Investment Philosophy
The purpose of this document is to define the Investment Philosophy for Nexus Mutual’s balance sheet. 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.
Objective
The objective of the investment philosophy is to create a diversified portfolio of assets that seeks to maximize return and preserve capital by investing within the mutual’s risk constraints while ensuring sufficient liquidity to meet cover obligations and generate long-term growth.
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 paid for owning risk. As such, we seek to maximize the duration of investments 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. 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 balance sheet.
Qualitative vs. Quantitative Risk Assessment
As mentioned previously the mutual provides insurance 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 and protocols that may or may not have seen a complete market cycle. Initially, the mutual will opt for a qualitative risk framework.
Considering ETH is cash, all investment risk can be defined relative to holding ETH. From this ETH 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 |
| Basis Risk | ETH denominated | High to medium correlation with ETH | Little to no correlation with ETH | The balance sheet is largely ETH denominated. ETH is 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 30% net leverage | 30%+ net leverage | Leverage may either be an explicit component of a particular strategy, or embedded leverage (Options, Futures, etc.) |
| Counterparty Risk | 10% exposure to a single counterparty or less | 20% exposure to a single counterparty | 20%+ exposure to a single counterparty | Other additional qualitative & quantitative measures of counterparty risk may be used to assess investments & managers |
| 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-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.
Risk Budgeting
Now that we have broadly defined risk buckets, we set some parameters around appropriate allocations to them.
| Bucket | Minimum (%) | Maximum (%) | Target (%)* |
|---|---|---|---|
| ETH | 5% | 20% | 10% |
| Lower Risk | 30% | 80% | 30% |
| Medium Risk | 0% | 40% | 35% |
| Higher Risk | 0% | 25% | 25% |
*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 10% ETH target represents enough immediate liquidity to cover ~50% 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.
Other Risk Constraints
At the moment & given the risk appetite of the mutual, these exposure limits may remain high. These are likely to be revised lower as the balance sheet becomes increasingly invested and more opportunities to diversify balance sheet investments are identified.
| Limit | |
|---|---|
| Max exposure to a single investment manager | 20% |
| Max exposure to a single counterparty | 20% |
| Max exposure to a single protocol (includes assets and cover liabilities) | 20% |
| Max exposure to protocols with less than $200M in TVL | 20% |
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.
| 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 | 5-20% | -28% |
| Lower Risk | 5-10% | -10% |
| Medium Risk | 10-20% | -35% |
| Higher Risk | 20%+ | -50% |
*Over a one year period
Benchmarks
| Strategy | Benchmark |
|---|---|
| Overall | stETH + 3.5% |
| Lower Risk | stETH |
| Medium Risk | stETH + 5% |
| Higher Risk | stETH + 10% |
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 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.
Nexus Community
We encourage all community members to provide their thoughts and engage in discussion around this philosophy at any time!