Crypto Hedge Funds

Throughout a research document published by PwC analyzing both quantitative and qualitative aspects of the global cryptocurrency hedge funds, PwC has encouraged more adaptation of sound practices within the sector.

The data of the report which was conducted in quarter one of 2020 was obtained from the largest cryptocurrency hedge funds selected based on assets under management (AUM). The report estimated that the AUM of crypto hedge funds increased in 2019 to over US $2 billion from US $1 billion the year before, which indicates the accelerative growth in interest toward Cryptocurrency investments.

The report shows the increase of Crypto hedge funds with at least an AUM of US $20 million from 19% to 35% in 2019. Crypto hedge funds surveyed in the report held on an average of US $44 million in 2019 compared to US $21.9 million in the year before. On average the same crypto hedge funds launched their operation with only US $18.9 million.

Investment strategies and performance

In regard to the fund’s performance, the PwC report took into account the results based on different investment strategies. The report categorizes the strategies and their result as follows:

Quantitative strategies: most of these funds have either a directional or market-neutral approach to their trading investment strategies. Such indicative strategies are market making, arbitrage, and high-frequency trading. Liquidity is key to these strategies. In 2019 these funds have experienced a 58% average return on investments, which is the highest among all the other strategies analyzed in this report.

Discretionary Long/Short: these are funds that cover a wide spectrum of strategies including long/short, event-driven, relative value, technical analysis, and some crypto-related strategies such as mining strategies. Funds like these combine their strategies also on early-stage projects. On the performance side of these strategies on average these funds performed +33% of return on investments.

Discretionary long only: these are funds that are long-only and which usually aim for a longer investment time horizon. These funds had a good return on investment rate of 42% in 2019.

Multi-strategy: funds that are approaching with a combination of two or more of the above-mentioned strategies. Multi-strategy investment performed at 19% in 2019.

Fees

When it comes to management fees, on average crypto hedge funds charge 2% of AUM. It is reported that some of the hedge funds make an insufficient profit to sustain a business. Considering that the median crypto hedge fund has US $8.2 million AUM and charges 2% of a management fee, this would make US $164K, which is not enough to sustain a business. This has caused some of the crypto hedge funds to explore other ways to increase their earnings. As a result, we have seen that some funds are investing their funds using quantitative approaches such as starting market making operations, and investing in early-stage focused funds, and taking an advisory role with them.

Trendiest cryptocurrencies to trade

In regard to which Cryptocurrencies hedge funds use the most during their daily trading, unsurprisingly, Bitcoin (BTC) has the highest trading rate. Almost all of the funds in the PwC report declared that BTC is part of their daily trading, but only 5% are BTC-only funds. Which indicates the importance of altcoins in the industry. When asked which altcoin is the most important or traded crypto among the hedge funds, Ethereum (ETH) with 67% is at the top of the most traded altcoins, XRP with 38%, Litecoin (LTC) with also 38%, Bitcoin cash (BCH) with 31% and EOS with 25% are the other top altcoins favored by crypto hedge funds.

On the other hand with the increase of liquidity in the Crypto derivatives market with the likes of DYDX and Deribit there has been more interest in these markets from Crypto hedge funds. These developments have allowed funds to more conveniently take short positions as the derivative market has become more diverse and liquidated. That has led hedge funds to be able to offer more complex investment strategies such as market-neutral since they have more advanced algorithmic trading tools available to them. The 2019 survey supports this view since almost half of the funds (48%) do plan to go short crypto and around 56% actively use derivatives. These numbers are expected to rise with the presence of more regulated future offerings.

A different perspective was observed on the use of leverage. Within the 2019 report, around 36% of the funds surveyed used leverage. In 2020 the figure has increased up to 56%, although only 19% of funds stated that they have actively used it. Whilst it is expected that more crypto hedge funds will be using leverage in their investments, it is still not clear that the market should see an increase in the coming years due to difficulties in obtaining debt financing by brokers.

Staking, lending, and borrowing

With yield-based strategies such as Staking and lending which also contributes to the overall stability and robustness of the blockchain network Crypto hedge funds have created new revenue streams as well as gaining a better understanding of specific crypto-related technologies. This is an important differentiation between crypto markets and capital markets.

Though, this operation of running a Proof-of-Stake (PoS) node requires hedge funds to hire engineers in order to set up and maintain a cloud and/or hardware configuration. According to the report, the percentage of crypto hedge funds involved in staking is around 42%, lending 38%, and borrowing 27%.

Custody

Within the PwC study, it has been observed that the vast majority of custodians used by crypto hedge funds are in some form regulated, this has been seen as a positive development for the industry and indicates the further institutionalization of the space. Though, this has not only been achieved due to institutional investor pressure and the continuous implementation of industry best practices but also because most fund managers are becoming increasingly regulated. These new regulations not only require funds to be stored in a safe environment (including with an independent custodian) but many jurisdictions also forbid a regulated fund manager from directly holding client assets.

On the other hand, It is known that approximately half of the surveyed crypto hedge funds are quantitative funds. These quantitative funds typically leave their assets directly with the various exchanges as they trade actively throughout the day. Given the fact that 80% of funds reported using an independent custodian, this indicates that a vast number of quantitative funds also utilize an independent custodian.

Liquidity

In the crypto hedge funds universe, these are the quantitative funds that have provided the most liquidity and these are also the funds that possess the highest liquidity amongst all crypto hedge funds. Quantitative funds that usually trade on quite liquid exchange-listed crypto assets can conveniently provide better liquidity to investors than a fundamental investor targeting early-stage projects or a multi-strategy, where the fund manager needs to consider the various strategies and instruments in its portfolio.

Fund administration

It is highly unlikely that any institutional investor would choose funds without a designated independent fund administrator. Though this was acceptable in the early days of fund management, there is no valid reason for a crypto hedge fund to calculate its own Net Asset Value (NAV) each month. Though it is also possible that on rare occasions some smaller funds, such as those with small AUMs or who hold niche crypto-assets continue to value part of their portfolio themselves. Regardless of the choice of fund administrator, the valuation policy needs particular focus. Most funds will have their valuation methodologies and frameworks set out in their private placement memorandum (PPM). It is crucial for any fund to ensure that it complies with what is set out in its documentation. Management fees are determined based on NAV and performance fees are typically charged on NAV appreciation over a set period (e.g. above a ‘high water mark’).

Team expertise

During the same study in the previous year (2018), on average the size of investment teams has seen a slight increase from 7.5 to 8.7 people, and the average years of investment management experience doubled to 50 (from 24). These new findings indicate that an increasing number of experienced investment professionals are entering the crypto space, leading to financially savvier crypto fund teams. But there may also be survivor bias. It is possible that the crypto funds that closed during the previous year had a higher proportion of junior staff, which could also explain the higher average experience in crypto fund teams in relation to 2019.

Regulation

In regard to the jurisdiction of the crypto hedge funds, the Cayman Islands and the British Virgin Islands are the most notable offshore jurisdictions. Additionally, when it comes to Crypto fund manager locations the US is leading with 52% of the surveyed crypto hedge funds located in the US (from the onshore ones), with the UK being the second in place with 15%, Gibraltar 10% and Switzerland with 8% the fourth.

Moreover, the characterization of the income/gains tax derived from the fund’s crypto investments could depend on whether the investments are treated as securities, commodities, or other property for tax purposes and most importantly to which jurisdiction they belong to.