「Trend Research by LD Capital」“In-depth interpretation of Grayscale Trust ｜ Why can you buy Ethereum at half price? (2)”

Author: Jinze Jiang, Drake Zhang, LD Capital Research

Introduction

Grayscale Ethereum Trust (ETHE) is the largest publicly traded Ethereum product on the US stock market, with a holding of over 3 million ETH. However, its current secondary market trading price compared to the net asset value (NAV) is at a nearly 50% discount. In our previous report, we analyzed the reasons for the discount and premium of this product, as well as several scenarios in which the discount might narrow. Based on the cyclical rotation pattern, we believe that if betting on a potential bull market, ETHE may have better elasticity compared to ETH spot. However, we also found that historical data analysis shows that ETHE’s risk-reward metrics are not ideal, with risk-adjusted returns, maximum drawdown, and volatility performing worse than ETH/USD. This implies that if one is prepared to hold ETHE for the long term, specific return enhancement strategies might be needed; otherwise, if a bull market does not arrive quickly, its performance carries the risk of being weaker than the broader market.

In the second installment of this series, we will explore how to build an index enhancement strategy for ETHE. This will allow investors to obtain the long-term Beta return value of the asset while engaging in appropriate active management to achieve Alpha returns, thus improving the experience of holding the asset in the long run.

Risk and Return Overview of Grayscale ETHE

First, let’s analyze the key characteristics of the core target of this strategy, Grayscale ETHE:

The table above presents statistics on the price performance of ETHE and ETH-USD from 01/01/2020 to 04/30/2023, calculated on a monthly return basis. ETHE’s performance is worse than that of ETH spot in terms of alpha coefficient, maximum drawdown, value-at-risk, and risk-adjusted return, among other risk metrics. However, the right-skewed, fat-tailed distribution of its returns implies that its positive fluctuations have greater potential:

Return Performance: Grayscale ETHE has an arithmetic average monthly return of 8.91% and an annualized return of 178.48%, while the arithmetic average monthly return of Ethereum spot is 10.60% and its annualized return is 235.03%. From this perspective, Ethereum spot outperforms Grayscale ETHE. In terms of geometric average return, Grayscale ETHE’s annualized return is 40.03%, while Ethereum spot’s annualized return is 120.08%, indicating that Ethereum spot has better long-term investment performance.

Risk Performance: Grayscale ETHE’s monthly and annualized standard deviations are 38.16% and 132.18%, respectively, higher than Ethereum spot’s 29.01% and 100.48%. This indicates that Grayscale ETHE has larger price fluctuations and relatively higher risk. Additionally, Grayscale ETHE’s maximum drawdown is -89.60%, higher than Ethereum spot’s -77.96%, further illustrating Grayscale ETHE’s higher risk.

Risk-Adjusted Return: Sharpe Ratio and Sortino Ratio are metrics used to evaluate the risk-adjusted return of investments. As seen in the table, Grayscale ETHE’s Sharpe Ratio is 0.8, while Ethereum spot’s Sharpe Ratio is 1.25; Grayscale ETHE’s Sortino Ratio is 1.72, while Ethereum spot’s Sortino Ratio is 2.69. This indicates that, when considering risk, Ethereum spot’s return performance is superior to that of Grayscale ETHE.

Market Correlation: The table’s Beta coefficient shows that Grayscale ETHE’s beta is 0.9, which implies that Grayscale ETHE has relatively higher systematic risk (ETH). However, the Alpha coefficient shows that Grayscale ETHE’s annualized alpha is -8.14%, indicating that after adjusting for market risk, Grayscale ETHE did not achieve positive returns during the statistical period.

Profit and Loss Ratio: Grayscale ETHE’s profit and loss ratio is 1.46, slightly lower than Ethereum spot’s 1.48, which means that their performances in terms of profits and losses are not significantly different.

Profit and Loss Cycle: In terms of positive return cycles, Grayscale ETHE has 23 positive return cycles out of 41 cycles, accounting for 56.10%, while Ethereum spot has 26 positive return cycles out of 41 cycles, accounting for 63.41%. This indicates that Ethereum spot has more profitable cycles.

Value-at-Risk (VaR): Grayscale ETHE’s historical VaR (5%) is -38.01% and its analytical VaR (5%) is -53.85%, while Ethereum spot’s historical VaR (5%) is -30.15% and its analytical VaR (5%) is -37.11%. This suggests that at the same level of confidence, Grayscale ETHE’s potential maximum loss is greater than Ethereum spot’s.

Conditional Value-at-Risk (CVaR): Grayscale ETHE’s CVaR (5%) is -44.36%, while Ethereum spot’s CVaR (5%) is -43.67%. This implies that under the worst-case scenario, Grayscale ETHE’s losses could be comparable to those of Ethereum spot.

Upside Capture Ratio and Downside Capture Ratio: Grayscale ETHE’s upside capture ratio is 86.74%, while its downside capture ratio is 117.95%. This indicates that Grayscale ETHE captures lower gains during market upswings and experiences greater losses during market downturns.

Return Distribution Shape: Grayscale ETHE’s excess kurtosis is 0.46, and skewness is 0.84; ETH’s excess kurtosis is -0.37, and skewness is 0.27. This suggests that Grayscale ETHE’s return distribution exhibits a more pronounced peak relative to a normal distribution, indicating a higher probability of extreme returns (positive or negative). Additionally, its positive skewness implies a right-skewed distribution with larger positive extreme returns. This may signify that Grayscale ETHE has higher investment risk but potentially higher returns during positive market fluctuations.

Why does ETHE, which is also based on ETH spot as its underlying asset, consistently underperform?

This is mainly due to its unique product, market structure, and changes in the market environment, which led to a premium over NAV (2019–2021) followed by a discount (2021 onwards). The nearly 90% decline in price from premium to discount has weighed on overall risk-return indicators.

The reasons behind the negative/positive premium are the Grayscale ETHE Trust’s non-redeemable fund product structure. Factors contributing to the positive premium include higher accessibility of the product compared to ETH spot, making ETHE more suitable for traditional financial institutions and retail investors than self-custody of private keys; balance sheet accounting, tax advantages, and helping investors bypass compliance issues. Reasons for the negative premium include the non-redeemable fund structure, limited arbitrage opportunities, discounted opportunity costs, and the impact of competitive products.

For more analysis, see the first report in the series: “50% Off ETH: Opportunity or Trap? A Deep Dive into Grayscale Trust.”

Principles of Index Enhancement Fund Strategy

Fundamental concepts and ideas related to ETHE index enhancement:

Index enhancement strategy is an investment portfolio management approach that seeks to amplify the returns of a base portfolio or index and outperform the index in terms of returns or risk metrics.

The strategy requires ETHE to be the cornerstone position, allocating no less than 60% of funds to ETHE spot, with the remaining funds allocated to cash, fixed-income products, US-listed blockchain and cryptocurrency-related stocks, and options derivatives of these stocks.

Index enhancement combines elements of active and passive management. Due to the active management aspect, the investment introduces the risk of the strategy manager’s subjective judgment, whereas passive index funds only need to worry about market risk.

Establishing a portfolio based on ETHE focuses on the excess returns generated from betting on the narrowing of the secondary market price and NAV of ETHE. However, given ETHE’s poor historical return statistics, we need to improve the holding experience during the holding process by:

1. Diversification: Include assets with relatively low correlation, stable returns, and lower volatility in the portfolio to offset the poor risk-return ratio, such as cash, fixed-income products, US-listed blockchain and cryptocurrency-related stocks, and options derivatives of these stocks.
2. High Position: As ETHE has higher return potential during positive market fluctuations, maintaining a high overall position for ETHE avoids missing out on extreme upswings. Under non-significant risk situations (e.g., Ethereum trust crisis, Grayscale financial crisis), the allocation should not be less than 80%.
3. Derivative Enhancement: Using options strategies in stock enhancement is more advantageous than merely holding the underlying. Excess returns are mainly derived from capturing options pricing volatility premiums and constructing more targeted investment strategies with complex options strategies.
4. Margin Trading: Margin trading can enhance the index through two aspects: using owned stocks or ETFs as collateral for financing to increase leverage when bullish; and lending out owned stocks to generate returns through securities lending. If ETHE supports margin trading in the future or stocks in the stock enhancement part support it, this could be an alternative strategy.
5. Initial Coin Offerings (ICOs): With improvements in the regulatory environment, more traditional brokers are entering the crypto asset trading business. It is possible that crypto assets will have initial offerings on regulated brokerage platforms in the future. Historically, returns from ICOs and IDOs have been considerable, and at that time, our holdings could be used for ICO participation along with a small amount of cash.

Specific methods

Since 4 and 5 are currently difficult to implement, focusing on 1 to 3, we need to:

1. Select an Index: Mainly track the ETHE index, with ETH/USD as a reference index. Since it is a single asset and not a traditional broad-based index enhancement, the focus should be on controlling volatility and drawdowns when providing extra value through active management for the more concentrated “narrow-based” index.
2. Fund Allocation: To ensure the portfolio performance does not significantly deviate from the benchmark index, at least 60% of funds should be allocated to ETHE, ideally maintaining a weight of 80–90%, with the weight of return-enhancing funds ranging from 10% to 20%.
3. Stock Enhancement: As ETHE shares are currently traded on the OTCQX market, a so-called over-the-counter (OTC) market where securities usually have limited trading activity and no standard options market, it is not possible to use brokerage platform balances as collateral for covered call option selling strategies or margin trading. Therefore, the primary focus of enhancement should be the preferential allocation of selected blockchain and cryptocurrency-related stocks.

Table 1: Major US-listed blockchain or cryptocurrency-related stocks

Table 2: Major blockchain or cryptocurrency-themed ETFs listed in the US and Canada

The criteria for selecting investment targets are:

Companies with a clear business plan in the crypto ecosystem or indirectly benefiting from the development of the cryptocurrency industry, including crypto mining companies, mining equipment/chip suppliers, crypto financial service companies, or other financial institutions primarily serving crypto-related clients, and metaverse business companies;

Or fund products whose primary investment strategy focuses on digital currency spot or its derivatives;

Or shares of fund products investing in the aforementioned two categories.

Why choose crypto stocks:

Based on the moderate correlation between crypto stocks and crypto assets, establish crypto market exposure through a safe, convenient, and compliant approach.

The correlation between crypto stocks and crypto assets typically ranges between medium (0.40) and significant (0.90). Furthermore, historically, the beta value of many crypto companies’ stock prices and cryptocurrencies is greater than 1. This amplified risk exposure can make crypto stocks an effective tool for gaining exposure to price fluctuations in the crypto market. In addition, not only ETHE, but some crypto funds (such as BITW) also have a market value lower than NAV due to similar structural issues, which can also be used to bet on the return of discounts.

Table: Monthly Return Correlation of Major Crypto Stocks and ETH, ETHE (05/01/2021–05/04/2023):

Note: The statistical period is constrained by the COIN stock only being listed for trading in May 2021; CASH represents cash.

Derivative Enhancement

Option enhancement mainly focuses on the covered call strategy based on the owned stock/ETF spot positions, that is, selling an equal number of call options with a certain out-of-the-money degree, which can achieve excess returns relative to the spot market in the case of a market decline or steady rise.

At the same time, after combining macro, technical, and industry fundamental factors, adjustments can be made to the covered call strategy. For example, using a ratio call spread. In the case of a suitable term structure, a calendar spread can be executed.

When portfolio protection is needed, option structures can be formulated based on the level of implied volatility. For example, when the implied volatility is relatively high and the wings are higher than the at-the-money (ATM) options, a put spread collar structure can be chosen.

Option Enhancement Strategy Example

It is important to note that the details of volatility changes, such as skew and term structure, will affect the specific option structure. These indicators need systematic real-time tracking. Below are some illustrative diagrams of option structures:

Subjective Timing

Macro level, technical, and industry fundamental analysis for partial spot position timing is also a source of excess returns, but overall, as an ETHE enhancement strategy, position timing should be downplayed.

Specifically:

Macro timing: A comprehensive judgment of the overall future trend of the digital currency market is made by analyzing macro, policy, economic cycles, and other factors.

Industry timing: Company/project research, event-driven, multi-factor stock selection, etc.

Technical timing: Using graphic technical analysis to judge the trend’s sustainability and make appropriate position adjustments around key resistance and support levels.

The unquantifiable macro judgment and event-driven aspects are the core differences reflecting the strategy manager’s expertise. For example, Ethereum 2.0 upgrade (Shapella) concluded on April 13, 2023. However, a point many people overlook is that a large amount of ETH withdrawal will not occur immediately, and it may take more than five days to arrive. Therefore, if the price rises within a few days after the upgrade’s completion, it may be appropriate to consider reducing positions or selling some call options to harvest volatility value. The chart below shows the ETH spot price, which surged around April 13, then consolidated for five days before quickly falling.

The main purpose of the above strategies is:

1. Long-term holding of core crypto market assets — ETH is the core infrastructure of mainstream Web 3 applications. In addition to serving as a channel for fiat wealth liquidity spillover and portfolio diversification like BTC, it will also have additional α brought by Web 3 ecosystem applications.
2. Timing operations without affecting cornerstone positions — Timing operations do not affect the high position of ETHE, avoiding missing the tail-end abnormal upward trend.
3. Focusing on the alpha of stocks — Carefully selecting more outstanding companies will yield excess returns higher than the market average in the long run.
4. Capturing volatility returns — Transforming black swan risks and fluctuations during the bull-bear transition into long-term bullish “alpha” for the index through options.

Empirical Study

Next, we will conduct an empirical analysis of the proposed index-enhanced fund strategy based on Grayscale ETHE, using historical data to evaluate the effectiveness and feasibility of the strategy.

Based on the historical market data from January 2020 to April 2023 and the following alternative targets (where OPRE is used to simulate the return of the option part), we perform monthly return statistics. Then, we apply conditional constraints on the highest and lowest proportions of each asset allocation. We obtain optimized portfolio allocations based on three methods:

1. Maximum Sharpe Ratio Optimization — Finding the optimal risk-adjusted portfolio on the efficient frontier based on mean-variance.
2. Minimum Variance — The minimum portfolio risk (measured by variance or standard deviation) among a set of assets.
3. Maximize Returns under a Given Annual Volatility Target of 100% — Seeking to maximize the expected return of the portfolio under a given risk level.

The performance of each portfolio is shown in the table below, where the black ETHE line and the unoptimized reference portfolio 1 blue line can be used for comparison:

The table below shows the performance comparison of four optimized portfolios, including the maximum Sharpe ratio, minimum variance, maximum return under 100% volatility, and a single asset Grayscale Ethereum Trust (as a benchmark). It can be seen that the optimized portfolios outperform the simple holding of ETHE on almost all risk-return indicators, with the maximum Sharpe ratio portfolio being superior to other portfolios in terms of returns, risk control, and risk-adjusted returns:

These data can be observed from the following aspects:

Returns: Over the given period, the maximum Sharpe ratio portfolio has the highest final balance of 60,653, significantly outperforming other portfolios and the benchmark asset. The minimum variance portfolio and the maximum return portfolio under 100% volatility have final values of 42,977 and 45,878, respectively, which are also higher than the benchmark asset’s 31,840. This shows that the optimized portfolios have better returns than the single asset.

Risk: In terms of standard deviation, the minimum variance portfolio has the lowest risk level (99.02%), while the benchmark asset has the highest risk level (133.75%). In terms of maximum drawdown, the minimum variance portfolio and the maximum return portfolio under 100% volatility have lower maximum drawdowns (at -80.44% and -80.63%, respectively) compared to the benchmark asset’s highest maximum drawdown (at -89.60%). This indicates that the optimized portfolios also perform better in risk control.

Risk-adjusted returns: Sharpe ratio and Sortino ratio measure the expected returns per unit of risk and per unit of downside risk, respectively. Looking at these two indicators, the maximum Sharpe ratio portfolio performs the best (Sharpe ratio of 0.96, Sortino ratio of 2.06), which means that in terms of risk-adjusted returns, this portfolio is superior to other portfolios and the benchmark asset.

Relative returns and risk: Active return, tracking error, and information ratio measure the excess return, risk, and risk-adjusted excess return of the optimized portfolio relative to the benchmark asset, respectively. Looking at these three indicators, the maximum Sharpe ratio portfolio performs the best: active return of 30.19%, information ratio of 0.92 (ratio of active return to tracking error). This indicates that the maximum Sharpe ratio portfolio also has an advantage in performance relative to the benchmark asset, and this portfolio can achieve a certain excess return while assuming moderate risk.

Note: The optimization is based on the monthly return statistics of the selected portfolio assets within the given time period. The optimization results cannot predict which allocation will perform best outside the given period, and the actual performance of the portfolios constructed using the optimized asset weights may differ from the given performance targets.

Conclusion

In summary, the relatively poor risk-return ratio of ETHE can be enhanced through different allocation methods. The simulated portfolios outperform the benchmark asset ETHE in terms of returns, risk control, and risk-adjusted returns. Investors can choose an investment method suitable for their own risk preferences and investment goals, thereby improving their portfolio experience and striking a balance between maximizing returns and minimizing risk.

LD Capital is a leading crypto fund who is active in primary and secondary markets, whose sub-funds include dedicated eco fund, FoF, hedge fund and Meta Fund.

LD Capital has a professional global team with deep industrial resources, and focus on develivering superior post-investment services to enhance project value growth, and specializes in long-term value and ecosystem investment.

LD Capital has successively discovered and invested more than 300 companies in Infra/Protocol/Dapp/Privacy/Metaverse/Layer2/DeFi/DAO/GameFi fields since 2016.

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