Bull Run Ready

Why Diversifying Into Alts Matters

Image source: Dribbble

Hey there,

As we stand at the cusp of a potential bull market, we’re taking a look at how you can tweak your portfolio to bag those sweet gains. Joining me is Nathan Gurr, who's got a knack for digging through historical market trends to whip up a solid investment strategy.

Bitcoin's remarkable performance over the past decade is undeniable. Since 2011, Bitcoin’s annual rate of returns stands at 230%, which is 10 times higher than the second best-performing asset, the Nasdaq 100 index. The rise has not been steady, but seems to follow a 4-year cyclical up and down pattern which crypto-natives fondly call the ‘halving cycle’.  

Pantera Capitals’s predictions on the next cycle take BTC to $150k

The Bitcoin protocol incentivizes miners to validate transactions by rewarding them with new bitcoins. This reward undergoes a halving every four years, effectively reducing the number of bitcoins awarded per block. Initially, miners received 50 bitcoins per block. This reward was halved to 25 bitcoins during the 2013-2017 cycle, then further reduced to 12.5 bitcoins in the 2017-2020 cycle. Currently, the reward stands at 6.25 bitcoins per block. After the anticipated fourth halving that’s set to occur around April 2024, the reward for miners will decrease to 3.125 BTC per block, continuing Bitcoin's deflationary monetary policy.

The supply shock resulting from the halving often triggers a price increase, as buyer demand intensifies for the increasingly scarce new coins entering circulation. In this article, we'll operate under the assumption that the four-year cycle persists, using historical performance as a guide to forecast potential developments in the upcoming cycle.

Over the years, as more liquidity entered crypto markets, the price action of Bitcoin became increasingly correlated with the overall financial system which could be a major factor playing into the next halving cycle’s returns.

In contrast to prior Bitcoin cycles which attracted retail investors, there is excitement among crypto enthusiasts that the 2024-2025 cycle might be different and we might see both retail and institutional investors ready to jump in and invest meaningfully.

Institutional investors are looking at spot ETFs for BTC and ETH as a signal of legitimate, regulatory-approved investment avenues that will let them get exposure with minimal compliance and reduced risks.

Retail will continue to invest in this asset class for the benefit of self custodied money and decentralized applications, with many choosing to hold the assets off exchanges.

Web3 funds are investing in liquid tokens

Venture Capital is a hit-or-miss game, where a few outsized successes have to return the size of the fund for a meaningful return. Crypto VCs that have raised over the last two years are waiting for the tide to turn with plenty of dry powder. While it's been noted that Web3 VC funding had dropped dramatically in 2023 compared to 2021/2022, many funds have alternatively been deploying this capital into the top liquid tokens trying to make use of the market correction during the 2022-23 bear market.

Arthur Cheong’s thesis on Liquid Venture Investing is one of the best reads on why the current distorted markets are a great opportunity for VCs. To paraphrase him:

  1. There are four categories of market participants - VCs who invest in private markets, Institutions who are dipping their toes in, crypto trading firms that focus on short-term market movements, and everyday retail traders participating in spot markets
  2. There are very few structural buyers in the crypto liquid markets and VCs stay away because they are focused on primary market venture deals
  3. The distorted market sentiment is a great time to generate superior risk-adjusted returns

In a sense, this is the anti-DAO thesis. When DAOs raise money from the market through a token sale, they need to diversify their treasury funds into USDC to ensure they remain ready for volatility in their token price. Now that we are in a bear market, it makes sense for VCs to diversify cash holdings into tokens likely to appreciate in the bull market.

For most capital constrained investors, approaching crypto investing via a liquid venture approach will yield the best risk-adjusted returns now given the dynamic nature of the space.- Arthur0x

General Partners (GPs) and Fund Manager’s benchmark crypto VC’s performance against BTC & ETH to understand if they have made better returns for the additional risk compared to simply holding BTC & ETH. While traditional VCs are compared against S&P performance of 10%, Crypto VCs are compared against the new frontier asset class with a 5-year return of BTC exceeding 1500%, making every strategic move crucial for long-term success.

Diversification outperforms BTC and ETH

Bitcoin, often regarded as digital gold, pioneered the cryptocurrency revolution, followed by Ethereum in 2015 aiming to become the world’s global computer. Analyzing their performance during the prior two halving periods, we can observe that BTC historically leads the charge in a bull market with ETH’s price movement trailing by a few months. From 2018’s cycle peak to 2022’s peak, both BTC and ETH saw an approximately 4x increase in prices.

To gauge alt-coins performance, we divided crypto into 5 categories and analyzed returns of key tokens from the 2020 Bitcoin halving (May 11, 2020) to their respective all-time-high (“ATH”) prices in 2021 & 2022.

  • The Big Giants- Bitcoin and Ethereum have solidified their dominance in their respective niches - BTC as digital gold, and ETH as a global tamperproof database
  • Smart Contract Platforms- Last season, we saw the emergence of alternative L1s that promised to ease the problems of Ethereum’s congestion with fast transactions and low fees (MATIC, SOL, AVAX, NEAR, DOT, ADA, ATOM, BNB, FTM)
  • Infrastructure- Infrastructure to ease the pain of developing blockchain-based solutions and connecting with different chains (LINK, LTC, VET, GRT, QNT)
  • Memecoins- Memecoins emerged as stores of value in human culture, memes, and the ethos & pathos of a group of people. (DOGE)
  • DeFi and Payments- Defi protocols replicated what CEXes were doing in a sefl-custodial manner with users controlling their assets for financial transactions such as swaps, buying futures & options, and lending (UNI, XLM, XRP, XMR, MKR, AAVE, SNX)
  • NFT & Gaming- NFTs took off in 2021 and the rotation of capital gave birth to a new category of tooling and gaming-related contracts (MANA)

When we look at these categories some observations jump out:

  • Bitcoin and Ethereum's Diminishing Returns: Due to their substantial market sizes, these giants require a significant influx of capital to make large movements in either direction.
  • Rapid Growth in New Segments: Fresh market segments tend to capture investor attention swiftly, leading to rapid growth. In the last cycle, meme coins and NFTs were prime examples of this phenomenon. Additionally, these new segments often start with low fully diluted valuations (FDVs), making them attractive for early investment.
  • Diversification's Strong Performance: A diversified crypto portfolio that includes alts significantly outstripped a portfolio solely comprising BTC & ETH, with a staggering 5.8x better performance (9151% vs. 1572%). Furthermore, this diversified approach surpassed the total crypto market cap's performance by 7.9x (9151% vs. 1149%).
  • Altcoins' Superior Returns: Remarkably, a diversified portfolio consisting only of altcoins (excluding Bitcoin and Ethereum) outperformed a portfolio limited to Bitcoin and Ethereum by 6.7x (10667% vs. 1572%) and a 9.2x higher return compared to the total crypto market cap (10667% vs. 1149%).

How to balance your portfolio

It’s vital to consider one’s risk tolerance and aim for a portfolio that optimizes the risk-reward balance. In traditional finance, investors employ various portfolio construction strategies:

  1. Market Cap Weighting: This method allocates investments in proportion to a company's market value, offering a straightforward way to emulate market performance and achieve diversification.
  2. Square Root of Market Cap: This strategy seeks to strike a balance between large and small companies, reducing risk concentration while maintaining stability and growth potential.
  3. Logarithm of Market Cap: By weighting investments according to the natural logarithm of market cap, this approach tones down the influence of large-cap companies, leading to a more diversified portfolio.
  4. Equal Weighting: This evenly distributes investment across all companies, potentially unlocking higher returns from smaller-cap stocks that are often overshadowed in market-cap-weighted portfolios.

We analyzed different portfolios using the Portfolio Strategy tool from IntotheCryptoverse, starting from the last cycle's halving and focusing on the top 10 cryptocurrencies by market cap as of May 11, 2020.

The performance of these portfolios didn't vary significantly, mainly because some of these altcoins such as BCH, BSV, LTC, EOS, XTZ, XLM significantly underperformed during the bull market and have been trending down. $1000 invested would have turned into $4k-$6k depending on the portfolio allocation. In a bear market, portfolios dominated by market cap tend to preserve their value more effectively.

However, a contrasting picture emerges when examining investments in the current top 10 cryptocurrencies by market cap, starting from the same point on May 11, 2020.

An equally weighted investment of $100 in each of the current top 10 cryptocurrencies would have yielded about $28k, far exceeding the $7k from a market cap-weighted approach (with allocations like BTC-55%, ETH-26%, BNB-7%). This disparity highlights the importance of identifying this cycle's winners.

To predict which coins might remain robust, examining those that have performed well during the past year's bear market can be important. This performance indicates sustained interest and ongoing development efforts.

By diversifying in leading coins across various sectors instead of just the top 10 coins - BTC, ETH, MATIC, FIL, DOGE, DYDX, GALA generates the following returns.

A market cap-weighted investment in these coins would result in approximately $8k at today’s prices, comparable to the $7k from investing solely in the top 10 coins by market cap. However, a portfolio weighted towards alts either through an equal weighting or log-based weighted would have generated around $50k at today’s prices and $420k at the peak, showcasing the potential of diversification beyond just the top 10 cryptocurrencies.

Depending on one's risk profile, different weighting approaches can be considered:

  • YOLO - Equal weighted portfolio across each sector. Allocating a higher percentage of your portfolio to new promising asset classes - LSTs, RWAs, ZK, Identity, gaming, AI can significantly enhance your portfolio value.  
  • FIRE - Concentrating around 70% between ETH and BTC, and distributing the remaining 30% between market leaders from different sectors
  • HODL- These investors typically hold on to their blue chips for the long term and don’t react to market cycles. Allocating about 10% into a selective range of alts might help increase gains.

Forecasting returns for the 2024/2025 cycle

Altcoin forecasting can be harder than forecasting for BTC and ETH because most of them are navigating their second four-year cycle and it can be difficult to estimate how high a market cap a Layer 2 blockchain, a DeFi protocol, or a web3 gaming project can go.

One strategy is to observe the best-performing stocks from the traditional equity markets within each industry to understand the financial and user metrics needed to reach certain valuations. While we have projected these token prices based on their historical performance, these should be treated with a healthy degree of skepticism.

Given the subjectiveness of forecasting future values, it is best practice to forecast using a range of values, and therefore we created a ‘Bear’, ‘Base’ and ‘Bull’ case. In the Bear case scenario, we have forecasted each token reaching their last cycle’s ATH price. For the Base scenario, we forecasted BTC reaching $100K per token and ETH reaching $900B in fully diluted market capitalization. For the optimistic Bull case scenario, we forecasted BTC reaching just under $3T in market capitalization and ETH reaching just over $1T in market capitalization at $10.5K per token.  

We are sharing our forecasts here as a directional guide to our market thinking rather than precise market predictions. If you differing views, feel free to hash it out in our DMs.

On that hopeful note, let it rip!

Massive shoutout to Benjamin Cowen, the creator of IntotheCryptoverse tools for his informative videos that greatly helped us with this deep dive.