokers and clearing houses depends on underlying assets held by other institutions.  If one institution fails there may no longer be access to the underlying asset it held.  This can cause the institutions it has traded with to themselves become insolvent.  The problem repeats itself throughout the system resulting in general market failure.

”…there is no dispute that nowadays systemic risk inseparably belongs to the main issues associated with modern financial systems…. Interdependencies among financial institutions are a hidden threat to the financial system as a whole.” Jana Procházková.

Systemic risk is not simply a theory.  On 15th September 2008 the failure of Lehman Brothers brought the fiat system to its knees for this very reason.  The system survived through massive bailouts and the expansion of money supply by US, Japanese and European governments.  The event raised important questions for any portfolio:

-          Should the value of the portfolio depend upon the viability of a system already shown to be fragile?

-          Will government always be able to bail the system out?

A recent analysis by Donald Amstad at Aberdeen Standard Investments suggests central banks have run out of ammunition in terms of lowering interest rates or increasing money supply to defend another event.

The Implications of Systemic Risk for Portfolio Diversification

2008 graphically demonstrated that the fiat financial system is ONE system.  No matter what assets are in a portfolio if they are part of the fiat financial system then during a market correction they provide very limited protection at exactly the moment when diversification is supposed to deliver value.  Hedge funds through their counterparties are a necessary part of this correlated unity and the systemic risk it expresses.  That is to say, a hedge fund cannot help a portfolio diversify away from fiat systemic risk

Not all Assets are Exposed to Systemic Risk

I say “fiat” because through the development of currencies based upon blockchain technology such as Litecoin, Monero, and Bitcoin there now exists a form of finance that is independent of the fiat system.  These currencies are non-collateralized, meaning that their value is not dependent upon any other asset.  Further, because ownership is secured on a decentralised ledger – the blockchain – there are no counterparty requirements for that value.  In short, blockchain based currencies are immune to both counterparty risk and the systemic risk of the fiat financial system failing.

Needless to say this means the inclusion of crypto-currencies into a portfolio represents genuine diversification.  Assets have been allocated that are NOT part of the fiat system.  During a market event they are unlikely to be part of the general correlation of falling prices.

How SMIs are Built

SMIs use the same design features of digital currencies. They are non-collateralized tokens whose ownership is secured by the blockchain.   This enables them to deliver returns from an investment strategy without counterparty or systemic risk. 

The way they do this is through two design features:

·          SMIs run a simulated strategy rather than actually trading financial instruments.

·         They expect token holders to maintain the value of tokens at the price of the simulated returns.

The reason for a simulated strategy is to avoid counterparty risk.  Any trading of assets would entail counter party risk.  If those assets or the intermediaries involved with the trade were part of the fiat system, the SMI would carry both counterparty and fiat systemic risk.

Instead the trades are irrevocably time-stamped (again using a blockchain) to guarantee the trade was made before the results are known to avoid fraud.  Once the trade is complete the result is published as if the trade had taken place but without slippage or fees.  The result is a “Target Price” that the tokens are expected to trade at.

Investors purchase tokens at the Target Price in the expectation of participating in the returns of the simulated strategy.  Because the only reason to hold the tokens is to trade at the Target Price it is in the interest of investors to do this.  This self-interest keeps the tokens pegged in the same way that the value of gold was kept stable for thousands of years to provide a stable means of exchange.

Bitcoin Enhanced, a long/short Bitcoin strategy is the first example of this SMI structure.  Its website shows these design elements in operation.

Downsides to the SMI Approach

The great benefit of the SMI approach is the ability of the asset to provide genuine diversification to a portfolio.  This robustness is likely to be much appreciated during a market event.  However, the SMI approach has the downside that should the investment strategy fail or there is loss of liquidity for another reason, the investor may not be able to exit the position

SMIs Carry Redemption Risk

Ignoring lock-in periods, a hedge fund investor can withdraw their funds if performance is poor.   Investing in a SMI is likely to be a more all-or nothing proposition if returns head south.  In short, the very independence that confers the benefits of the SMI approach carries redemption risk.  Unlike a hedge fund where a manager has an on-going responsibility to the investor, the issuer of SMI tokens has no further obligations expect to report the returns of the simulated strategy.

A lack of liquidity in a SMI can also affect the early start-up phase of the token.  Until there are sufficient investors willing to buy the tokens at the Target Price, the investor has no option but to wait for liquidity to improve before exiting.

Hedge funds are not immune to liquidity issues.   However these depend upon market conditions and the instrument being traded.   With SMI’s redemption risk is present because of the non-collateralized structure of their design.

Countering Redemption Risk with Greater Diversification

Redemption risk may at first sight appear to be a major drawback to the SMI approach.  However from the point of view of an investment portfolio it is likely not to be.  The reason for this is because diversification works precisely because there are independent assets that can fail without jeopardizing the value of the entire portfolio.  You just need enough of them to make the failure of any single asset negligible.

This approach to risk is taken by firms like Google and Amazon.  Both companies have server-farms made up of millions of servers to deliver their services to customers.  Daily a portion of servers fail but because the tasks are distributed across the entire network no single failure is critical to the on-going operations of the companies.

Genuine portfolio diversification can only work on the same principles: contain enough independent assets so that the failure of any does not catastrophically destroy value. 

Redemption Risk or Systemic Risk?

The problem with the hedge fund structure from a diversification point of view is that investors never leave the fiat system.  This is analogous to Google or Amazon running their services on a single super-computer, something no executive would contemplate given the risk of catastrophic failure. 

The greater liquidity of a hedge fund under normal market conditions makes the structure appear to carry less risk for a portfolio than an SMI.  However the systemic risk of market collapse remains ever present.  During a market event investors may not be able to exit their hedge fund position through institutional failure and loss of liquidity in the assets being traded.  That is to say, both the SMI and Hedge Fund approach carry redemption risk, but for very different reasons.  This suggests a mix of hedge fund and SMIs, even if based upon the same strategy, can build robustness into a portfolio.

The key to mitigating the redemption risk of the SMI approach is to have enough SMI’s in the portfolio so that if value in any token cannot be redeemed at any time the value of the portfolio as a whole is not at risk.

Return Profile of a Traditional Hedge Fund and the SMI Approach

Finally, no comparison of the hedge fund and SMI approaches would be complete without comparing the return profile of each.  Because SMIs have no fees the returns from holding tokens significantly outperforms a hedge fund version of the same strategy. 

For example if $100 was invested into a strategy that returned 20% per annum, after 10 years the SMI structure would have returned $619 compared to $379 for a hedge fund with a 2% management and 20% performance fee structure (returns reinvested).  This represents a 35% increase in returns over the 10 year period.  By year 20 the SMI is returning 180% more than the hedge fund.

 

Graph comparing returns of an SMI with a hedge fund from the same strategy

Summary

The fiat financial system has become a system of dependencies.  This singularity has undermined the traditional approach to portfolio diversification and exacerbated the risk of systemic collapse.  The only way to diversify away from the systemic risk of the system is to hold assets of independent value.  SMI’s are a new asset class that achieve this independence through blockchain technology. 

The same investment strategy can run as a hedge fund or an SMI with consequently very different risk profiles for the portfolio.  The advantage of the hedge fund is that, discounting lock-up periods, under normal market conditions investors can readily withdraw their funds.  This liquidity may not be available in an SMI, especially in the early stages of the asset or in the event of poor performance.  This makes investing in an SMI more of an “all or nothing” bet than a hedge fund.  However during a market event the situation is reversed: liquidity may not be present to exit hedge fund positions yet SMIs are likely to remain unaffected.

 

Table comparing the benefits of hedge funds and SMIs for a portfolio

The redemption risk of SMIs can be mitigated though greater diversification.  In the same way that Google relies on many independent servers to deliver its business, a portfolio can reduce redemption risk by holding multiple SMIs or other assets such as commodities or property with independent value.  In other words holding SMI’s not only reduces systemic risk from a portfolio, by their very nature they encourage greater diversification.

Because there are no fees associated with SMIs returns are greater than with a hedge fund, even if the same strategy is being traded.