With over $50 trillion in assets under management, the active investing industry impacts all of us - whether directly through savings; or indirectly through how capital is allocated across geographies, sectors, or asset classes.
DeFi has the potential to radically improve the existing active investment industry through its openness and transparency - leading to better strategies and allocation of capital. In turn, this will unlock an explosion of competition, choice and yield (interest/returns) for savers and investors.
This article explains how active investing works today, how it works in DeFi, and why DeFi is the future of active investing. Feel free to also check out our previous article Why DeFi is the future of passive investing.
How active investing works today
As the name implies, active investing is when a fund manager (such as Fidelity or Bridgewater) sets up a fund, which is a pool of money. Members of the public or other financial institutions (such as pension funds) can buy shares in the fund.
The objective of the fund is to invest its pool of money in a portfolio of assets according to a strategy, earning yield in order to outperform the general market over time. The fund manager does this by investing in assets such as stocks, bonds, commodities, real estate, or derivatives that it thinks are undervalued and will provide an outsized risk-adjusted return. The value of the fund rises and falls in line with its underlying portfolio.
For the fund to outperform the wider market, the fund manager undertakes research, validates and reports on its strategy, and rebalances its portfolio by trading assets where it sees opportunity, in line with the rules of its investment mandate. Those trades are executed via a multitude of other financial intermediaries such as brokers, exchanges, clearing houses, and custodians - all of which take a cut. See Why DeFi is the future of exchanges and trading to understand how DeFi will disrupt this aspect of finance too.
With all these intermediaries, compounded with the requirement to research, manage risk, and report; active funds charge their investors a lot more than passive: typically about 1% of the value of the fund annually; or even 2% of the total value and 20% of returns in the case of some specialized active managers such as hedge funds.
How active investing works in DeFi
The products and services provided by active managers in traditional finance can be replicated in DeFi by a category of decentralized application (dApp) most commonly referred to as yield optimizer, such as Yearn Finance (although asset manager and yield farmer are also used interchangeably).
These dApps have the same objective as with an active investing fund in traditional finance: outperform the rest of the market; although they differ markedly in the way they are governed and execute their strategies.
How a simple yield optimizer dApp works in DeFi
An investor deposits a token, such as USDC, into a dApp and receives a fund token in return, which represents a claim of a share of the fund. The liquidity from the sum of investor deposits is then used to purchase a portfolio of underlying assets. Over time, the fund rebalances its portfolio - trading assets as better opportunities arise. As the underlying assets rise in value, so too does the fund token, which can be redeemed by the investor if she ever wishes to exit her position.
Who sets the strategy of the fund and decides what trades to make?
Instead of a fund manager making the decisions, DeFi dApps are configured with investment strategies that are executed automatically and continuously. This is only possible in DeFi where a smart contract has direct access to assets and other financial products and services on a shared platform.
The choice and configuration of the investment strategy are often governed by a decentralized autonomous organization (DAO). A DAO is a way of coordinating a group of people with a common purpose - using tokens and smart contracts to do so in a manner that is trustless and open. Decisions are made collectively with votes weighted in a variety of ways.
One of the most popular examples of DAO-based decision making is Yearn Finance, whose community votes on the investment strategy and allocation for each of its funds. New investment opportunities are continually discussed in order to optimize yield, surfacing opportunities that can consistently return 5% to over 30% a year, depending on the risk tolerance of the fund.
Another example is the yield optimization dApp Numerai. Here, instead of the community voting directly on which assets to purchase, it instead votes on artificial intelligence algorithms and data sources in order to optimize trading and capital allocation. Numerai can tap into some of the world’s top data scientists - rewarding them for the best algorithms and data - in a fully decentralized manner. Some of the top Numerai funds have returned over 800% over 2021!
But where does the yield come from?
Yield in DeFi today typically comes from one of three sources:
- Changes in asset price can result in yield when the underlying portfolio of tokens rises in value (which can include derivative tokens that rise in value as other tokens lose value).
- Newly minted tokens are when a protocol or dApp mints new tokens as a reward for a certain action. For example, a decentralized exchange might mint governance tokens as a reward to those who provide it liquidity. dApps may also provide retrospective airdrops of governance tokens as a means of incentivizing use of their dApp, such as with dYdX. Layer 1 protocols mint new tokens to incentivize token holders to stake their tokens as part of a proof of stake security system. While this may seem like printing money out of thin air, these tokens can have real utility and are thus valued as such by the market.
- Fees & interest can be taken from those who use a particular product or service. The Curve DEX for example accrues fees to those who hold the CRV governance token. Liquidity provider token holders also collect fees directly from users who trade with automated market makers. In lending dApps such as Aave and Compound, those who lend assets are provided interest payments from those who borrow.
Why DeFi makes active investing better
Active investing in traditional finance and yield optimization in DeFi share three common components: each has an investor, a fund manager, and a process for trading and settlement.
The key difference is that in a DeFi ecosystem, all three components live on the same public decentralized ledger, as opposed to the closed and opaque ledgers of a multitude of financial institutions. This results in:
- a transparent and open financial system that anyone can interact with and build on; and
- automated execution of transactions which increases efficiency, saves on cost, and reduces barriers to entry for new projects.
Openness leads to better strategies
In DeFi, fund managers are replaced by a fund dApp that is self-executing computer code. This means anyone can set up their own fund or contribute to the strategy of an existing one through the governance and reward mechanisms of a DAO. As a result, DeFi yield optimizers can leverage a far greater pool of knowledge than traditional fund managers, as anyone with access to the internet can contribute! Yearn’s Millenium Prize is a case in point.
What’s more, instead of data being siloed and hidden within the ledgers of individual financial institutions, the transparent nature of public decentralized ledgers provides a rich and trusted dataset upon which investment strategies can be formulated. “Cooking the books” will no longer be a thing as all data is out in the open. Everyone has to be competitive as everything is visible.
Composability leads to compounded innovation
In traditional finance, active investment products and services are coordinated via a series of siloed institutions. This makes building on top of one another difficult as systems and data are the property of each individual institution, resulting in a lot of wastage as the same products and services are replicated a hundred fold.
In a DeFi ecosystem, as all dApps exist on the same ledger, products and services can be composed seamlessly with one another. If a DeFi project builds an algorithm that is optimal for switching capital between different liquidity pools, then anyone can leverage or improve that algorithm.
This allows for endless products and services to be layered on top of one another, forming a chain of tokens and dApps stitched together, with anyone being able to contribute to any part. How can the closed and siloed products and services of traditional finance ever compete with the innovative powers of an open self-evolving yield optimization machine?
Automation and composability provide instant liquidity
In DeFi, as everything is on the same ledger, trading and settlement happens instantaneously - there is no waiting two days for a multitude of intermediaries to settle the trade behind the scenes. This allows DeFi yield optimizers to instantly allocate capital to where it gets the best yield, resulting in massively reduced fees, greater participation and access for everyone, and capital that is automatically programmed to always and instantly seek the best returns.
What’s in store for the future?
To date, the vast majority of yield generated within DeFi comes from the closed loop of crypto, which is still heavily driven by speculation. The yield does not come from real-world assets, such as rent from property or dividends from a company.
While we are still early, what DeFi has so far demonstrated is a more efficient and optimal paradigm for allocating assets. On the assumption that capital seeks the best risk-adjusted returns, it can only be a matter of time when more and more of the $400Tn of real-world assets become represented as tokens and managed within DeFi.
But for this to work, you need a development framework that allows developers to build DeFi dApps as they intuitively imagine them, in order to improve productivity and reduce hacks, bugs and exploits. At Radix, our asset-oriented programming language Scrypto promises to be a game-changer for the industry. Scrypto launches this December.