Cryptocurrency hedge funds are investment funds that pool capital from investors into a group of assets focusing on cryptocurrencies or other decentralized digital assets. Funds are actively managed by experts or insider investors, who charge a fee for the analysis and selection of investment opportunities. A wide variety of both manual and automated strategies exist for diversifying and allocating funds—including restricting to high value market cap, hand picking specific assets, and much more. Investors following these strategies typically seek to reduce risk exposure to volatility in the value of any specific cryptocurrency on the market. In addition to hedge funds specializing exclusively in cryptocurrency assets, traditional hedge funds have increased their exposure to cryptocurrency assets.
Interest in cryptocurrency hedge funds has grown as the returns seen on some of these funds, especially as they work to add new ICOs into the funds and try to replicate the 82,000 percent returns that the Ethereum ICO achieved. With the growth in popularity of cryptocurrencies, as well, many funds have seen high returns, following the growth in returns of cryptocurrency, such as the 300 percent return seen in Bitcoin in 2020, or the 2,318.57 percent accumulated return of new cryptocurrencies. The Eurekahedge Cryptocurrency Hedge Fund Index, and index of cryptocurrency hedge funds, saw a 238 percent return in the first eight months of 2021, which outperformed Bitcoin over the same period. Bitcoin often serves as a metric for interest in cryptocurrency as it is the most popular cryptocurrency.
This saw the estimated total assets under management (AuM) of cryptocurrency hedge funds to increase from US $2 billion in 2019 to $3.8 billion in 2020. For individual funds, this saw an average of funds increasing from US $12.8 million to US $42.8 million, and the median AuM increased from US $3.8 million to US $15 million. Considering that most funds launched with a median AuM of US $1 million, this suggests that the funds have generally seen a 15 times increase in those AuM. The majority of investors in these funds remain high-net worth individuals (around 54 percent of investors) or family offices (around 30 percent of investors). Most funds have a median of twenty-three separate investors and an average ticket size of US $0.5 million or below.
The growth in popularity of cryptocurrencies, their mainstream acceptance, and the relative performance of cryptocurrency hedge funds has added up to nearly one-third of traditional hedge fund managers planning to add cryptocurrencies to their portfolios in 2022. The main hurdle to this is the lack of regulatory clarity.
Surveys performed in 2021 found that over the previous year, the most common crypto hedge fund strategy was a quantitative strategy, representing 37 percent of funds, followed by discretionary long/short at 28 percent of fund, discretionary long-only at 20 percent of funds, and a multi-strategy for 11 percent of funds. Further, 2020 saw over half—56 percent—of these funds trade derivatives. In the same year, short-selling in funds reduced from 48 percent of funds short-selling, to 28 percent of funds short-selling in 2020. Furthermore, more funds in 2020 were involved in cryptocurrency staking, lending, and borrowing.
Of those funds surveyed, 92 percent reported trading Bitcoin (BTC), 67 percent reported trading Ethereum (ETH), 34 percent reported trading Litecoin (LTC), 30 percent reported trading Chainlink (LINK), 28 percent reported trading in Polkadot (DOT), and 27 percent reported trading in Aave (AAVE).
Cryptocurrency hedge funds invest in cryptoassets through a variety of mechanisms and instruments including initial coin offerings, pre-sales, SAFT, SAFTE, JCO and others. Most of these investments hold additional risk due to the regulatory uncertainty, especially from US regulators such as the SEC and CFTC. The SEC has released a number of recommendations and statements regarding ICOs and has taken action against securities some cryptoasset securities offerings such as Munchee Inc and Centra. The status of individual cryptocurrencies as a security, commodity, property, or some other status is still unclear. Despite this uncertainty, the number of cryptocurrency hedge funds increased significantly in 2017 as both crypto and traditional hedge funds produced high returns from cryptoassets compared to traditional assets.
Due to some of the uncertainty around regulation in cryptocurrency, many consider the investments in these funds to be increasingly risky. Despite the capability these funds have shown to double the amount of money invested in a fund, some have warned that this also doubles the risk taken in these funds, especially without SEC oversight.
The uncertainty around regulation has also, as noted above, been noted as a major hurdle to the addition of cryptocurrencies to traditional hedge funds, which to some would be seen as a benchmark of wider adoption of cryptocurrencies as an asset class. Inversely, regulatory clarity would move the adoption of cryptocurrency in hedge funds. This is as reports from 2021, which surveyed investment managers, noted that many of these managers saw digital assets as a major area of focus in 2021 and 2022. This interest has continued to grow as the cryptocurrency hedge funds have continued to see consistent growth, with traditional hedge funds seeing a 26.2 percent increase across 2020, and cryptocurrency hedge funds saw 128 percent growth over the same period.
Other than regulatory uncertainty, the other barrier to investing in cryptocurrencies for hedge funds comes from client reaction or reputational risk. Of the funds surveyed, 77 percent saw reputational risk as a major barrier, while 82 percent of those funds saw the uncertainty in regulations as a bigger barrier to investment. A further 68 percent of those funds surveyed suggested that cryptocurrency assets were outside of their current investment mandates.
With the uncertainty around regulations, most legal groups have advised cryptocurrency hedge funds operate under similar regulations, at least for issuers, under the SEC for issuers, especially at the adviser level and management level. Although the confusion of classification of cryptocurrency and cryptoassets either as securities or commodities change how these entities should act. This leaves most suggesting that, regardless of any possible framework a potential could offer, those wishing to issue a cryptocurrency hedge fund should seek legal advice.
Another hurdle in the mainstream adoption of cryptocurrency for traditional hedge funds, and for investors investing in cryptocurrency hedge funds has been the consideration of the security and infrastructure of cryptocurrencies. This is as exploits remain common in the digital assets space, especially in the more experimental areas of decentralized finance (DeFi). For example, in August 2021, more than $600 million was stolen in a crypto heist, which saw hackers exploit a vulnerability in the Poly Network. This has hampered the reputation of cryptocurrency investments, but also, as some hedge fund managers note, has underpinned the importance of cybersecurity and shoring up the infrastructure of cryptocurrencies and digital assets to improve the adoption rate of these assets in hedge funds.
Several cryptocurrency hedge funds have released tradable cryptocurrency tokens for example Blockchain Capital (BCAP), TaaS Fund (TAAS), and Blackmoon Crypto (BMC). A new class of decentralized asset management platform has emerged around the crowdsourcing or open sourcing of fund management with associated tokens. ICONOMI is developing an Open Fund Management Platform in which individuals can create an array of Digital Asset Arrays (DAAs) where others can invest. Numerai is building an AI and machine learning hedge fund platform for data scientists.Cindicator is also developing community and AI driven asset management fund.
