A drop in the stock market is not a bad thing for everyone.Of course, many investors will lose money as portfolio values fall, but those who are just starting out or underweight stocks can benefit from lower valuations, which tend to be higher long-term returns.
Naturally, the stock market doesn’t fall for no reason. As the economic environment changes, so do expectations. The positive feedback loop that causes valuations to rise will eventually reverse and turn negative. But at some point, economic and business conditions stabilize and valuations drop enough to attract new investors and lure old ones back. For example, companies with countercyclical business models can increase their attractiveness by raising their dividend payments.
But not all securities markets exhibit the same dynamics as stocks. For example, before the two currencies were merged into the euro, the Italian lira had been depreciating against the German mark for decades, and when hyperinflation started, the currency would become effectively worthless.
So, what about cryptocurrency tokens? Critics have long raised concerns about its intrinsic value, or lack thereof, and there appears to be no relationship between the token’s price and the product it’s supposed to serve as a medium of exchange.
But with nearly 10,000 cryptocurrencies available, security choices should be important. So, is it? Can Token Pickers exhibit differentiated performance?
Probability of making money in cryptocurrencies
One of the more lucrative ways for cryptocurrencies is to invest in private seed rounds of startups seeking token financing. Early-stage prices tend to be at significant discounts relative to public offering prices, comparable to pre-IPO investments.
But according to an analysis of nearly 10,000 cryptocurrencies by London-based asset manager Jackdaw Capital, more than four-fifths of tokens are trading below their initial trading prices.
Crypto Tokens: Current Price vs Initial Trading Price
The odds—that a token will trade on an exchange for more than 20% of its initial listing price—makes token investing challenging. But there are different kinds of tokens. Certain classes may still offer investors the prospect of attractive returns through security selection.
To find out, we constructed a universe of over 3,500 tokens traded today and divided them into 17 categories. The largest category – Non-Fungible Tokens (NFTs) and Collectibles – has 585 components, while the smallest category – Mobile Earning – has only 19. These token varieties represent different crypto products and should be relatively unrelated.
Token Type: By Number
Next, we created equal-weight indices for each of the 17 token classes. Most of our categories are only a few years old, but NFTs and masternodes dating back to 2013 have nearly a decade of track record.
Most of these indices yield so high performance that we need a logarithmic scale to measure them. This explains much of the appeal of cryptocurrencies: the potential for 1,000% annual returns is irresistible.
Token Performance by Type
But over the past few months, the cryptocurrency market has had a rough time. As of this writing, its total market capitalization has fallen from nearly $3 trillion to less than $1 trillion, while Bitcoin has fallen from an all-time high of $69,000 in November 2021 to $20,000.
Still, the 2022 cryptocurrency crash is barely recorded on the log charts, as the coin index uses average returns and equal weights for index calculations. The coin exhibits such high positive skewness that the average return has risen much more than it has fallen. Terracoin (TRC-USD), for example, surged from $52 to $2,535 in just a few days in 2013. The coin has a maximum loss of 100%, but the upside could be parabolic.
Crypto Volatility: TRC’s Performance
Adjust the token performance according to the actual situation
However, since the average investor cannot participate in every token sale, the average return is not an accurate measure of the performance of the token index. Median returns are a better indicator. It tells a very different story.
All 17 token types have lost money for their investors since the index’s inception.
The performance varied between 2013 and 2018 (the peak of the first crypto bull market), although only a few coins traded. Some token types—such as governance—have performed well relative to NFTs. However, from 2017 to 2018, hundreds of initial coin offerings ((ICOs)) occurred. Many of these are speculative at best. Others are outright scams.
All token varieties have continued to decline since 2018. Despite their different purposes and ostensible business models, all types of tokens follow the same downward trajectory. This means that security choices don’t really matter in the crypto space.
Also, our universe is made up of tokens that are still being traded and therefore contains some survivorship bias. As a result, returns are slightly inflated, which makes the outlook even more negative.
Token Performance by Type: Median Return
Inflation and Deflation Tokens
But maybe these bearish results aren’t as bad as they seem. What happens if we differentiate between cryptocurrencies with limited supply (like Bitcoin) and cryptocurrencies with no supply limit (like Ethereum)? Bitcoin and other tokens with a limited supply can have a deflationary effect, especially when issuers buy back tokens, while an unlimited number of tokens can lead to inflation as more and more tokens contribute to the token price Downward pressure.
We divided the 550 DeFi tokens in our universe along these lines and found little difference between the two varieties from 2018 to the present. The so-called deflation-limited supply coins actually performed worse.
DeFi Token Performance: Finite vs Unlimited Token Supply
Fund managers struggle to create value through securities selection in stocks and other traditional markets. Alpha generation has been low to negative for the past few decades. In theory, the new and complex world of cryptocurrencies should offer a wealth of information asymmetries that sophisticated investors can take advantage of.
But unfortunately, in the investment world, theory and reality often collide. All kinds of tokens show the same negative performance trends, making it a challenging environment for security selection.
Ordinary cryptocurrency hedge fund managers only provide exposure to Bitcoin. Investors can efficiently replicate such exposures at low cost through exchange-traded funds (ETFs).
The new world is much like the old world.
Disclaimer: Please note that the content of this site should not be considered investment advice and the views expressed do not necessarily reflect the views of CFA Institute.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.