Investment Philosophy
The purpose of this document is to update the Investment Philosophy for Nexus Mutual’s balance sheet from the previous version. This is a living document, and will be updated periodically as shifting market dynamics and balance sheet considerations require. This philosophy is meant to provide guidance on how capital should be allocated broadly rather than providing specific guidance on individual investments.
At the end of this post, you will find a summary of the major changes since the previous version.
The document has been drafted as a collaborative effort of members of the Nexus Mutual Investment committee within the Nexus Mutual DAO.
Objective
The objective of the investment philosophy is to create a diversified portfolio of assets that seeks to maximize return, generate long-term growth and preserve capital by investing within the mutual’s risk constraints while ensuring sufficient liquidity to meet cover obligations.
Key Considerations
Before considering the mutual’s approach to risk budgeting, it first makes sense to describe key considerations that materially influence the mutual’s risk appetite.
- Asset/Liability Match: Given that the mutual provides novel insurance in a nascent industry, not enough experience data exists to make reasonable projections around future cover payments, and therefore the true duration of the liabilities is unknown. As prudent managers of the mutual’s balance sheet, we endeavour to ensure sufficient liquidity & asset/liability match to meet tail-risk scenarios on active cover.
- Time Horizon: We operate under the assumption that Nexus Mutual has the resources necessary to continue operating indefinitely. While in the short-term, volatility can lead to variable investment performance, in the long-term investors are compensated to own assets with the best risk-adjusted returns over full market cycles… As such, we seek assets that can deliver favorable returns over an extended period of time, with possibly longer durations,as-is reasonably permitted by the mutual’s liabilities.
- Capitalization: Through regular operations of the mutual, the size of the capital pool will naturally vary relative to the minimum capital requirement (MCR). When the capital pool is larger relative to the MCR, the mutual is better positioned to take investment risk. When the size of the capital pool is closer to the MCR, the mutual may prefer to reduce risk.
Risk Buckets
Defining the Base Currency
Because cover amounts are defined in terms of ETH or DAI, ETH & DAI are both effectively ‘cash’ on the mutual’s balance sheet and represent risk-free investments relative to the mutual’s liabilities.
Qualitative vs. Quantitative Risk Assessment
As mentioned previously the mutual provides coverage in a nascent industry; while quantitative data exists, high volatility and brief data histories make it difficult to draw reasonable conclusions regarding the nature of risk among crypto assets, protocols and related companies that may or may not have seen a complete market cycle. Initially, the mutual will opt for a qualitative risk framework.
All investment risk can be defined relative to holding ETH and DAI. From this base, we propose three risk buckets: lower, medium, and higher risk. The table below provides some general guidance on how investments and strategies may fall into these risk categories.
All new managers & investments will be assessed on each of the risks below and this assessment will be included with new investment proposals, including a recommendation on which bucket a new manager/investment belongs.
| Risk | Lower Risk | Medium Risk | Higher Risk | Comments |
|---|---|---|---|---|
| Illiquidity Risk | Can be liquidated in 72 hours or less | Can be liquidated in 7 days or less | Liquidation takes more than 7 days | Locking up capital for periods of time presents risk to the balance sheet should the mutual need those funds to pay claims. Note that the risk buckets here refer to liquidity in non-stressed scenarios. Stressed scenario liquidity is also a consideration but difficult to quantify. |
| Basis Risk | ETH/DAI denominated | High to medium correlation with ETH/DAI | Little to no correlation with ETH/DAI | The balance sheet is largely ETH denominated. ETH and DAI are effectively ‘cash.’ Investing in other tokens introduces basis risk. |
| Protocol Risk (DeFi Safety Score) | DeFi Safety Score >=80%; simple design | DeFi Safety Score >=80%; Newer protocol; composability (2 layers) | DeFi Safety Score >=70%; 3 or more protocol layers | Putting funds in a vault or liquidity pool to earn a yield opens up our funds to risk of loss from smart contract hacks |
| Liquidation Risk | No liquidation risk | Max 20% expected loss in liquidation | 20%+ expected loss in liquidation | In the case of lending, Nexus collateral could be at risk of liquidation |
| Leverage | No leverage | Max 10% net leverage | 10%+ net leverage | Refers to leverage of the balance sheet as a whole. Leverage may either be an explicit component of a particular strategy, or embedded leverage (Options, Futures, etc.) |
| Counterparty Risk | 20% exposure to a single counterparty or less | 20%-30% exposure to a single counterparty | 30%+ exposure to a single counterparty | Other additional qualitative & quantitative measures of counterparty risk may be used to assess investments & managers. This refers to protocols, managers & individual investments, and should also allow for liabilities. |
| Economic risk | Negligible possibility of loss as a result of investment | Limited loss possibility | Unlimited loss possibility | Some investments may result in losses on a short term basis, e.g. impermanent loss. |
Lower Risk
Lower risk investments are ETH/DAI-like, with no (or very limited) leverage, liquidation, protocol, illiquidity, or basis risk.
Medium Risk
A medium risk strategy meets at least one of the medium risk criteria above. An example of a medium risk strategy could be borrowing a non-ETH token via Compound using ETH as collateral and depositing it in a Curve pool to generate an attractive yield.
Higher Risk
A higher risk strategy meets at least one of the higher risk criteria above. Examples include investing directly in non-ETH tokens, options strategies, certain types of token staking, etc.
Monitoring
It is recommended that a section on Monitoring should be added for each strategy, already at the proposal stage.
The goal would be to define a set of criteria/KPIs which would trigger a review and or an exit or partial withdrawal.
These parameters would be dependent on the type of strategy.
Some examples of possible metrics
- Level of TVL (a metric used to measure the overall health of a DeFi protocol)
- Set alert in case of a xx% drop (in ETH terms)
- Consider setting partial withdrawal in case of a xx% drop
- Nexus Mutual investment as % of the pool/vault/strategy TVL
- Less than xx% at inception
- Maintain below xx% (which would mean automatic withdrawals and/or consideration for withdrawal)
- Concentration risk within the pool/vault/strategy
- Monitor deviations vs initial conditions
Risk Budgeting
Now that we have broadly defined risk buckets, we set some parameters around appropriate allocations to them.
| Bucket | Minimum (%) | Maximum (%) | Target (%)* |
|---|---|---|---|
| Cash (ETH/DAI) | 10% | 30% | 20% |
| Lower Risk | 30% | 80% | 40% |
| Medium Risk | 0% | 35% | 25% |
| Higher Risk | 0% | 20% | 15% |
*Targets will change over time
The maximums and minimums shown in the table allow for a great deal of flexibility and variance in risk appetite. In these early days of the mutual’s investing, this flexibility is critical. The targets in the table above indicate a strong risk appetite, reflecting the current balance sheet strength of the mutual. The 20% cash target represents enough immediate liquidity to cover ~100% of the mutual’s formulaic MCR (active cover amount ÷ 4.8). The lower risk bucket will consist mostly of ETH2 staking.
As the mutual is initially deploying capital, allocations to these buckets are likely to fall outside of the minimum and maximum ranges shown above. We expect this to persist until the balance sheet has been fully invested. The targets, benchmarks, and expected returns laid out here are guidelines, and while our goal is to try and meet these over time, we will not invest the mutual in inappropriate assets or imprudent investments to meet them.
We will instead opt to add risk in a measured fashion, only targeting appropriate investments and executing after thorough diligence. Given the incipient and developing nature of the ecosystem, these investments are not yet widely available, and effective asset sourcing will be a critical element of the successful execution of this investment philosophy.
Asset Liability Mismatch
Currency Mismatch
In defining the base currency, we have determined that both ETH & DAI are cash on the mutual’s balance sheet. Given sufficient capitalization, a potential passive investment strategy may be to underweight DAI and overweight ETH relative to their respective proportions of active cover liabilities. Here we allow for this possibility while defining reasonable limits on the potential mismatch.
This is meant to be a long term target. Currently, since the mutual is overcapitalised and members have an ETH long bias, the overweight towards ETH is significantly higher.
| ETH - DAI | |
|---|---|
| Maximum ETH Overweight | 35% |
| Minimum ETH Overweight | 0% |
Expected Returns and Risk Tolerances
Expected returns and max drawdowns are relative to ETH. Ultimately, the overall expected return and potential max drawdown will depend on the investment strategies deployed.
| Strategy | Expected Return | Max Drawdown* |
|---|---|---|
| Overall | 3-8% | -20% |
| Lower Risk | 3-6% | -10% |
| Medium Risk | 5-8% | -35% |
| Higher Risk | 8%+ | -50% |
*Over a one year period
Benchmarks
| Strategy | Benchmark |
|---|---|
| Overall | stETH + 1% |
| Lower Risk | stETH |
| Medium Risk | stETH + 2% |
| Higher Risk | stETH + 4% |
The above table provides relative benchmarks for the balance sheet investments. As the mutual is in the early stages of investing the balance sheet, we expect the return to underperform the overall benchmark due to the mutual’s allocation to cash, with performance improving as more investments & manager relationships are diligenced & executed. This underperformance may persist as we deploy capital. After the balance sheet has been fully invested, the suitability of these benchmarks will be reassessed.
Nexus Community
We encourage all community members to provide their thoughts and engage in discussion around this philosophy at any time!
Summary of the changes
Base currency :
At the present time, the majority of cover is defined in ETH terms, and therefore, early iterations of the investment strategy will only consider ETH, with parameters for DAI to come when it represents a more meaningful portion of the assets balance sheet. As DAI became an increasing part of Nexus’ liabilities over the last 18 months, we believe it important to leave the door open for diversification into stables and stablecoin investments.
Other risk constraints :
| Limit | |
|---|---|
Some of these were redundant. This section has been incorporated into “Counterparty risk” in the risk assessment section.
Currency Mismatch
This is meant to be a long term target. Currently, since the mutual is overcapitalised and members have an ETH long bias, the overweight towards ETH is significantly higher.
| ETH - DAI | |
|---|---|
| Maximum ETH Overweight | 35% |
| Minimum ETH Overweight | 0% |
Qualitative vs. Quantitative Risk Assessment :
| Risk | Lower Risk | Medium Risk | Higher Risk | Comments |
|---|---|---|---|---|
| Illiquidity Risk | Can be liquidated in 72 hours or less | Can be liquidated in 7 days or less | Liquidation takes more than 7 days | Locking up capital for periods of time presents risk to the balance sheet should the mutual need those funds to pay claims. Note that the risk buckets here refer to liquidity in non-stressed scenarios. Stressed scenario liquidity is also a consideration but difficult to quantify. |
| Basis Risk | ETH/DAI denominated | High to medium correlation with ETH/DAI | Little to no correlation with ETH/DAI |
|
| Leverage | No leverage |
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Refers to leverage of the balance sheet as a whole. Leverage may either be an explicit component of a particular strategy, or embedded leverage (Options, Futures, etc.) |
| Counterparty Risk |
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Other additional qualitative & quantitative measures of counterparty risk may be used to assess investments & managers. This refers to protocols, managers & individual investments, and should also allow for liabilities. |
Risk bucketing
| Bucket | Minimum (%) | Maximum (%) | Target (%)* |
|---|---|---|---|
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| Lower Risk |
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| Medium Risk |
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| Higher Risk |
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Monitoring
It is recommended that a section on Monitoring should be added for each strategy, already at the proposal stage.
The goal would be to define a set of criteria/KPIs which would trigger a review and or an exit or partial withdrawal.
These parameters would be dependent on the type of strategy.
Some examples of possible metrics
- Level of TVL (a metric used to measure the overall health of a DeFi protocol)
- Set alert in case of a xx% drop (in ETH terms)
- Consider setting partial withdrawal in case of a xx% drop
- Nexus Mutual investment as % of the pool/vault/strategy TVL
- Less than xx% at inception
- Maintain below xx% (which would mean automatic withdrawals and/or consideration for withdrawal)
- Concentration risk within the pool/vault/strategy
- Monitor deviations vs initial conditions
Expected Returns and Risk Tolerances
| Strategy | Expected Return | Max Drawdown* |
|---|---|---|
| Overall |
|
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| Lower Risk |
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-10% |
| Medium Risk |
|
-35% |
| Higher Risk |
|
-50% |
Benchmarks
| Strategy | Benchmark |
|---|---|
| Overall | stETH + |
| Lower Risk | stETH |
| Medium Risk | stETH + |
| Higher Risk | stETH + |
The above table provides relative benchmarks for the balance sheet investments. As the mutual is in the early stages of investing the balance sheet, we expect the return to underperform the overall benchmark due to the mutual’s allocation to cash ETH, with performance improving as more investments & manager relationships are diligenced & executed. This underperformance may persist for 12 to 18 months as we deploy capital. After the balance sheet has been fully invested, the suitability of these benchmarks will be reassessed.