HedgeWeek presented Pythagoras with an award for the highest risk-adjusted returns among all crypto funds in the Barclay Hedge database.
How did Pythagoras achieve this? What is Pythagoras’ approach to achieving the highest Sharpe ratio in crypto trading?
As background, please note that Bitcoin has the highest volatility compared to other asset classes. Bitcoin has 10x the volatility of the S&P. Bitcoin price has gone up 200x from $100 to $20,000 between 2014 to 2022 but it has had three 90% drawdowns along the way. How do you achieve a high Sharpe trading in this environment?
Pythagoras’ approach in our arbitrage fund is strictly market-neutral designed to capitalize on mis-pricings in a very inefficient, fast-growing market. Pythagoras may achieve the highest returns, but our fund looks to achieve the lowest volatility and the highest risk-adjusted returns. Market neutral trading includes arbitrage trading including cross-exchange arbitrage, volatility arbitrage, basis trading, cash and carry trading, defi staking, and providing liquidity. Market neutral means to us that we have no exposure to the price of any crypto at any time, e.g. no beta to the market, only alpha from exploiting inefficiencies. Market neutral trading results in absolute returns regardless of bull or bear markets and in all market cycles.
Pythagoras’ traders think about return and risk in the same breath. Some investors ask, what is the return without asking about the risk, simultaneously. When we look at possible trades we look beyond return potential to include analysis of risk, volatility and loss potential. Pythagoras places a higher priority on the Sharpe, Sortino and Calmar ratios than we do the absolute return. We are proud to have achieved a Sharpe of 2, a Sortino of 4 and a Calmar of 2 during our eight years.
Pythagoras sets a risk budget first when adding a new strategy to the portfolio and subsequently we maximize the return within the risk budget. For example, our traders might set a maximum drawdown target of 5% for each uncorrelated trading strategy. Then they look at the return of that single strategy and what impact the new strategy has on the portfolio. But they start with setting the risk budget versus starting with a target return.
The CEO of Pythagoras has been managing hedge funds HFs which traded in many traditional asset classes. He points out that crypto has some unique risks which need to be integrated into the design of risk management systems for a trading system and portfolio.
The crypto market has 10x the volatility of the S&P. Crypto has among the highest volatility compared to any other asset class. Thus, it’s important to have volatility control as an integrated part of a successful trading system, such as the items mentioned above, like taking a market neutral approach, setting a risk budget first, and looking at return and risk in tandem, rather than separately.
The barriers to entry to trade in the crypto market are low, and thus the crypto market is dominated by retail investors. Therefore, the crypto market is often very emotional, sentiment-driven market. Fear and greed and FOMO is rampant. Traders need to understand human behavior and mass psychology and incorporate this into their quant models.
Retail investors seem to expect 10x or 100 x returns from the crypto markets. People hear stories of their neighbors or cousins making millions and they too want these riches. Again, professional traders need to factor in retails’ expectations into their models.
Leverage is abundant in the crypto market. Bitmex pioneered 100: 1 leverage in 2015 and many exchanges followed suit. There has been an explosion of lenders in the space offering hedge funds very liberal terms. In exuberant times, over-leverage is commonplace. Witness the crash of 2022 where excessive leverage used by Three Arrows Capital caused it collapse when the markets crashed. Professional traders need to carefully manage and control their own leverage and watch out for markets with excessive leverage when managing their portfolios.
Counterparty risk is high in the crypto space. In traditional finance, counterparty risk is low when trading on NASDAQ, NYSE, or when dealing with prime brokers, custodians, and banks. These types of counterparties don’t exist in the crypto world, yet. Currently, crypto traders place their assets on the crypto exchanges in order to trade at a moment’s notice, e.g. there is no time to retrieve assets out of cold storage. However, the exchanges can get hacked, suspend withdrawals or suffer other types of losses. Trading managers need to manage counterparty risk by wide employing careful diversification and limiting exposure to cash flow-rich exchanges with track records of covering customer losses out of their own pockets.
Technology risk is high in the crypto industry. If you lose your laptop which holds your crypto or the keys to your digital wallet, your crypto is gone. If you send your crypto to the wrong digital address, you cannot recall your mistake. If your wallet or exchange gets hacked, its goodbye crypto. If there is a bug in the smart contract which governs the defi protocol where your trade, you risk substantial loss. A professional crypto manager must carefully navigate and mitigate against all of these risks, with good technology audits, evaluation of the track records of the technologists involved, and have good backups to your digital keys and good safeguarding of the devices where your crypto is stored.
Conclusion. Achieving the highest risk-adjusted returns in crypto is very challenging. It takes a team of experts to carefully manage the idiosyncratic risks of crypto, while maximizing returns and taking advantage of a nascent, fast-growing and exciting market. We are proud of our team and their accomplishments.
Last Updated: Aug 5, 2022