What are Automated Investment Strategies?
Yield aggregators provide crypto investors with automated investment strategies so that they can easily earn yield, which has become very popular since the advent of DeFi summer in 2020. In this article, we’ll explain what automated investment strategies are, assess the pros and cons, and how you can utilize them to effortlessly grow your crypto holdings.
Yield aggregators are basically a set of smart contracts that collect investor funds to put them to work in protocols that can earn a return on these assets. Commonly known as ‘yield farming’, this brings a lot of convenience as the investment strategies are pre-programmed and automatically executed, allowing you to ‘set and forget’.
Almost $1.3 billion of the total value locked in DeFi come from yield aggregators according to DeFiLlama, with the best-known examples of automated investment strategies are protocols like Yearn Finance and Beefy. On the Optimism network, the two most popular yield aggregators are Beefy and Reaper Farm.
Strategies are built on top of other DeFi primitives such as money markets (e.g, Aave) and Automated Market Makers (e.g., Curve or Uniswap), with the process automated by simply depositing to a vault.
Your assets will be combined with other investors’ funds, then deployed to execute the strategy and earn yield. The profits generated are automatically realized and then repeatedly re-invested into the strategy to generate a steady return for the depositors.
Some of the commonly utilized strategies by yield aggregators are:
Lending on platforms like Aave to earn the interest and collect more tokens over time. The accrued tokens earned from the interest payments are withdrawn after some time to harvest the gains. The additional assets earned by the strategy are added to the lending platform to earn interest and compound the return.
Liquidity provision: deposited funds are used to provide liquidity to AMMs like Curve or Uniswap to earn a share of protocol fees and liquidity mining rewards. Protocols often incentivise the provision of liquidity by distributing their native governance token (such as CRV rewards for Curve pools). For instance, Yearn’s crv3crypto vault allows liquidity providers of this Curve pool to deposit their LP tokens into the strategy. The LP tokens are then supplied to Curve, staked in the gauge to earn CRV rewards and then the CRV proceeds are automatically reinvested to accumulate more LP tokens.
Leveraged yield farming, which allows you to multiply your farming position through lending pools. Examples include Alpha Homora and Gearbox Protocol. The returns that can be earned are multiplied (but as with any application of leverage, there’s a risk of liquidation), since acquiring borrowed assets allows you to enter a larger yield farming position. When you stop farming, the borrowed tokens are returned.
To compare the performance of different vaults, they also display the Annual Percentage Yield (APY), which takes into account the effect of compounding to estimate how much you can earn from depositing your assets into a strategy. As well as the APY, the Annual Percentage Return (APR) is also often displayed.
Benefits and Risks
High yield doesn’t come without high risk. Therefore, before deciding to invest in a vault strategy, there are benefits and risks associated with yield aggregators that you should be aware of.
Yield farmers do not have to come up with their own strategy, benefitting from the work of strategists. Anyone to earn a passive yield without extensive knowledge about the protocols utilized.
Capital is shifted across different protocols automatically, so there’s no need to monitor the APY for different protocols or transfer your funds to seek the highest returns. The profits are auto-compounded.
Since automated investment strategies are conducted on-chain, there’s no risk associated with custodians or third parties.
Gas costs are socialized. All funds deposited by different investors are pooled together, which reduces the gas costs for an investor who wants to take advantage of a strategy.
An endless number of strategies and ways to earn yield are possible thanks to the composability of on-chain automated investment strategies.
Smart Contract Risks: because yield aggregators build on top of a variety of protocols, that means they are exposed to the smart contract risks of each protocol. If any one of the building blocks suffers an exploit, then it can put funds deposited into a strategy at risk.
Liquidity: if there’s a high interest for lending protocols where the utilization rate is close to 1 (meaning nearly all funds being supplied to a pool are being borrowed), then if enough lenders withdraw their liquidity at the same time, some lenders may be left waiting for borrowers to pay back their loans so there are enough funds for these lenders to withdraw their assets.
Liquidation for leveraged strategies: If the value of the assets you put up as collateral falls sharply, then you may face liquidation. When the debt ratio (the debt value divided by your position value) exceeds the liquidation threshold, then your position would be closed by a liquidation bot to repay the debt and return any remaining assets to your wallet.
Instability of the APY: the advertised APYs may be unreliable, since the returns offered by lending protocols or for providing liquidity may be volatile. Also, price fluctuations in the tokens harvested by a strategy or supplied as liquidity to an AMM can also affect the amount you earn. For LP token vaults, the returns depend on trading activity for a particular pool. If trading activity declines a lot, then the trading fee revenue will also fall weighing on the APY.
Sustainability of yield: while native token emissions are often a source of yield, they are relatively short-lived as at some point the emission schedule will be completed. Yield derived from money markets can be more sustainable but is affected by market sentiment, where the interest earned on lending out crypto-assets may be very low in bear markets as borrowing demand plunges, especially for non-stable assets. Revenue-sharing tokens have the most sustainable yield.
In an upcoming article, we’ll compare the advantages and disadvantages of different types of vaults in detail.
Now you know what yield aggregators are, how they execute strategies and some of the main advantages and risks, let’s look at some examples. In the following sections, we’ll provide an overview of two popular yield aggregators: Yearn Finance and Reaper Farm.
Yearn Finance was launched in July 2020 and is now present across 4 chains (Ethereum, Fantom, Arbitrum and Optimism). Launched by Andre Cronje with no funding, it quickly became a popular yield aggregator after incentivizing usage with its YFI token.
The primary yield product of Yearn’s are the yVaults, where proportional shares are represented by yvTokens or yTokens. The second version of yVaults allows for multiple strategies to be executed at once, accepting individual tokens or liquidity provider tokens as deposits.
The vaults charge a performance fee of 20% (which is split between the project’s treasury and the strategist) and a management fee of 2% (which goes to the treasury). Because Yearn is a permissionless yield aggregator, anyone with the right skills can apply to become a strategist.
An example of a yVault is the WETH vault, which has almost $100 million in assets under management and gives you the opportunity to earn more WETH. To represent an investor’s share of the vault’s earnings, yTokens are delivered in proportion to the amount invested, so in this case, you’d deposit WETH and receive some yWETH in return.
Source: Yearn Finance
The strategies tab highlights the different methods that are used to generate a return. Three strategies account for over 95% of the WETH allocated to strategies for this vault to offer an APY of 1.91% since inception and generating more than 1,900 WETH in returns to date.
The primary strategy involves lending WETH to the Alpha Homorra money market to earn interest payments, which are then periodically harvested to generate a return for the vault’s users.
Another strategy utilizes the Ethereum staking platform Lido to accumulate staking rewards and buy staked ETH if it is cheaper than staking.
A third strategy provides liquidity to Curve to earn CRV rewards, which are then converted into WETH and deposited back into the strategy, automatically shifting to the Curve pool that’s most profitable.
Yearn Finance sprung out of the Curve ecosystem and enjoys a close relationship with the Curve team. Yearn is also one of the largest holders of the project’s vote escrowed token (veCRV), holding almost 50 million veCRV. To learn more about veCRV and its benefits, check out our article on veTokenomics.
As well as yVaults, Yearn’s other major offering is yCRV which is a derivative of veCRV that can be staked to receive st-yCRV. Holders of the st-yCRV token receive admin fees earned by Yearn’s veCRV position, which is used to acquire more yCRV. Also, given Yearn’s sizable veCRV position, the yield earned by st-yCRV holders can be boosted with bribes. For each yCRV that is staked, 1 veCRV worth of voting power is used to vote in favor of the Curve gauge, which maximizes bribe revenue for st-yCRV holders.
Holders of the yCRV derivative token can also become an LP for the CRV/yCRV pool, receiving lp-yCRV tokens to earn fees and emissions. The liquidity pool rewards paid out in CRV are compounded and put back into the pool to increase the LP position over time. Similar to st-yCRV, for every 1 yCRV converted to the lp-yCRV derivative token attains 1 veCRV worth of voting power to vote in favor of the yCRV Curve gauge. The more votes there are for the yCRV gauge, the larger the amount of CRV emissions that will be directed to the CRV/yCRV pool, resulting in higher yields for lp-yCRV token holders.
Reaper Farm was launched by the ByteMasons team which modified Yearn’s architecture to suit their own strategies and integrations. Although it is one of the leading yield aggregators on Optimism, Reaper Farm got its start in the Fantom ecosystem, eventually expanding to other chains, such as Arbitrum and BNBChain. This yield aggregator offers a variety of opportunities to earn yield, including single strategy, multi-strategy, options and bespoke vaults.
The most popular vault on Optimism in terms of total value locked involves supplying USDC to Sonne Finance, which generates yield from the interest fees earned from lenders as well as OP token rewards that are in place to incentivize the usage of this lending protocol.
Reaper takes a 4.5% slice on the profit generated by their vaults, while a security fee of 0.1% is taken on withdrawal and distributed to all other vault users. The profits are compounded automatically when the fee to harvest any gains exceeds the gas cost.
Similar to Yearn’s specialized strategies for Curve, Reaper Farm also has its own customized strategies. There are currently 4 bespoke vaults for the project’s close partners (BeethovenX, Spookyswap and Velodrome) which offer optimized yields by automating the process of earning fees and rewards on these decentralized exchanges.
An example of Reaper’s bespoke vaults is the veVELO NFT vault, one of the most profitable, which gives veVELO NFT holders a way to maximize their returns by automatically compounding and voting to earn more veVELO tokens and other tokens from the fee revenue. Similar to Curve’s model, veVELO is the locked version of Velodrome’s native token that enables users to direct VELO emissions to certain pools.
Source: Reaper Farm
Holders always retain custody of their veVELO tokens (which grant a claim to a share of the protocol fees, as well as bribes and rebases) but transfer their voting rights to the voting manager contract to vote on their behalf. The voting manager contract then allocates veVELO to different voting strategies to optimize the returns on bribes, which are then converted into more veVELO.
We can combine yield aggregators with perpetual swap contracts to create what’s known as a ‘long-short strategy’.
DeFiLlama’s yield section can help you find the best APYs for long-short strategies on Optimism. Select the asset you want to deposit into a yield aggregator strategy and sort by the largest Farm APY to find the highest paying vaults. Then deposit the asset to the vault of your choice to earn the highest return and then short the same asset using perpetual swaps on Perp.
Let’s assume an investor has a portfolio of 2 wrapped ETH (WETH) and 1,500 USDC, while the price of ETH is $1,500. An investor can construct a delta neutral strategy by depositing 2 WETH to Reaper Farm’s WETH strategy to earn a yield of around 13%, and then use USDC as collateral to short 2 ETH on Perp.
If the funding rate for the ETH market on Perp stays positive, then the yield is boosted via the funding payments that the short position accumulates. Also, your price exposure to ETH is eliminated, as a decline in the value of the WETH earning yield in Reaper Farm’s vault will be balanced out by the profits generated by the short perpetual swap position.
Vaults are Coming to Perp!
If you’re interested in passive investment strategies, then keep an eye out for an upcoming product launch of ours, which will enable anyone to earn yield from a low-risk trading strategy. By generating profit no matter what the market conditions are, you can discover another way to grow your crypto holdings with an automated ‘set-and-forget’ strategy!