How Two Prime Has Outperformed Bitcoin

As part of the latest installment of Blockworks’ Q&A series with fund managers, I recently spoke with Alexander Blum, a managing director of Two Prime, about his firm and its investment offerings.  

Blum, who founded Denver-based Two Prime in 2019, bought his first bitcoin for $9 in 2012. He previously founded digital investment group Atomic Capital, worked as a technology advisor for the Bill & Melinda Gates Foundation and The World Economic Forum, and was also an economic development specialist for the Peace Corps. 

Blum’s co-founder, Marc Fleury, had created open-source application server JBoss, which he sold to Red Hat, a company ultimately acquired by IBM, in 2006 for $350 million. 

Chief Investment Officer Nathan Cox rounds out Two Prime’s leadership. He was formerly the CIO for Prana Capital Group, where he developed and managed derivatives, futures and equity strategies for the firm’s volatility focused hedge fund. 

Two Prime’s flagship product, its Digital Assets Fund I, returned 488.6% — net of fees — during its first year of trading from June 2020 to June 2021, Blum noted in an Aug. 24 blog post. This significantly beat the return of raw bitcoin exposure, which amounted to 281.9% over the same span. The fund’s Sharpe ratio was 2.08 compared to BTC’s 1.89, he wrote at the time.

On June 1, Two Prime launched a second investment offering, the Liquid Yield Fund I, which is focused on delta-neutral, high-yield generation. The fund produces an 11.6% annualized return – net of fees – as compared to the S&P Global High Yield Bond Index’s return of 5.37%, the blog post notes.

Keep reading to learn more about the firm and its strategies.

Strack: What are the goals of the Digital Assets Fund I and how does the firm accomplish them?

Blum: The goal is basically to outperform on a risk-adjusted returns basis and Sharpe ratio basis. [Marc and I] were doing that for ourselves as we saw the options market grow and then created that as a product for other investors subsequently.

Our CIO and myself have a public equities, public funds background, so we’ve taken a bunch of statistical indicators that we know from working at a firm trading VIX derivatives. So things like standard deviation movements over a certain timeframe or mean reversion over certain timeframes and then combining that with crypto-specific statistics like stock-to-flow model. 

We’ve identified what we call volatility regimes, so different volatility behaviors like rising volatility, decreasing volatility and what we classify as high or historically low volatility, and can make pretty good trading decisions under those different regimes.

And then things like movement of bitcoin on and off exchange or miner hashrate and just blending those things into our own algorithm. …We’re trading options to kind of express those views on the market, so in times of high risk we’re basically trying to finance puts as inexpensively as possible … and then buying calls when we think things are going to go up. 

Really, the complication is how to finance puts in ways that aren’t exorbitantly expensive, and that’s what we’ve done a pretty good job of to date. 

Strack: What makes this offering unique to others?

Blum: I think some of the differentiating factors are really a focus on risk management before just trying to get 10,000% gains. It’s really the Sharpe ratio that we judge our success on. We’ve outperformed bitcoin, but more importantly, we’ve done that with less risk involved. 

And then I think just the focus on what we consider a structured product or an emphasis on the derivatives side of it as an avenue or means for that risk management is unique. 

Part of the consequence of that is liquid options or derivatives markets. …We’re not going far out on the risk curve to Radium or tokens nobody has ever heard of, but just doing this with highly liquid bitcoin and Ether that have a track record and some statistics to make decisions around. So to me that means it’s reproducible and understandable and not just ad hoc gambling.

Strack: Who invests in the Digital Assets Fund?

Blum: We’re a private fund, and so it’s restricted to accredited or qualified purchasers in the United States. We can also accept foreign investors, and they need to comply with whatever regulations are relevant to their jurisdiction.

We have a blend of RIAs that put their clients into our products, and then high-net-worth individuals. …We have ongoing conversations with larger banks that everybody would have heard of. That’s a longer diligence and onboarding process, but that’s kind of the trajectory that we hope to be moving in.

Strack: Why did you decide to launch the Liquid High Yield Fund 1?

Blum: At the time there were massive spreads on contango in crypto futures markets versus spot, so we said this is a pretty good way to capture 20 or 30% annualized yield. …[We] spoke to some of our investors as well who expressed, yeah, if you can take minimal risk and outperform like a high yield corporate bond or a junk bond that’s getting 5 or 6%, that sounds pretty attractive.

By the time it was registered…the yields have been significantly compressed or have even gone negative in some cases. At that point we had our own money invested and outside investors as well, and so we started looking more closely at DeFi as another way to get low-risk yield or relatively low-risk yield. 

So now we’ve been doing a blend of basically trading that same sort of future basis trade and then supplementing that with some DeFi strategies – basically just stablecoin staking for high yield – and that’s been producing pretty well for us. 

But the main goal is, there’s a ton of yield here. If we can produce something that’s equivalent or lower-risk to a high-yield corporate bond we seem to have a pretty good appetite from our investors for a product like that. 

Strack: Who has been participating in that fund?

Blum: It’s obviously more like a debt or fixed income product as opposed to the [Digital Assets Fund I], so it’s kind of a different bucket of money and a different bucket of investors.

Similarly, it’s accredited and qualified purchasers only, and right now it’s small RIAs to medium-sized RIAs. A couple venture capital funds that have just cash sitting idle waiting to be invested, they’re interested in yields, and then high-net-worth individuals. We’re trying to move more toward institutions.

It’s pretty different investment goals to get 500% returns versus 15 or 20%, and so it’s been more conservative people that have cash on hand for the yield fund that are looking for things … that are risk-free as opposed to a bond or a Treasury note.

Strack: How might Two Prime look to expand its offerings?

Blum: With our Digital Assets Fund, as we see other cryptocurrencies start to have a liquid derivatives market … we’d add them into that fund.

We’re in the process of becoming a SEC-registered RIA, so that will allow us to do a more diverse set of stuff. We’ve discussed just taking the same statistics we use now to make trading decisions but changing the risk parameters. So we could do a 40% yield fund with puts [with] slightly different trading behavior. Same with the Digital Assets Fund – we could do one with half as much volatility and a better Sharpe ratio and probably lower returns, and so that might be one thing we get more specialized in. 

I’m most excited about DeFi, and so I think a DeFi fund is the hot thing right now and potentially something we can do. … And then as an RIA, I think we’d love to potentially start more of a venture style fund that’s either investing in private sale tokens or investing in the companies behind them. 

Strack: What excites you most about DeFi?

Blum: One is just the level of innovation and new stuff happening. It also has a clear analogue to regular, public or capital markets now in that … we can replicate these rent-seeking services but just put a smart contract in the middle and allow a collateralized loan or a derivatives product or a fixed income product – but just do it without a middleman, more efficiently, more quickly, with more liquidity. 

…If you can get over the trust and technical barriers to that, it seems to have innately better features in some cases than what’s available today and has more accessibility and democratic access to it than highly regulated accredited-only equivalents. 

It just seems to open up market access, allow for innovation and do it better, and that seems like not just a tiny incremental improvement, but something exponentially better that can usurp the existing way these things are done today.