Cryptocurrencies had evolved from their early days when they were only known by a lucky handful and traded in opaque environments. Ultimately, they are an investment vehicle like most with proven and known potential of generating returns.
This realization has seen everyone from ordinary folk to large financial institutions engaging to gain a piece of this big pie, one of which is hedge funds.
According to PwC’s 3rd Annual Global Crypto Hedge Fund Report 2021, the amount of money held by crypto hedge funds increased from $2 billion in 2019 to $3.8 billion in 2020, easily suggesting a surge in popularity.
About two-thirds of the crypto hedge funds presently in operation were established in 2018 and 2019, right after the unprecedented rise of Bitcoin and other projects.
The same report also found there to be between 150 and 200 active crypto hedge funds. Most investors are well aware of what hedge funds are but might wonder how they work in the context of cryptocurrencies. Let’s find out.
Firstly, what is a hedge fund?
It’s beneficial first to understand the concept of this form of fund. In simple terms, this is a pooled investment trading or investing in an array of liquid financial markets like equities, indices, currencies, options, bonds, mutual funds, to even land and real estate.
Hedge funds invest on behalf of institutional investors and high net-worth individuals. The concept of hedging refers to the practice of buying and selling multiple instruments simultaneously to manage risks, mitigate losses and ultimately ensure a profitable return (hence being called ‘hedge’ funds).
Such funds employ sophisticated trading skills through things like short selling and leverage and a plethora of risk management strategies. Hedge funds are rather unorthodox and riskier investments, differing uniquely from more conservative funds like mutual and exchange-traded funds.
Investors with invested money in hedge funds typically incur two types of charges, an annual management fee to compensate the managers and a performance fee for the profits made by the fund in question.
As expected, hedge funds have existed for decades and form a large part of the asset management industry. A new breed of hedge funds focused almost wholly on cryptocurrencies has emerged due to the recency of this unique asset class.
How do hedge funds work in the context of cryptocurrencies?
Now that we have a basic understanding of hedge funds, let’s explore how they function within the realm of cryptocurrencies. Presently, we see funds that manage their portfolios exclusively in digital currencies and others who add it along with their existing instruments.
For the former, the fund will invest in a select few of the most popular coins, namely Bitcoin and Ethereum, which most research suggests are the two most utilized. Litecoin, Bitcoin Cash, EOS, and XRP have been reported as close contenders for the average hedge fund’s portfolio.
Let’s consider the common strategies for maximizing returns. According to the PwC’s 3rd Annual Global Crypto Hedge Fund Report 2021, quantitative methods lead the pack with close to half the pack, followed by discretionary long/short, and then the use of hybrid strategies.
Regarding the types of markets crypto hedge funds engage in, derivatives and short selling are the main methods used by the vast majority. As a subset, hedge funds solely invested only in cryptocurrencies also partake in staking, lending, and borrowing services in addition to their active trading practices.
Like most funds, investors keep their money for a long predefined period with an approximate 2% management fee and a 20% performance fee, as is the industry standard with other funds.
The overall present landscape of crypto hedge funds
Historically, these types of funds have been reserved towards high net-worth individuals. The lion’s share of hedge funds within crypto is presently domiciled in the United States, United Kingdom, and Hong Kong.
In the US, for instance, one needs to become an ‘accredited investor’ to invest in crypto hedge funds. The SEC (Securities and Exchange Commission) states that this is an individual with a net worth of at least $1 million or a yearly income above $200 000 for the last two years.
Therefore, crypto hedge funds are still quite exclusive to the wealthy, which is one of the industry’s challenges as there are fewer investors by numbers. The PwC suggests many hedge funds in crypto will find it difficult to break even aside from this reason.
Regulation in cryptocurrencies has been a looming problem for a while now, particularly in the United States. If rules become more strict with margin and other requirements, coupled with competition from newer managers, hedge funds may see profits diminished.
Lastly, hedge funds are businesses and have a significant number of operating costs, one of the largest being third-party valuation research.
Overall, the same findings reflected the three primary challenges for most hedge funds being the numerical lack of clients, regulatory uneasiness, and deficiency of resources.
One of the unique elements of cryptocurrencies is their volatility, which is amongst the highest of all financial securities. While this feature is not always desirable, it has seen a flock of investors getting interested in crypto hedge funds.
Cryptocurrencies in recent years have outperformed all other markets by a country mile. The yearly return for the average hedge fund generally has hovered around 10% or 11%. In the same PwC study, it found the median crypto hedge fund returned about 128% in 2020, down from 30% the previous year.
It’s a no-brainer to conclude such funds will become more widespread based on these numbers alone as investors move from traditional assets to more precarious ones like digital currencies.