Bitcoin - Lessons from the Trenches

Back in November 2021, when Bitcoin was at $68,000, I was working with a client on a hedged cryptocurrency product to market to institutional investors. The idea was to implement a hedge overlay comprising a portfolio of various futures contracts, including VIX an 10-Year Notes, that would smooth out the volatility of BTC and reduce the tail risk.

I developed an algorithm that applied machine learning techniques to create a dynamic hedge portfolio that adjusted according to changes in the correlations between the underlying assets (see for instance Dynamic Hedging, Taleb) . The approach seemed promising: we were able to show a 50% reduction in annual volatility and maximum drawdown, with an increase in the Sharpe ratio from around 1 to 2. "In other words", I told the client, "by holding BTC alone the investor is taking unnecessary risk equating to an additional 33% in annual volatility for which he is not being compensated, since it can be diversified away. With this hedge overlay we are able to produce around the same annual rate of return with a little over half the annual volatility and drawdown."

A compelling argument, you might think, especially in the light of the ensuing market crash over the last several months, an event that was all too foreseeable. However, as I explained to my client, investors tend not to think that way. If a market has produced the kind of returns that BTC has, it would take a large amount of TNT to dislodge them from their long-only, buy-and-hold approach. Even when the hedge is effectively costless, as here, producing the same returns with less risk, investors for the most part would rather close their eyes and continue to hold on, in the hope of achieving some magic valuation like $100,000. True Believers in cryptocurrency give the impression that they regard hedging as some kind of admission of defeat, rather than a prudent implementation of risk control. Typically, such investors only become interested in "hedging" after losing a sizeable portion of their net worth.

I saw the exact same behavior with "New Paradigm" investors at the peak of the tech bubble in 2000. There was just no way to talk them down from the 100x PE multiples they clung to as the market tanked, decimating their portfolios.

The only cure, it seems, is a large and rather harsh dose of economic reality.