What Is A Smart Beta Model In Crypto? Benefits And Risks

13 MIN READ
What Is A Smart Beta Model In Crypto? Benefits And Risks

In recent years, financial asset managers, hedge funds, and institutional investors have increasingly adopted smart beta models to enhance advanced strategies based on systematic investing, mixing active and passive portfolio management's benefits. These strategies are still mostly limited to the traditional stock markets since there are some complexities in implementing them in the crypto market. However, some of the best traders and a few advanced platforms are implementing these advanced models in their crypto strategies. But what is a smart beta model in crypto exactly?

It is an investing strategy that leverages specific factors such as value, momentum, and volatility to outperform a specific benchmark. These smart beta models are based on developing strategies based on predefined parameters and systematic investing, aiming to generate higher returns compared to the benchmark while improving risk management and reducing volatility at the same time.

As you may understand, it's not an easy investing strategy, but research and statistics have proven that the most profitable hedge funds and asset managers are obtaining good results, in most cases outperforming the target benchmark index. To apply these models in crypto, you should implement a rules-based selection of crypto assets and a non-marketcap-weighting approach while also considering diversification, reduced volatility, and periodic rebalancing.

We are very dedicated to research, analyze, and explain the latest market trends and strategies to our users. At PlasBit, we believe the crypto education is the most important factor in Web3, and we'll debunk and explain how to implement these systematic strategies in crypto trading, evaluate the benefits and risks, and create a case study.

Systematic Investing: What is a Smart Beta Model in Crypto?

In traditional finance, smart beta models allow the implementation of systematic, rule-based trading, creating a portfolio that should outperform a referred benchmark while improving diversification and implementing sound risk management. What is a Smart Beta model in crypto and what are its goals? Smart Beta is basically focused on investment strategies that leverage specific factors to drive returns, such as value, momentum, size, quality, and low volatility. This strategy is usually implemented through sophisticated algorithms in advanced ETFs dedicated to institutional investors, but solutions for retail crypto traders are emerging, and it's possible to implement a simplified smart beta strategy manually as well. It may seem complicated: before analyzing in detail the factors behind smart beta models, let's clarify with an example.

Let's assume you consider Bitcoin's performance the main benchmark of the crypto market. You could simply invest in Bitcoin, but you are scared of volatility and risks associated with crypto investing, and you want to minimize risks and reduce volatility while seizing the opportunities effectively. This is the perfect situation for implementing a crypto smart beta model based on momentum trading. Here is a practical example:

[Timeframe: 4 weeks]

Benchmark (Bitcoin) performances:

Week 1 - BTC: +5%

Week 2 - BTC: +5%

Week 3 - BTC: -1%

Week 4 - BTC: -8%

If you've "simply" invested in BTC, you would have performed +0.41% over these 4 weeks. Instead, if you use a smart beta model based on momentum, you would probably sell at the end of the second week, based on predefined parameters, considering that the asset could have reached chart resistance. Using momentum, you should have rebalanced your portfolio at the end of the second week, selling all or part of the BTC allocation. Consequently, this would be a possible performance of a Bitcoin Momentum smart beta strategy:

Week 1 - BTC: +5%

Week 2 - BTC: +5%

[Sold your BTC allocation based on predefined metrics]

Week 3 - BTC: -1%

Week 4 - BTC: -8%

[Buy more BTC at a lower price based on predefined metrics]

As you might understand, compared to the benchmark, instead of performing +0,41%, you would have performed +10,25%. Well, this is only a simplified basic example, but you can already understand the potential of smart beta models to try to outperform the market's benchmarks while reducing risks and volatility, using both active (when selling) and passive (when HODLing) management.

A Step Back: What do Alpha and Beta mean?

Before analyzing the specific factors behind smart beta models, let's clarify what Alpha and Beta are in finance.

Alpha: Active Management for Higher Returns

Alpha is a financial metric that measures if and how a portfolio outperforms a specific benchmark. Consequently, it measures the ability of the fund manager to select and ponder the assets that could bring better results compared to the benchmark. A positive Alpha means that the portfolio outperformed the benchmark, obtaining higher returns. On the contrary, a negative Alpha means that the portfolio underperformed the benchmark, with lower returns and performances.

This approach is active, which means it is based on the subjective choices of the fund managers. For example, if you decide to focus on Memecoins tokens to outperform Bitcoin, you're trying to implement an Alpha strategy. As you can understand, it's not easy because it requires financial knowledge, blockchain expertise, advanced trading skills, time for periodic rebalancing, efforts, and a carefully planned strategy. That's not all, because often, in crypto, you should apply this strategy using various wallets and blockchains, making it complicated and not user-friendly to implement Alpha approaches.

Benefits of focusing on positive Alpha portfolio models

  • Potential for outperforming
  • Risk-adjusted returns

Disadvantages of focusing on positive Alpha portfolio models

  • Higher costs
  • Complex strategies
  • Time-consuming

Approaches to Generating Positive Alpha

  • Stock Picking: Identifying undervalued or overvalued stocks through fundamental analysis to capitalize on mispricings.
  • Market Timing: Making strategic decisions about when to enter or exit the market based on predictions of future market movements.
  • Sector Rotation: Shifting investments between sectors based on their anticipated performance relative to the overall market.
  • Arbitrage: Exploiting price differentials between related securities or markets to earn a risk-free profit.
  • Quantitative Models: Using statistical and mathematical models to identify investment opportunities that can generate positive Alpha.

Beta: Evaluating Portfolio Volatility and Risks

While Alpha measures the returns, Beta focuses on volatility compared to a specific benchmark. For example, if the benchmark has 10% range volatility over 10 days, while your portfolio has 5% range volatility over the same period, it means your portfolio has a Beta=0,5 compared to the benchmark, meaning that the portfolio's volatility is half of the benchmark. Consequently, with a Beta lower than 1, the risks are less compared to the benchmark since volatility and oscillations are less impactful.

If Alpha is an active approach based on trying to obtain higher returns, focusing on lower-than-1 Beta means adopting a defensive strategy, looking for reduced volatility and risk. It's basically a passive approach, focusing on systematic action based on market trends and price performances.

Benefits of focusing on lower-than-1 beta portfolio models

  • Less volatility and risks
  • Capital preservation
  • Suitable for conservative investors

Disadvantages of focusing on lower-than-1 Beta portfolio models

  • Lower potential returns
  • Limited capital appreciation

Approaches to Achieving Lower-than-1 Beta in Cryptocurrency

  • Large-cap Cryptocurrencies: Focus on large-cap cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH), which tend to have lower volatility compared to smaller altcoins.
  • Index Funds or ETFs: Invest in cryptocurrency index funds or ETFs that track baskets of cryptocurrencies with lower volatility profiles.
  • Volatility Hedging Strategies: Use derivatives or options strategies designed to hedge against cryptocurrency price volatility, thereby reducing overall portfolio Beta.

Smart Beta: Historical Background

During the early 2000s, most professional investors were using an active approach based on Alpha to try to outperform the market's benchmarks. However, it requires active management, time, and deep expertise. On the other hand, investors looking for a passive approach preferred investing in traditional passive indices, such as the S&P 500, which is weighted by market cap, meaning that larger companies have a greater influence over the index's performance.

To overcome these limitations, financial research and investing firms started exploring trading strategies that mix these two approaches, allowing for semi-passive management while trying to outperform the market's benchmarks.

The first Smart Beta strategies were created and tested around 2005, but it's only in recent years that these models have become standards for investing firms and institutions. The proliferation of exchange-traded funds (ETFs) tracking smart beta indices further accelerated its adoption. These ETFs provided investors with easy access to diversified portfolios based on specific factors, offering a transparent and cost-effective way to implement smart beta strategies. In our PlasBit research, we highlight that if these advanced models were designed mostly for equities, the principles are also being applied to other asset classes, including, in recent years, cryptocurrencies. The migration of smart beta strategies to the crypto market is a natural extension of this evolution since traditional market-cap-weighted indices are not very suitable for the volatile and risky crypto market.

What is a smart beta model in crypto?

Types of Smart Beta Strategies in Crypto

Smart Beta models include various strategies that aim to outperform benchmarks while reducing volatility at the same time. Some strategies are more conservative, while others are more growth-oriented: every investor should decide their own strategy based on their needs and financial situation, considering various factors like time available, financial goals, timeframe, budget, and more. What is a Smart Beta model in crypto, and are the strategies suited for all kinds of investors? No strategy suits all investors, and everyone needs to accurately consider subjective factors before deciding which one to use. The most common Smart Beta strategies are based on:

Momentum

It's one of the most popular smart beta models, and it's based on the fact that stocks that have performed well recently would likely continue to follow their trends. It is basically the approach used by swing traders but executed more professionally based on predefined parameters and systematic investing. As we explained in the example of the first chapter, using a smart beta momentum strategy can allow us to perform better or similarly to the benchmark during uptrends while reducing price drops during downtrends. Based on technical analysis mainly, in fact, investors using this strategy hold the asset until it reaches a local peak and sell it when technical indicators, such as RSI (relative strength index), MFI (Money flow index), and fear and greed index, show that the trend is starting to change, indicating both the speed and size of price changes. In this way, investors aim to outperform the benchmark by following its trend during positive moments while selling and holding stablecoins during downturns.

Value

In this strategy, investors rely on fundamental indicators to evaluate the underlying value of assets. Based on predefined parameters (e.g., a certain P/E ratio), through advanced calculations and often algorithms, investors can identify stocks (in this modern approach, cryptocurrencies) that have strong fundamental value but are oversold and undervalued. For example, investors can calculate metrics about developer activity, code commits, network security, and users' adoption, giving a "value score" to the specific cryptocurrencies. Comparing the value with the recent price actions, it's possible to understand if a cryptocurrency is effectively undervalued and can perform better than the benchmark in the future. Shortly, this strategy is based on investing in undervalued assets that have strong fundamentals and are likely to outperform the benchmark over a determined period.

Low volatility

If you're looking for a lower-than-1 beta (lower volatility compared to the benchmarks) that reduces underlying risks, this strategy could be the right choice for you. This smart beta strategy focuses on selecting the cryptocurrencies that experienced lower volatility over a determined period. In this way, investors can try to seize crypto markets' opportunities effectively while reducing volatility and risks. That's not all because, with this strategy, investors can also try to decide and specify the maximum volatility they're willing to accept. For example, suppose you decide that you want to invest in Bitcoin but accept a maximum of 10% volatility. In that case, you can progressively reduce the exposure to Bitcoin by selling part of your holdings and re-buying them after the end of the market's downturn. It's not easy, and implementing this strategy in the wrong way can lead to significant losses. It's always highly recommended that you learn deeply and test accurately before using this and more advanced crypto trading strategies. DYOR!

Income

In the stock market, this strategy focuses on cherry-picking the stocks that give the higher dividends to investors. It means that you're not focusing on the potential notable growth of the assets. Instead, you're focusing on the dividends that the company offers. It's a more stable approach since the asset should have lower volatility and more stability over a long time. At the same time, you'd leverage the returns that it offers, capitalizing on them. Similarly, in crypto, you can use this strategy to focus on cryptocurrencies that offer the highest staking APR, selecting and investing only in the most stable with higher returns. For example, with this strategy, you might choose to invest in Solana, Atom, and Matic, focusing on their value but, most of all, on their fixed staking return. As you can understand, to be effective, this strategy is mostly designed for investors with a relevant budget because even if the returns percentage is the same for every investor, a higher budget means higher returns (e.g., if you invest 100$ aiming for 10% return in a year, you will get $10 more. Instead, if you're investing 100,000, with 10% yearly you will get $10,000 more). However, the concept of this investing strategy is the same for every kind of investor.

Multi-Factor

Instead of using just one of the previous strategies, you can also implement more of them with a multi-factor strategy. As you might understand, this type of strategy is the most complex since it involves various Smart Beta models. For example, you can implement both momentum and value, selecting only the cryptocurrencies with the best fundamentals and underpriced, exploiting their price actions with the momentum approach. Another example could be implementing low volatility and momentum, investing in Bitcoin (the less volatile crypto), but automatically selling when the price changes by a decided percentage. The most important thing in multi-factor strategies is to carefully select and decide the parameters, meaning that, for example, if RSI reaches more than 70, you automatically sell. The main difficulty is deciding the correct parameters and following the implemented strategy rationally. Implementing this strategy in a systematic way through sophisticated algorithms is advised, but you can also try to implement it manually. Let's understand better how!

How do you Manually Implement a Smart Beta Model in Crypto?

As we just said, most of the Smart Beta strategies should be applied with automatic algorithms to rebalance and weigh the portfolio. However, you can manually use simplified versions of Smart Beta models as well. Let's understand the steps:

1. Decide your Smart Beta strategy

The first step is to understand and decide which Smart Beta model is most suited for your goal and risk profile. If you're a conservative investors, the low volatility model could be the right choice for you. If you're more focused on "high-risk high-rewards", probably a strategy based on value could be a good option for you, investing in undervalued cryptocurrency with good fundamentals and strong rising potential.

2. Choose the assets of your portfolio

Smart Beta strategies are not limited to single-assets, of course. Instead, you can select the cryptocurrencies you prefer based on predefined factors, creating a customized crypto basket. So, in this second step, you should decide which cryptocurrencies include in your portfolio.

3. Ponderate the crypto assets of your portfolio

Decide the predefined parameters for weighting your crypto assets. Usually, traditional ETFs are market-cap weighted, and it means that crypto's percentage are proportionally to their market cap. However, in Smart Beta strategies, the focus is to beat market's benchmarks (like the S&P 500 in stocks), so you probably would prefer to implement a more sophisticated weighting methology to try otuperforming the market.

4. Evaluate assets' metric and rebalance your portfolio

This step could be challenging to be implemented manually, but it's still possible. Periodically (once a week, or a month, for example), you should evaluate the parameters and check if there are relevant changes. After analyzing your portfolio's performance, you might decide to rebalance the portfolio to re-create your initial allocation, or you can decide to change the allocations based on predefined metrics.

We hope that this guide will empower you with all the information and strategies you need to implement more sophisticated trading approaches based on Smart Beta models. But remember, every investor has different goals, risk tolerance, budget, and timeframe, so there is not an investment strategy that fits all the investors. You should carefully evaluate your situation to understand if it's possible for you to implement an advanced crypto trading strategy. If you're trading manually, it will require a lot of research, study, and time, but it could also bring you higher returns than the average if implemented well.

Future of Crypto Investing: Advanced Strategies Based on Smart Beta

In conclusion, what is a Smart Beta model in crypto, and why are these strategies so important and advanced? Smart Beta models are the last frontier in crypto investing to empower users with advanced crypto trading strategies, and we're just at the beginning. At PlasBit, we strongly believe that cryptocurrencies can give people the financial freedom they have never had in all of human history, and leveraging advanced strategies could be an important competitive advantage in your investment approach.

However, remember to always prioritize research and deep understanding of what you're doing because losing money is very common for crypto traders. As you already may know, only less than 30% of traders are actually profitable, and being among them is not easy. As Warren Buffett often said: "The first rule is never lose money. The second rule is never forget the first rule". Recovering loss is harder than making a profit. Don't be greedy and be patient, always following a studied and rational investment strategy.

There is no need to perform +100% every day because even if you make 1% a day in crypto, it is a very good result, and thanks to compounding effects, it could bring incredible results in the long term. Crypto is here to stay and probably replace traditional finance and currencies. The secrets to advanced and profitable trading are knowledge and patience. Follow a well-studied and defined plan and never rely on emotions. Be rational and consistent, and you'll be able to exploit Smart Beta models for advanced and more profitable crypto trading strategies.

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