As public reputation becomes one of the most important success factors beyond financial success, investment opportunity should ensure ethical decisions and keep sustainable investment as core of their strategy. These long-term investment strategies based on criteria other than pure financial data are summarized under "Value Investment". Value investment is based on the assumption that the current price of an asset might not be the actual value of an asset (e.g. stocks and derivatives). Thus, criteria other than their current prices can be taken into account to calculate their value. The value investing approach offers thereby methods to select potential investment based on social or sustainability criteria. Furthermore, value investment includes diversification of the portfolio to achieve a desired level of risk.
In this blog post I will introduce dInvest, a project Tharidu and me are working on. With the development of blockchain technologies and the Ethereum blockchain, an autonomous and decentralized approach can be taken to create an investment opportunity. Users are able to invest directly with the cryptocurrency Ether into a company which exists in the Ethereum blockchain. Alternatively, they can invest with other cryptocurrencies (e.g. Bitcoin) or fiat currencies by utilizing currency exchanges. An autonomous organization build on Smart Contracts exists solely as code and can execute the details as specified in the contract. As an example, The DAO enabled users to act as venture capitalists by suggesting investments to other users. If a certain amount of investments was raised the contracts would be executed inside the blockchain. However, this approach failed as The DAO suffered security flaws, which led to a severe attack on its system. Furthermore, The DAO failed to give incentives to users proposing investments. Investments are voted for two weeks, while a vote can only be given by bounding a user’s capital into the vote. Thus, late voting and waiting for other’s resulted in available capital.
Certain investors want to invest their money in order to gain returns while being socially responsible and sustainable to e.g. achieve corporate sustainability objectives. However, financial intermediaries, such as investment banks or hedge funds, do not always adhere to investors’ requirements as there might be conflicting interests. Furthermore, the investment strategy applied by the financial intermediary can change through time and is highly influenced by social factors. In addition to that, investors do not have complete transparency over the transactions.
We decided to develop an autonomous hedge fund in the Ethereum blockchain. Users are represented in the Ropsten network of the Ethereum blockchain as addresses. Users can hold certain amounts of test Ether, which they can invest into dInvest. The investment will contain an amount of Ether and a time period defined by the user. The details of the investment will be defined in a smart contract between the user and dInvest. Selecting stocks for different investment amounts and time periods is comparably computation intensive and will require the application of investment algorithms. Thus, their executing is costly in the blockchain and will therefore be executed by an autonomous agent (invest agent) outside of the blockchain. The required information will be passed on to dInvest on demand and therefore keeping the operational cost to a minimum. The invest agent will suggest investment strategies to the hedge fund according to the current Ether value. The hedge fund will decide to approve or reject the offer based on the sustainability criteria of users’ investments. Only if the criteria is fulfilled, the Ether will be transferred to the buy agent and make the investment. The invest agent will transfer the investment return to the hedge fund where the profit/loss will be divided to investors according to their investment value.
We managed to achieve a linear cost function of user investments and their sustainability criteria in the smart contract. Based on a value investment investment strategy we managed to achieve around 360% increase of the portfolio in a back-testing simulation over around 6 years. The sustainability criteria was implemented using exclusion of assets based on industry codes (i.e. exclusion of defense, alcohol, tobacco, or coal industries). If you are interested in the academic side and the results of our implementation, you can check out our report. As the paper does not cover the implementation in detail, I will post the details in separate blog posts and link them here. You can also check out our source code on GitHub.