In this series, we analyze stablecoin investment strategies to provide the insights you need to optimize your portfolio. Part 1 applies efficient frontier theory to determine optimal allocations for various levels of risk between three different strategies: lending aFRAX on AAVE, lending USDC on AAVE, and yield farming with Curve’s 3pool (USDC, USDT, DAI).

We all know diversification is key to investment strategy, and this helps manage the risks involved in investing stablecoins but as we look to manage our risks, how can we make sure we’re not leaving money on the table?

Analyzing the efficient frontier is one way to find the optimal portfolio for your situation. The efficient frontier refers to the investment or set of investments that offer either the highest expected return for a specific level of risk or the lowest risk for an expected return.

Efficient frontier theory can be applied to any set of investment strategies. In this article, we’ll explain how we’ve applied efficient frontier theory to stablecoins and analyze three strategies: lending both aFRAX and USDC on AAVE, and using Curve’s 3pool (USDC, USDT, DAI).

This will give us insight into how to weigh our portfolio to maximize our potential earnings at a comfortable level of risk.

Calculating the efficient frontier

To find the efficient frontier, we start by selecting a set of investments. For this analysis, we’ll be allocating $100,000 worth of stablecoins to three different strategies: 

• Lending aFrax on Aave to earn interest plus FXS rewards
• Lending UDSC on Aave to earn interest plus Aave rewards
• Yield farming with the Curve 3pool (USDC, USDT, DAI) to earn lending fees and CRV rewards

Next, we estimate the returns each strategy can provide and assess the risk involved in pursuing each strategy.

Estimate returns

Expected returns for each strategy are estimated using current and historical market conditions. This does mean returns will be subject to variation and it’s important to consider that returns could change dramatically if market conditions do as well. 

That said, these estimates still provide a realistic benchmark and there’s nothing stopping an investor from running an efficient frontier analysis based on those market conditions and adjusting their portfolio to the new conditions.

Assess the risk

Risk is calculated by considering the expected volatility in the value of assets accrued as part of the earnings for each of the strategies. 

For example, the Aave rewards earned by lending USDC will fluctuate in value and as those rewards stack up, those fluctuations will have a greater impact on the portfolio.

When you accumulate reward tokens, the investment/portfolio takes on greater risk. This adds volatility to the portfolio & therefore, risk.

Simulate the portfolio

After calculating the risk/reward for each strategy, we run a simulation of 1000 different portfolios to find the expected return and volatility of different allocations to these strategies.

Some simulations weigh the strategies equally, distributing ~$33,000 to each. Others allocate more money to different strategies, all in different proportions of the hypothetical $100,000 investment.

We annualize the expected returns and volatility to see what they look like over the course of a year and here’s what our efficient frontier looks like: 

Expected returns range from ~10% to ~40% while the standard deviation, which refers to the potential volatility we can expect from a portfolio, ranges from ~0% to 35%.

In other words, the total drawdown of the simulated portfolios over the course of their hypothetical year could range from 0% to 35%.

It’s important to note that this chart isn’t suggesting that a specific allocation to each of these strategies will yield the highest possible return. The analysis illustrates how to allocate funds to find the highest expected return for a given level of risk.

For high-risk, high-reward portfolios, we can look to the top-right of the chart. As we follow the curve to the bottom-left, expected returns decrease but our potential drawdown decreases as well. 

1. Portfolio A (low-risk): A portfolio balance of 34% Aave Frax, 53% USDC lent out on Aave, and 12% in the Curve 3pool would have an expected annual return of 20.47% and standard deviation of 19.06%.
2. Portfolio B (medium-risk): A portfolio weighting of 57% Aave Frax, 29% Aave USDC, and 13% in the Curve 3pool would have an expected annual return of 29.88% and standard deviation of 26.44%.
3. Portfolio C (high-risk): a portfolio weighting of 80% Aave Frax, 10% Aave USDC, and 10% in the Curve 3pool would have an expected annual return of 36.93% and standard deviation of 33.59%.

However much risk an investor decides to take on, the portfolios that form the top of the curve offer the greatest expected returns.

If we’re looking at a long-term investment where a large drawdown wouldn’t be a big deal or we’re simply comfortable taking on more risk, the high-risk, high-reward portfolios are the ones we want to pay attention to.

For a portfolio in which the goal is to minimize the risk of volatility rather than maximize the overall earning potential, we can look at the portfolios on the left side of the curve.

Expanding the efficient frontier

Lending stablecoins on Aave and yield farming with Curve’s 3pool are some of the more common strategies for investing stablecoins but as we mentioned, efficient frontier theory can be applied to any set of investment strategies.

Reach out on Twitter @Stably_Official to let us know what strategies you’d like to see us analyze!