Bringing you live news and features since 2013
Bringing you news, views and analysis since 2013
Dramane Meite
Dramane Meite, Hashdex

46679

Gaining momentum: Factor-based investing emerges in crypto

RELATED TOPICS​

Dramane Meite, CFA, International Head of Product at crypto firm Hashdex, writes that portfolio managers have one core mission: find ways to generate returns that are repeatable and consistent with their investors’ risk appetites. 

This, of course, is not an easy task. But as investing has evolved alongside technological developments, data access has allowed for new tools and resources that can help investors generate above-market returns. 

One of the outcomes of this decades-long evolution has been factor-based investing. This type of strategy leverages variables (factors) that provide a quantifiable signal about an asset’s performance. A value factor provides a signal about a stock’s relative price, a growth factor provides a signal about its growth prospects, and so on.   

Factors deviate from the efficient-market hypothesis (EMH) in that they exploit the fact that an asset’s price may not reflect all of the information available about that asset. As a result, many academics consider factors to be “anomalies” that shouldn’t exist within efficient markets. 

The momentum factor, which tracks an asset’s recent price trajectory and provides a signal about its future price, is arguably the most well-developed. Famed economist Eugene Fama, credited with the popularity of EMH, has called momentum the “premier anomaly” because of its predictive capabilities.  

Momentum’s popularity is justified. The use of this factor has a long history of proving its worth in traditional financial markets. There is evidence of momentum trends in global financial markets going back more than 200 years and—more recently—momentum strategies have outperformed comparable market cap-weighted equity benchmarks over the last two decades.

But can this type of investment strategy be applied to a developing industry like crypto?

Let’s look at the data. 

An emerging but data-rich asset class 

This month is the 14th anniversary of the publication of the Bitcoin whitepaper. Since the launch of the world’s first cryptocurrency, the industry has evolved from an isolated passion project to a global industry with use cases touching every sector of the economy. 

As the crypto ecosystem has developed, there has been a steady increase in both crypto asset liquidity and data availability. This is allowing for increasingly sophisticated investment strategies. While little empirical research has been done on factor-based investing in crypto, we believe the momentum factor is an incredibly informative signal that can be applied to digital assets. 

Momentum is particularly informative because of the inherent human biases that have been part of its investment landscape since crypto’s early days. These biases are rooted in human behavior, so unless humans collectively make a sudden dramatic shift in how we respond to information, these biases will persist. And these are the behaviors that a momentum strategy can help exploit. 

Philip Fisher, one of Morningstar’s “great investors of all time” and author of the classic investment book Common Stocks and Uncommon Profits said, “The stock market is filled with individuals who know the price of everything, but the value of nothing.” 

This quote is as true in crypto as in the stock market. That is, investors’ collective focus is often misdirected and easily swayed.   

We’re all familiar with investor herding in crypto markets and the large daily price movements that can follow an influencer’s tweet or speculation around the Fed’s next policy move. It’s very common for people to hear about specific crypto assets from their friends, family, or social media. This type of information dissemination feeds into a cycle of FOMO and herd behavior, and, in turn, impacts the price of these assets. 

In addition, crypto has a number of unique attributes relative to other global asset classes, including that it can be traded around the clock, 365 days of the year. Idiosyncratic features like this make crypto particularly vulnerable to herding, groupthink, and other investor behaviors.

These behavioral biases make crypto ripe for the application of the momentum factor. 

Finding momentum’s value in crypto 

The momentum factor can be applied to investment portfolios in many ways. A long-only approach in which assets are evaluated based on relative short-term price performance may be the most effective way to create excess return opportunities in a crypto portfolio. But as with any crypto investment strategy, there should be risk controls and strict asset eligibility requirements. 

Risk mitigation is important because short-term price volatility will remain a fixture in crypto for the foreseeable future. Risk controls can help limit the risk contribution from individual crypto assets and ensure that smaller assets with higher volatility profiles do not create unnecessary portfolio risk. While the momentum factor can be a potentially effective driver of return, without a balanced approach to risk a portfolio will be less resilient over time. 

Despite the current crypto winter, this is an industry with rapidly developing fundamentals. Going forward, while it remains clear that crypto assets are going to become increasingly liquid and tradable, generating investment returns from these assets will grow increasingly complex. As this ecosystem continues to mature, an effective momentum investment strategy can help investors capitalize on the development of this industry.  

Latest News

MSCI has launched MSCI AI Portfolio Insights, writing that it combines generative artificial intelligence “GenAI”..
The Capgemini Research Institute’s World Wealth Report 2024, published today, reveals the number of high-net-worth..
New research from cloud security firm Zscaler reports a disconnect between European company confidence in..

Related Articles

graph
The exodus from hedge funds continues with investors questioning unswayed by relatively strong performance from the alternative asset class...
The exodus from hedge funds continues with investors questioning unswayed by relatively strong performance from the alternative asset class...
Waves
A joint statement from BNP Paribas Asset Management, Federated Hermes Limited, Mirova, Robeco and Storebrand Asset Management has been published, entitled The urgent need for better ocean-related data to make informed investment decisions...
A joint statement from BNP Paribas Asset Management, Federated Hermes Limited, Mirova, Robeco and Storebrand Asset Management has been published,..
Frozen soap bubble
From the end of this month, the UK’s Sustainability Disclosure Requirements (SDR) regime comes into force which the Financial Conduct Authority says has a simple aim: “Financial products that are marketed as sustainable should do as they claim and have the evidence to back it up.”..
From the end of this month, the UK’s Sustainability Disclosure Requirements (SDR) regime comes into force which the Financial Conduct..
Global ESG Investing
On May 15 Florida’s Republican Governor Ron DeSantis signed legislation that furthers his ongoing campaign to oppose the role of climate change and ESG factors in state policymaking...
On May 15 Florida’s Republican Governor Ron DeSantis signed legislation that furthers his ongoing campaign to oppose the role of..
Subscribe to the Institutional Asset Manager newsletter

Subscribe for access to our weekly newsletter, newsletter archive, updates on the site and exclusive email content.

Marketing by