A Discussion on "Alpha Returns" and "Beta Returns" in the Cryptocurrency Field

Alpha return and beta return are two concepts that are often heard in the investment process and are widely used to evaluate the performance of stocks, funds, or investment portfolios. Alpha is used to measure the investment return compared to the market index, while beta is used to measure the volatility of the investment, indicating its relative risk.

These two names originally came from a paper published by Nobel laureate William Sharpe in 1964, titled "Portfolio Theory and Capital Markets," which pointed out that investors face systematic risk and non-systematic risk in trading in the market. Among them, systematic risk can be derived from the security market line in the Capital Asset Pricing Model (CAPM).

E ( $r_{i}$ ) = $r_{F}$ + β ( $r_{M}$ - $r_{F}$ )

is defined, where β is the index that measures the level of systematic risk undertaken by a security or an efficient portfolio. Therefore, he divided the return on financial assets into two parts: the part that fluctuates with the market is called beta return, and the part that does not fluctuate with the market is called alpha return. Corresponding to the formula:

Asset return = Alpha return + Beta return + Residual return

where the residual return is a random variable with an average value of 0, which can be ignored.

Understanding Alpha and Beta#

First, we need to define a market benchmark, and each financial asset corresponding to this market benchmark will have a beta coefficient to indicate the degree of volatility compared to the market benchmark. For example, if the beta coefficient is 1, it means that the financial asset's volatility is consistent with the market benchmark. If the market benchmark rises by 10%, the financial asset will also rise by 10%. Correspondingly, the return generated by the fluctuation of the target with the performance benchmark is called beta return. For example, if the performance benchmark rises by 10% and the target rises by 11%, the 11% is the beta return. Beta return can be seen as a relatively passive investment return, which means the return generated by bearing the market risk (if the performance benchmark falls by 10%, the target falls by 11%). This kind of return generally does not need to be actively obtained through stock selection or market timing, but is obtained along with the performance benchmark (such as the overall market). Most of the passive index funds we hear about are this type of fund.

So what is alpha return? According to the formula above, we know that

Alpha return = Asset return - Beta return

What does this mean? Let's give an example. For example, a fund tracks a performance benchmark that rises by 10%, and its beta is 1.1. The beta return is 11%. However, the fund achieves a return rate of 20% through some strategies, and the additional 9% excess return is the alpha return. We need to note that this part of the alpha return is unrelated to market volatility (the return generated by the performance benchmark's rise is the beta return). This part of the return needs to be obtained through the fund manager's active management, market timing, stock selection, and other means to obtain excess returns. The majority of actively managed funds in the market pursue alpha returns.

To better compare and explain, let's make an analogy. For example, the speed at which we travel on a train is actually equal to the speed of the train plus our own speed relative to the train. The train itself is moving fast, so we will naturally move fast on the train. When the train slows down, our speed will also decrease. This is the beta return. But while the train is moving forward, we can also run forward in the train, which will increase our own speed. This is the alpha return.

In investment, people generally believe that alpha is difficult to obtain, while beta is relatively easy to obtain. Because the market itself is volatile, and for investment, by adjusting the proportion of holdings (different investment portfolios), the beta coefficient can be easily changed, thus obtaining returns from market volatility. However, to obtain alpha returns, it is necessary to complete through operations such as market timing and stock selection, which tests the ability of investors.

Alpha and Beta in Cryptocurrencies#

The traditional financial field has developed for almost a hundred years, and there has been relatively mature research on alpha and beta returns. As a newly developed asset in the past ten years, cryptocurrencies still have many immature aspects. If the index of the securities market (such as the Shanghai Composite Index) can be used as a measure of beta return, then in the field of cryptocurrencies, only BTC can play a similar role as an index, for the following reasons:

BTC occupies a large proportion of the total market value of cryptocurrencies, sometimes even exceeding 70% during bear markets.
Other cryptocurrencies with large market capitalization have a high correlation with the price of BTC.
Although some institutions have spontaneously launched some index products, they are not widely recognized by the market.
A large number of investors use BTC as the pricing benchmark. This makes the volatility of BTC itself become the de facto market benchmark, so holding BTC alone can obtain beta returns. If seeking alpha returns, it is necessary to obtain returns higher than holding BTC during a bull market.

Alpha returns come from alpha strategies. Traditional fundamental analysis strategies focus on selecting coins and rely on selecting sectors and investment portfolios to outperform the market. This method requires investors to have high research and analysis capabilities and is widely used in hedge funds in foreign markets. In terms of specific strategies, they mainly include:

Long/short strategy, which involves buying some assets and selling short others. Hedge fund managers can adjust the proportion of long and short assets to freely adjust the market risk faced by the fund, often to avoid market risks that they cannot grasp and minimize risks to obtain stable returns. For example, buying BTC while shorting ETH, earning the exchange rate difference between ETH and BTC.
Arbitrage strategy, which involves buying and selling two types of related assets simultaneously to capture price differences. In the transaction, some risk factors are hedged, and the remaining risk factors are the source of excess returns for the fund. For example, buying BTC when the perpetual contract funding rate is positive while shorting the spot market, earning the funding rate.
Event-driven strategy, which involves investing in projects that are about to undergo special major events, such as spin-offs, acquisitions, mergers, mainnet launches, version updates, hacker attacks, or token buybacks. For example, buying BTC three months before the approval of a BTC ETF and selling it when the ETF is approved, earning the FOMO sentiment triggered by the event.
Momentum trading strategy, which involves managing investment portfolios based on the strongest tokens in the market trend. According to a certain period of time, continuously sell the tokens with the least return and buy the tokens with the highest return in the market, which is called the "strong get stronger" strategy.

Conclusion#

In terms of capital size, the total market value of the entire cryptocurrency market is currently close to $2 trillion, which is still very small compared to the traditional financial market. On the other hand, the cryptocurrency market has its own unique characteristics: 1) it is greatly influenced by policies, and 2) the market is filled with a large number of irrational retail investors. These two characteristics make it much easier to find alpha returns in the cryptocurrency market, which is why there are myths of hundreds of times of price increases in each bull market.