Hedge funds have started to dip their proverbial toes in the water of cryptocurrencies. In fact, the significant uptick in crypto hedge fund launches could be a defining factor of the market this year.
However, there’s a debate in the market about whether crypto hedge funds can truly generate alpha in a market in which the numbers show that many traditional hedge funds provide only beta exposure.
A bit of cryptocurrency in hedge funds
Jason Meklinsky, head of Americas Business Development at financial services provider Apex Group, said they are definitely seeing a bit of cryptocurrency creeping into some of the hedge funds they serve. Apex serves over $2 trillion worth of assets.
“It’s the exception to the rule,” he said in an interview. “Not everyone understands it, so some folks are just trying to ride the trend. Our position is it’s OK as long as we see it’s a pure-play crypto fund. We look at manager pedigree, auditor, counselor… The buck stops with us.”
Meklinsky added that they have about 10 to 15 pure-play crypto opportunities in their pipeline, half of which are fund managers with real experience in the space.
“They understand how to manage portfolio volatility,” he explained. “It’s not for the faint of heart, but generally, what we see are long/ short equity funds that have a carve-out of maybe 5% to 10% of assets dedicated to that space. It’s a toe-dip, not an all-in. They’re more dedicated to the multi-strat community.
Meklinsky explains that a smaller piece of a larger portfolio has a smaller impact from volatility. He also believes that regulation coming in the next 18 months will impact how people view cryptocurrencies and investors’ appetite for the risks associated with them.
Growing crypto interest among hedge funds
PricewaterhouseCoopers found in a 2021 survey that crypto hedge funds managed about $4 billion in assets at the end of 2020. That compares to the $3 trillion managed by the entire hedge fund industry and the $2 trillion combined cryptocurrency market.
In a post for the CAIA Association, FactorResearch founder and CEO Nicolas Rabener noted in a recent post that hedge fund interest in cryptocurrencies has increased dramatically as alpha from traditional markets has been “almost completely arbitraged away.”
He added that basically all classic hedge fund strategies are being deployed in the crypto space, with quant funds leading the way with 37% of crypto hedge funds.
However, Rabener believes this will erode alpha, just as it has in most traditional markets.
More crypto fund launches expected
In its 2021 Hedge Fund Spotlight, With Intelligence reported a significant increase in the number of crypto products that entered development last year, especially during the fourth quarter. It expects this trend to continue in 2022, bringing even more, higher-quality launches driven by increased institutional interest.
Marc Bernegger, co-founder of crypto fund AltAlpha Digital, says after last year’s explosion of crypto hedge funds around the globe, there are now over 400 active funds, excluding those focused on venture capital. He added that the number of crypto hedge funds is growing daily.
With Intelligence suggests that crypto strategies and hybrid funds “may come to define the hedge fund launch market in 2022.” The firm believes that one adjustment investors may find in the coming year could be funds that currently offer shares in multiple currencies but later add a bitcoin share class.
With Intelligence noted that the crypto market surpassed $3 trillion in assets during the fourth quarter even though China banned all cryptocurrencies. In a separate whitepaper, Peltz International reported that many of the hedge funds launched last year were crypto funds, reflecting growing interest among institutional investors.
The firm added that the increase in established exchanges, the emergence of digital custody solutions and specialized storage and security systems that safeguard assets are driving increased institutionalization of the crypto infrastructure. Peltz also pointed out that “regulatory clarity” is liked to further increase crypto adoption among hedge funds.
New crypto hedge fund launches
Cryptocurrencies’ return profile is less correlated to traditional asset classes, leading to significant upside and alpha-generating opportunities. According to Peltz, just 1% to 2% of hedge fund assets are dedicated to cryptocurrencies. The firm also highlighted several new crypto funds that were launched in 2021.
Pantera Capital, founded by Tiger cub Dan Morehead, raised $600 million for its Blockchain Fund, which is expected to close in March with $1 billion in assets. It invests in venture equity and crypto tokens, and about 75% of its assets were said to be from institutional investors.
SkyBridge launched its Bitcoin Fund in January 2021 with $310 million in assets from its $3 billion flagship fund. Valkyrie Investments is one of the largest crypto managers, and it created a DeFi fund that targets institutional investors.
The On-Chain DeFi Fund holds its assets on-chain so that it can use them to earn yield and passive income. The fund invests in over 24 crypto assets, including Ethereum, Binance Smart Chain, Polygon, Avalance, Solana and Fantom.
Brevan Howard started investing in cryptocurrencies and digital assets in April 2021, while Marshall Wace is looking to invest in blockchain technology, payments systems and stablecoins. It also wants to launch a portfolio of privately owned digital finance companies in their late stages.
Peltz also highlights new funds from Galaxy Capital, CrossTower, Graticule Asset Management and Argentium Digital Asset Management, among others.
The future of crypto hedge funds
Looking ahead, Bernegger expects more regulations to impact crypto hedge funds and institutional interest in them.
“I personally think that regulatory clarity including a framework is helping the crypto hedge funds industry as institutional investors need it,” he said in an email. “This will increase the entry barrier to launch new crypto hedge funds on the one hand but on the other hand it will create a sustainable long-term ecosystem.”
Bernegger notes that issues with working with digital assets in a fully regulated setting remain, such as storage, interactions with banks, and onboarding investors. However, he also said that the situation has improved over the last year, and he expects far fewer barriers going forward.
“It is still a very exciting space with many unique opportunities,” Bernegger adds. “We see several new crypto funds focusing on emerging trends like NFTs or the metaverse. On the other side, more established crypto hedge funds are growing their assets under management in a quite impressive speed, which also helps the whole industry. I personally think that we are still in the early phase, and we see the emergence of a new alternative asset class which will become far bigger in the future.”
Critical issues involved in crypto hedge funds
As hedge funds and institutional investors become more interested in the crypto markets, it’s important to study the performance of these crypto hedge funds. Rabener wrote in his blog for CAIA Association that many alternative assets have failed to be “alternative enough and provide returns uncorrelated to traditional asset classes.”
As a result, he took a closer look at the performance of crypto hedge funds compared to the rest of the market. He said the correlation of crypto hedge funds to the S&P 500 was 0.03 between 2015 and 2021. Their correlation to the top 50 hedge funds stood at 0.22 during the same period. However, crypto hedge funds reached a correlation of 0.8 to both asset classes in 2020.
Despite this significantly higher correlation in 2020, Rabener believes that crypto hedge funds still generated significant diversification benefits for investors. He also looked at the correlation between crypto hedge funds and bitcoin and found a nearly identical performance with a correlation of 0.88 between 2015 and 2021.
According to Rabener, this suggests that crypto funds represent cryptocurrency beta rather than alpha. However, he also points out that the story for the broader hedge fund industry is the same, as it has also failed to generate alpha.
Alpha or beta?
Rabener notes that the Credit Suisse Equity Market Neutral Index, which he describes as “the adequate index for evaluating the alpha generation of hedge funds,” has generated a 0% return over the 17 years between its inception in 2004 and 2021.
He pointed out that running a hedge fund continues to become more and more challenging because the markets have “become highly efficient with few arbitrage opportunities left for exploitation.”
As a result, he said most hedge funds have begun to provide beta exposure simply because alpha is scarce as stocks have been shifting higher. However, Rabener also said that investors’ analytics and data have also improved, enabling allocators to realize that most hedge fund strategies are “mere beta plays.”
He believes moving to the crypto markets “seems an obvious strategy for hedge funds in search of greener pastures.” However, Rabener adds that since most of these funds provide merely beta exposure, it becomes clear that alpha is “less easy to harvest than commonly perceived.”
Although he believes crypto hedge funds merely offer beta exposure, Bernegger is not convinced. He still sees opportunities for alpha generation.
“Compared to traditional markets, crypto hedge funds operate in a nascent and still inefficient asset class,” Bernegger said. “As most traditional markets have become highly efficient, trading cryptocurrencies still offers many ways to generate alpha (from established strategies like arbitrage to new fields like yield farming in DeFi protocols).”
Despite Rabener’s view of crypto hedge funds as purely beta exposure, he still sees a reason for investors to hold one in their portfolios.
“However, although there is not a compelling investment case for cryptocurrency hedge funds, it does not mean exposure to cryptocurrencies is unattractive,” he concludes. “The case for diversification has rarely been stronger.”
Michelle Jones of ValueWalk contributed to this report. Read full story on Forbes