Author: LD Capital

Introduction

Grayscale Ethereum Trust (ETHE), as the largest publicly traded Ethereum product in the U.S. stock market, holds up to 3 million ETH. However, its secondary market trading price currently shows a discount of nearly 50% compared to its net asset value (NAV). In our previous report, we analyzed the reasons for the premium and discount of this product, as well as several scenarios in which the discount may narrow. Based on the cyclical rotation pattern, we believe that if one bets on a potential bull market, ETHE has better elasticity compared to ETH spot.

However, we also found that historical data calculations show that ETHE's risk-return metrics are poor, performing worse than ETH/USD in terms of risk-adjusted returns, maximum drawdown, and volatility. This means that if one plans to hold ETHE for the long term, some targeted yield enhancement strategies may be necessary; otherwise, if the bull market does not arrive quickly, its performance may lag behind the market.

As the second report in the series, we will explore how to construct an index enhancement strategy for ETHE, aiming to capture the long-term beta return value of the asset while appropriately managing to achieve alpha returns, thus enhancing the long-term holding experience for investors.

Overview of Grayscale ETHE Statistical Characteristics (Risk and Return Overview of Grayscale ETHE)

First, let's analyze the characteristics of the core asset of this strategy, Grayscale ETHE:

The above table presents the statistical performance of ETHE and ETH-USD from January 1, 2020, to April 30, 2023, based on monthly returns. In terms of risk indicators such as alpha coefficient, maximum drawdown, value at risk, and risk-adjusted returns, ETHE underperforms ETH spot, but its returns exhibit a right-skewed fat-tailed distribution, indicating greater potential for positive volatility:

Return Performance: The arithmetic average monthly return of Grayscale ETHE is 8.91%, with an annualized return of 178.48%; while the arithmetic average monthly return of Ethereum spot is 10.60%, with an annualized return of 235.03%. From this metric, Ethereum spot outperforms Grayscale ETHE. In terms of geometric average returns, Grayscale ETHE's annualized return is 40.03%, while Ethereum spot's annualized return is 120.08%, indicating better long-term investment performance for Ethereum spot.

Risk Performance: The monthly and annualized standard deviations of Grayscale ETHE are 38.16% and 132.18%, respectively, higher than Ethereum spot's 29.01% and 100.48%, indicating that Grayscale ETHE has greater price volatility and relatively higher risk. Additionally, Grayscale ETHE's maximum drawdown is -89.60%, also higher than Ethereum spot's -77.96%, further indicating that Grayscale ETHE carries higher risk.

Risk-Adjusted Returns: The Sharpe Ratio and Sortino Ratio are indicators used to evaluate the risk-adjusted returns of investments. From 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 exceeds that of Grayscale ETHE.

Market Correlation: The beta coefficient in the table shows that Grayscale ETHE has a beta of 0.9, indicating relatively high systematic risk (ETH). However, the alpha coefficient shows that Grayscale ETHE's annualized alpha is -8.14%, indicating that after excluding market risk, Grayscale ETHE failed to achieve positive returns within 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, indicating that the performance in terms of profits and losses is quite similar.

Profit Cycle: In terms of positive return cycles, Grayscale ETHE had 23 positive return cycles out of 41, accounting for 56.10%, while Ethereum spot had 26 positive return cycles out of 41, 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%, while the analytical VaR (5%) is -53.85%, and Ethereum spot's historical VaR (5%) is -30.15%, with analytical VaR (5%) at -37.11%. This indicates that at the same confidence level, Grayscale ETHE's potential maximum loss is greater than that of Ethereum spot.

Conditional Value-at-Risk (CVaR): Grayscale ETHE's CVaR (5%) is -44.36%, while Ethereum spot's CVaR (5%) is -43.67%. This means that in the worst-case scenario, Grayscale ETHE's losses may be similar 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%, indicating that Grayscale ETHE captures lower upside returns during market upswings, while experiencing higher 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 indicates that Grayscale ETHE's return distribution exhibits a steeper peak compared to a normal distribution, indicating a higher probability of extreme returns (positive or negative). At the same time, its positive skewness indicates that the return distribution is right-skewed, with larger extreme positive returns. This may suggest that Grayscale ETHE carries higher investment risk, but may have greater return potential in positive volatility.

Why does ETHE, which is also based on ETH spot as the underlying asset, perform poorly overall?

This is mainly due to its unique product structure, market structure, and changes in market conditions, which led to an initial premium compared to NAV (from 2019 to mid-2021) and later a discount (from 2021 to present). The nearly 90% decline from premium to discount has dragged down the overall risk-return metrics.

The reasons behind the negative/positive premium include the fund structure of Grayscale ETHE Trust, which cannot be directly redeemed. The reasons for the positive premium include higher accessibility of the product compared to ETH spot, making ETHE more suitable for traditional financial institutions and novice retail investors compared to the costs of self-custody of private keys; balance sheet accounting treatment, tax advantages, and helping investors bypass compliance-related issues. The reasons for the negative premium include the inability to directly redeem the fund structure, limitations on arbitrage opportunities, discounting of opportunity costs, and the impact of competitive products.

For more analysis, see the first report in the series “Is Buying ETH at a 50% Discount an Opportunity or a Trap? An In-depth Analysis of Grayscale Trust”

Principles of Index Enhancement Fund Strategy

Basic concepts and ideas related to ETHE index enhancement

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

This strategy requires using ETHE as the cornerstone position, allocating no less than 60% of funds to ETHE spot, with the remaining funds allocated to cash, fixed income products, U.S. blockchain and cryptocurrency-related stocks, as well as options derivatives of these stocks.

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

The core source of excess returns for constructing a portfolio based on ETHE is betting on the narrowing of the secondary market price of ETHE relative to NAV. However, given ETHE's poor historical return statistics, in order to enhance the holding experience during the holding period, we need to:

1. Diversified Allocation. Include some assets in the portfolio that have relatively low correlation, stable returns, and lower volatility to correct the poor risk-return ratio, such as cash, fixed income products, U.S. blockchain and cryptocurrency-related stocks, as well as options derivatives of these stocks.
2. High Positioning. As indicated by the previous data, ETHE may have higher return potential in positive volatility, so to avoid missing extreme upward trends, ETHE's overall position should be maintained at a high level. Under normal circumstances (except for particularly significant risks, such as a trust crisis in Ethereum or a major financial crisis in Grayscale), it should not be less than 80% allocation.
3. Derivatives Enhancement. In the stock selection enhancement part, using options strategies has advantages over simply holding the underlying asset. The source of excess returns mainly comes from capturing the volatility premium in options pricing, supplemented by the construction of complex options strategies to form more targeted investment strategies.
4. Margin Trading. The index enhancement effect brought by margin trading generally comes from two aspects: when optimistic about the market, one can use their own stocks or ETFs as collateral for financing to amplify leverage; through the securities lending business, one can lend their own stocks to generate income. If ETHE supports margin trading in the future or stocks in the stock selection enhancement part, this could also be one of the alternative strategies.
5. IPO Participation. With the improvement of the regulatory environment, more traditional brokers are entering the cryptocurrency trading business. In the future, it is not ruled out that initial offerings of cryptocurrency assets will occur on regulated broker platforms. Historically, returns from so-called ICOs and IDOs have been quite substantial, and at that time, we could also use our holdings as IPO participation with a small amount of cash.

Specific Methods

Since points 4 and 5 are currently difficult to implement, we will focus on the operations of points 1 to 3:

Choose Index

Use ETHE as the main tracking index, supplemented by ETH/USD as a reference index. Since the asset is singular and not a traditional broad-based index enhancement, when facing the higher risk concentration of a "narrow-based" index, controlling volatility and drawdown becomes a more critical target for providing additional value through active management.

Fund Allocation

To ensure that the portfolio does not significantly deviate from the benchmark index, at least 60% of the funds should be allocated to ETHE, and under normal circumstances, the weight should be maintained at 80-90%, with the weight of yield enhancement funds inflating to 10-20%.

Stock Selection Enhancement

Since ETHE shares are currently traded on the OTCQX market, which is a so-called over-the-counter securities trading market, where securities typically have limited trading activity and lack a standard options market, it is not possible to use the broker's platform balance as collateral for covered call strategies or margin trading operations. Therefore, the primary focus of enhancement is on selectively allocating blockchain and cryptocurrency-related concept stocks.

The criteria for selecting investment targets are:

1. Companies with clear business plans in the cryptocurrency ecosystem or those that indirectly benefit from the development of the cryptocurrency industry, including cryptocurrency mining companies, mining equipment/chip suppliers, cryptocurrency financial service companies, or other financial institutions primarily serving cryptocurrency-related clients, metaverse business companies, etc.;
2. Or fund products that primarily focus on digital currency spot or its derivatives;
3. Or fund products that invest in the above two categories.

Why Choose Cryptocurrency Stocks:

Based on the moderate correlation between cryptocurrency stocks and cryptocurrency assets, establishing exposure to the cryptocurrency market in a safe, convenient, and compliant manner.

The correlation between cryptocurrency stocks and cryptocurrency assets typically ranges between moderate (0.40) and significant (0.90). Additionally, historically, many cryptocurrency companies' stock prices have a beta greater than 1 compared to cryptocurrencies. This amplified risk exposure can make cryptocurrency stocks an effective tool for gaining exposure to price fluctuations in the cryptocurrency market. Furthermore, not only ETHE, but some cryptocurrency funds (like BITW) also have market values below NAV due to similar structural issues, which can also be bet on for discount recovery.

Table: Monthly Return Correlation of Major Cryptocurrency Stocks with ETH and ETHE (5/01/2021--05/04/2023):

Note: The statistical period is limited by the fact that COIN stocks only began trading in May 2021; CASH represents cash.

Derivatives Enhancement

Options enhancement primarily focuses on covered call strategies based on the owned stock/ETF spot positions, i.e., selling a certain number of out-of-the-money calls. This can yield excess returns relative to the spot during market downturns or stable uptrends.

At the same time, adjustments can be made to the covered call strategy based on macro, technical, and industry fundamental factors. For example, using a ratio call spread. In cases where the term structure is appropriate, a calendar spread can be employed.

When protection for the portfolio is needed, the options structure can be determined based on the level of implied volatility. For instance, when implied volatility is high and the wings are relatively high compared to at-the-money options, a put spread collar structure can be chosen.

Examples of Options Enhancement Strategies

It is important to note the details of volatility changes, such as skew and term structure, which can affect the specific options structure. These indicators need to be systematically tracked in real-time. Below are some demonstration images of options structures:

Subjective Timing

Timing operations based on macro, technical, and industry fundamentals analysis can also be a source of excess returns, but overall, as an ETHE enhancement strategy, position timing should be downplayed.

Specifically:

• Macro Timing: Analyzing macro, policy, and economic cycles to comprehensively judge the overall future trend of the digital currency market.
• Industry Timing: Company/project research, event-driven, multi-factor stock selection, etc.
• Technical Timing: Utilizing technical analysis to assess trend sustainability and making appropriate adjustments around key resistance and support levels.

The unquantifiable macro judgment and event-driven aspects are the core differences that reflect the strategy manager's level. For example, the Ethereum 2.0 upgrade (Shapella) concluded on April 13, 2023. However, many overlooked the fact that a large amount of ETH withdrawal would not occur immediately and may take more than five days to settle. Therefore, if the price rises a few days after the upgrade's positive completion, it may be worth considering appropriate reduction or selling some call options to capture volatility value. The following chart shows the ETH spot price, which surged around April 13 and then consolidated for five days before rapidly declining.

The purpose of the above strategies is mainly to:

• Hold core assets in the cryptocurrency market for the long term --- ETH is the core infrastructure for mainstream Web 3 applications, which, like BTC, can accommodate the liquidity overflow of fiat wealth and diversification needs, while also gaining additional alpha from Web 3 ecosystem applications;
• Timing operations do not affect the cornerstone position --- Timing operations should not affect the high positioning of ETHE, avoiding missing out on tail-end extraordinary uptrends;
• Focus on the alpha of stocks --- Selecting more outstanding companies will yield excess returns above the market average in the long run.
• Capture volatility returns --- By using options to convert black swan risks and volatility from long-short transitions into "alpha" for long-term index bulls.

Empirical Study

Next, we will conduct an empirical analysis of the proposed index enhancement fund strategy based on Grayscale ETHE using historical data to assess the strategy's effectiveness and feasibility.

Based on historical data from January 2020 to April 2023, and the following alternative assets (with OPRE used to simulate part of the options returns), we will conduct monthly return statistics, then impose conditional constraints on the maximum and minimum proportions of each asset's allocation, and obtain optimized portfolio configurations based on three methods:

• Maximum Sharpe Ratio Optimization --- Finding the optimal risk-adjusted investment portfolio located on the efficient frontier based on mean-variance analysis.
• Minimum Variance --- Minimizing the combination risk (measured by variance or standard deviation) among a set of assets.
• Maximizing Returns under a Given Annual Volatility Target of 100% --- Seeking to maximize the expected returns of the portfolio at a given risk level.

The test results show the performance of each optimized portfolio, where the performance of ETHE (black line) can be compared with the unoptimized reference portfolio 1 (blue line):

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

These data can be observed from the following aspects:

Returns: During the given period, the final balance of the maximum Sharpe ratio portfolio is 60,653, performing the best and significantly outperforming the other portfolios and the benchmark asset. The final values of the minimum variance portfolio and the maximum return portfolio under 100% volatility are 42,977 and 45,878, respectively, also higher than the benchmark asset's 31,840. This indicates that the optimized portfolios outperform the single asset in terms of returns.

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 (of -80.44% and -80.63%, respectively), while the benchmark asset has the highest maximum drawdown (-89.60%). This indicates that the optimized portfolios also perform better in risk control.

Risk-Adjusted Returns: The Sharpe Ratio and Sortino Ratio measure expected returns per unit of risk and expected returns per unit of downside risk, respectively. From these two indicators, the maximum Sharpe ratio portfolio performs the best (Sharpe Ratio of 0.96, Sortino Ratio of 2.06), indicating that in terms of risk-adjusted returns, this portfolio outperforms the other portfolios and the benchmark asset.

Relative Returns and Risks: Active returns, tracking error, and information ratio measure the excess returns, risks, and risk-adjusted excess returns of the optimized portfolio relative to the benchmark asset. Among these three indicators, the maximum Sharpe ratio portfolio performs the best: active return is 30.19%, and information ratio is 0.92 (the 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, achieving certain excess returns while assuming moderate risk.

Note: The optimization is based on monthly return statistics of the selected investment portfolio assets during the given time period. The optimization results do not predict that the configurations will perform best outside the given time period, and the actual performance of the portfolio constructed with the optimized asset weights may differ from the given performance targets.

Conclusion

In summary, the poor risk-return ratio of ETHE itself can be enhanced through different allocation methods. The simulated portfolio outperforms the benchmark asset ETHE in terms of returns, risk control, and risk-adjusted returns. Investors can choose investment methods that suit their risk preferences and investment goals to improve their holding experience, achieving a balance between maximizing returns and minimizing risks.