The VIX Risk-Parity Crypto Barbell Strategy
Taking a TradFi investing strategy fully on-chain
The barbell strategy has its roots in the theories of Nassim Nicholas Taleb, a scholar and risk analyst famous for his work on uncertainty, randomness, and probability. He proposed this approach as a way to navigate “Black Swan” events — highly unpredictable and rare events with severe consequences.
The strategy involves allocating assets into two distinct categories: high-risk and low-risk investments, resembling the two ends of a barbell. On one end, investors place a portion of their portfolio in aggressive, high-reward assets like growth stocks or high-yield bonds. On the other end, they invest in conservative, low-risk assets like Treasury bonds, or cash. The idea is to capture both safety and significant upside potential, while potentially minimizing exposure to medium-risk, mediocre-return investments. By strategically balancing these two extremes, investors aim to both protect their portfolio during market downturns and benefit from market upswings.
Sometimes, we see cryptocurrencies take up one end of the barbell — the high-risk end. But what about the low-risk end of the barbell? Can we use tokens to represent that end of the barbell too?
Yes we can.
Introducing the VIX risk-parity crypto barbell strategy. In this strategy, we use a stablecoin to represent the low-risk end of the barbell, and a more volatile token on the high-risk end. The “VIX risk-parity” part of this strategy means that the overall implied volatility of the portfolio is matched to the volatility of the S&P500 (represented by the VIX), and this is applied every time the portfolio is periodically rebalanced.
Let me illustrate this with two portfolio examples — an ETH-USDT portfolio, and a BTC-USDT portfolio.
In both cases, ETH and BTC represent the high-volatility end of the barbell. USDT, a stablecoin, is our token of choice at the low-risk end.
ETH and BTC’s volatilities are gleaned from the DVOL ETH and DVOL BTC indexes respectively, and USDT is assumed to have a volatility of 0.
In these two portfolios, you will see that the ideal or target weight of ETH (or BTC) for example, is determined by the formula:
VIX / DVOL ETH (or BTC) = ETH Weight (or BTC Weight)
The weight of USDT is then determined by:
1 − ETH Weight (or BTC Weight) = USDT Weight
In these two portfolios, I have made it such that the portfolios are rebalanced to their target weights every 7 days. I have kept it as such just for simplicity’s sake.
It is also noteworthy to point out that the returns in the past year of both the ETH-USDT and the BTC-USDT portfolios compared to the S&P500 are slightly better. This varies slightly as I tinker with how often the portfolios are rebalanced. And of course, the returns will also vary when transaction costs are taken into account, and when different backtest durations are considered.
To sum up, in these two simple examples of running a barbell strategy fully on-chain, we can already see that they are promising alternatives to barbell strategies deployed with traditional assets like stocks, bonds and treasuries, offering comparable, if not slightly better returns than just buying the S&P500. To develop the on-chain barbell strategy idea even further, instead of simply using a stablecoin, we could use treasury bill tokens or even a yielding stablecoin like Savings Dai(sDAI) at the low-risk end. Staking a portion of the ETH in the ETH portfolio on Lido DAO and holding stETH for example can also increase the annual yield of the portfolio while still allowing us to capture the upside potential of ETH.
This is just the beginning!
