With crypto gaining mainstream adoption, traditional financial bodies are increasingly welcoming digital assets with open arms. This amalgamation of TradFi with the decentralized world of cryptocurrency has led to a rise in the popularity of crypto hedge funds. But what is a crypto hedge fund, and how do these institutions differ from their more traditional counterparts?
This guide explores everything there is about crypto hedge funds, including operations, fund management strategies, capital management, investment strategies, and the regulatory landscape. Here’s what you need to know.
- What is a hedge fund?
- Is there a crypto hedge fund?
- How does a crypto hedge fund work?
- Capital allocation in a crypto hedge fund: how to get the ball rolling?
- What are the strategies employed by crypto hedge funds?
- Types of crypto hedge fund
- Other fund types: crypto-focussed
- How crypto hedge funds have evolved over the years?
- How are crypto hedge funds regulated?
- Pros and cons of these hedge funds
- The way forward for crypto hedge funds
- Frequently asked questions
What is a hedge fund?
Think of a hedge fund as a private club where investors pool finances to achieve financial goals. A more specific definition would be a body of pooled investments that function with fewer regulations than traditional funds like ETFs, Mutual Funds, and more.
With fewer regulations in place, hedge funds are better poised for alpha generation — generating higher returns. In TradFi (traditional finance) a hedge fund aims to help investors maximize returns with a proper risk management strategy in place. And with risk management, we mean strategies to hedge the risks.
But are traditional hedge funds as relevant as they once used to be? Marcel Kalinovic, the CEO of Lit XChange, thinks not.
“Hedge funds returns in 2023 are collapsing due to their poor positioning in meme stocks and financial markets.”Marcel Kalinovic, CEO of Lit Xchange: Twitter
Is there a crypto hedge fund?
In short, yes! With the financial landscape evolving and investors showing interest in diverse asset classes, crypto hedge funds are becoming increasingly common. While they do exist, they do not have major diversifications from the traditional ones.
Crypto hedge funds leverage the unique opportunities presented by crypto investments. They offer strategic and crypto-relevant portfolio management and risk management strategies.
The idea behind setting up a crypto hedge fund is simple. With several bull runs gracing the crypto space over the past few years, many fund managers and high-net-worth individuals added crypto to their portfolios. Over time, these funds carved an identity with fund managers using traditional investment strategies to foray into the digital asset domain. And with institutional investors like Grayscale, MicroStrategy, and Tesla showing interest in cryptos, the crypto hedge fund space has only grown since its inception.
Here is a list of the top crypto hedge funds, per the AUM standings:
How does a crypto hedge fund work?
Institutional investors do not usually take positions in crypto assets using centralized and decentralized exchanges. The same goes for high net-worth investors (HNWI). Instead, they rely on crypto hedge funds, which serve as bridges to connect these esteemed firms and individuals to the crypto world.
Did you know? A pension fund named Virginia’s Police Officer’s Retirement System has exposure to a crypto-focused fund — the Morgan Vreek Blockchain Opportunities Fund. This is one instance of institutional investing.
Note that hedge funds are often good at making predictions. Here is how:
Portfolio management involves ideating the right set of assets for your funds. Consider this the process of choosing the right ingredients for the dish that is the hedge fund. And guess what? The chef here is the fund manager.
A hedge fund is an investment instrument that pools investor assets, prepping them for financial gains. Portfolio allocation is the process that determines where the investor’s assets will go.
Maybe the player has just BTC and ETH in their portfolio. Or there might be a decent mix of altcoins. For instance, DCG or the Digital Currency Group, the firm behind Grayscale Investments, has BTC, Decentraland (MANA), ETC, and several other crypto holdings. That’s not it. DCG brings forth a sizable crypto corpus comprising Brave (the web browser), an investment in Chainalysis — the blockchain analysis firm, and other broad market positions as part of its portfolio.
Pantera Capital, the first crypto hedge fund, has its capital allocated to early-stage crypto tokens, liquid tokens, bitcoin funds, and more.
This aspect of fund ideation involves planning the amount of funds that go into each asset. Consider this the amount of each ingredient that a chef plans to use. A fund manager needs to be very careful in this regard. Allocating too much to a highly volatile cryptocurrency might comprise the fund’s structure and stability.
It wouldn’t be wrong to term capital allocation a type of science that requires experience. We cover this important aspect of hedge fund management in more detail later in this discussion.
In regards to an investment instrument, alpha signifies the performance. A crypto hedge fund is aimed to generate alpha and outperform even some of the most rewarding TradFi hedge funds.
The concept of alpha generation relative to a hedge fund is all about beating the average performance of the index, asset, or fund it is measured against. For instance, if you plan on investing in a bitcoin fund, a 15% yearly return would be considered positive alpha if BTC, the asset, has given anything between 10% to 14.9% as returns. The idea is simple. Positive alpha means beating the average or beating the underlying asset or index.
Alphas are lip-smacking. But they come with risks that crypto hedge funds aim to manage. Risk management is like an anchor that a fund manager can drop if things go south. But then, risk management strategies can differ depending on the alpha generation strategies a given fund employs.
For instance, if an arbitrage-focused hedge fund is in sight, the fund manager must account for exchange risks, including downtime concerns and more. A good risk management strategy could be to diversify across diverse exchanges to lower platform-specific dependency.
Market analysis aims to analyze the breeze flowing through the crypto space. From setting up arbitrage positions to indulging in simple crypto trading, the fund manager should gauge the possibilities and act accordingly.
This might involve reading about key events, doing a broader market sentiment analysis, and evaluating the investment and capital flow.
Capital allocation in a crypto hedge fund: how to get the ball rolling?
Fund managers often work closely with capital allocators to prepare the most rewarding crypto hedge fund. As mentioned previously, capital allocation is a type of science and is defined by logic.
Here are the factors they focus on:
- The idea is always to generate the most positive alpha, all while keeping the risk within acceptable levels.
- Most funds hinge on asset diversification, and therefore, a due-diligence structure is necessary to look at. The allocator should know everything about the crypto before going all in. And this even involves checking the derivatives space to see the nature of the funds.
- Hedge fund portfolio management isn’t random and is only token-specific. Examples of DGB have shown us that analysis platforms, web3 browsers, and other broader players are also worth investing in.
- The market depth and liquidity of the assets in the portfolio. Alpha generation might be followed by exits. For the funds to be accessible, the asset has to be liquid. Checking the CEX and DEX landscape can help in this regard.
- Key ratios like Sharpe, comparing the risk-adjusted alphas associated with TradFi and crypto. This should help neutral allocators identify if crypto is as rewarding as claimed.
Apart from the mentioned aspects, the allocator must check for the historical performances of similar hedge funds, different categories of funds based on the assets they control, and different hedge fund indices.
However, another important aspect of capital allocation is the hedge fund’s strategy. And by strategy, we mean the way it aims to generate alpha.
Understanding the process
There is a lot more to a crypto hedge fund than the mentioned terminologies. When it comes to working, the pooled investments are used to take positions in diverse crypto-specific elements. These can be tokens, the ETF space, crypto firms, or almost anything else. Usually, a crypto hedge fund has a minimum investment threshold.
While all that seems basic enough, it all comes down to how the hedge fund levies fees. Like a traditional hedge fund, a crypto hedge fund attracts performance and management fees. While performance fees are levied based on the fund’s performance — given which benchmarking standard it follows — management fees are primarily the fund maintenance cost.
Notably, every crypto hedge fund has something called the “hurdle rate” in place. Based on the benchmarking standards, the hurdle rate is the minimum level of outperformance that a fund must show before it can levy performance fees. Typically, the performance fee is anywhere between 10% to 20%, whereas the management fee is often fixed at 2% or less.
What are the strategies employed by crypto hedge funds?
Active funds, or rather hedge funds, usually follow cryptocurrency trading, fundamental-focused liquidity provisioning, and arbitrage strategies for alpha generation.
It doesn’t tell that other strategies can also be employed, provided you plan on piggybacking this space for success. These strategies include:
- Quantitative trading using mathematical models
- Event-based strategies by giving importance to sentimental analysis
- Yield farming, staking, and other active DeFi activities.
- Leveraged trading
- Macro strategies that bank on geopolitical indicators
- Short-selling strategies to ride a dipping market
Fund managers assign portfolio players and allocate capital based on the strategy the hedge funds aim to follow.
A thread on what event-based trading entails:
Types of crypto hedge fund
While crypto hedge fund strategies make sense, it is better to use them as parameters and focus on enlisting the types of crypto hedge funds. A generic diversification would only include two fund types — active funds and passive funds.
In crypto, active funds hinge a lot on market analysis. This allows fund managers to focus on cryptocurrency trading as a primary strategy. Other strategies relevant to active funds include arbitrage and event-based alpha generation. They usually have higher overheads as the focus is always on higher returns.
Passive hedge funds in crypto are usually index-driven. For instance, there might be hedge funds that would only allocate capital to metaverse and DeFi indices. The portfolio management strategy relevant to passive crypto hedge funds often mirrors indices and not the underlying cryptos. They usually attract lower fees and are less prone to outperforming the market compared to active funds.
Other fund types: crypto-focussed
In addition to being active and passive, there are other hedge fund types to consider. These include the following:
- Quantitative funds: They employ systematic, algorithmic, and mathematical strategies.
- Long-only: These are bullish-only funds that look to maintain long positions without short-selling.
- Long/short funds: Depending on market trends, these funds can quickly switch between long-holding and short-selling. The only focus remains on generating alpha.
- VC style funds: Unlike active portfolio management and capital allocation, which focus on picking liquid assets, these funds usually invest in crypto startups — like venture capitalists.
- Multi-strategy: These funds, per the name, employ multiple strategies to generate alpha for high net-worth investors and others.
- Fund of funds: There are some funds that invest in other crypto hedge funds, especially as a method to diversify risks.
- Yield-focused funds: Some funds only focus on DEX and DeFi-based fund management. Their focus is primarily on using funds to generate yields through liquidity provisioning, staking, or other strategies.
- Global macro: Also termed Managed Futures or Systematic funds, the idea here is to trade future and forward contracts — liquid only — based on trends.
- Market-neutral funds: These are risk-mitigating funds where the focus is on profiting from relative price action.
Apart from the mentioned types, you can see fund managers also focussing on the following underrated fund types:
- Crypto mining funds
- Convertible arbitrage funds (asset to its future price contracts)
How crypto hedge funds have evolved over the years?
The crypto hedge fund space is a dynamic yet nascent one. However, it seems that the growth curve is similar to what was experienced by traditional funds in the late 90s before they blew up in the early 2000s. We are optimistic that they will gain prominence in the global crypto space over the next ten years.
However, the growth since 2013 — the year when Pantera came into existence — has been exemplary. Let us look at a few insights that can help trace the growth of these funds over the past few years.
Rise of the Assets Under Management (AUM) value
The data from 2018 to 2022 is available for analysis, and we can see a steady rise in the AUM value of the crypto hedge funds. A surge in AUM figures shows that hedge funds have been adding to their wallets over these past few years.
The current crypto hedge fund space: How are things post the FTX contagion?
However, this chart doesn’t consider the FTX crisis, after which the AUM dropped rather significantly. Data from 2021 to 2023 shows a more granular picture. As you can see, in December 2022 — post the FTX contagion — the AUM levels have come close to the 2020-2021 levels, dropping significantly from the 2021-2022 highs.
Post-FTX, the drop in the performance of hedge funds has been sharp, regardless of the fund strategy or fund type.
Evolution in fund strategies and types
Crypto hedge funds have been around since 2013. However, only in 2015 did we get a clear view of the strategies and types. Here is how the active hedge fund space evolved over the years, with the focus shifting from liquidity provisioning to trading.
Localization of crypto hedge funds
Another novel take on the current state of crypto hedge funds is how they are spread out geographically. For instance, the U.S. has taken the lead in the number of hedge fund setups, per the latest reports. Also, while the Asian and European fund setups and managers prefer active strategies like trading and arbitrage, the U.S. counterparts are more aligned towards Fundamental strategies, Fund of Funds, and other passive options.
Talent shift to the hedge fund space
As the crypto hedge fund space heats up, new and experienced players are ditching TradFi institutions to jump onto the alpha-generating bandwagon.
Between 2015 and 2017, when the fund space was in its infancy, mostly inexperienced players were around. Things have changed now. From 2021 onwards, we have seen many experienced individuals helming key positions.
Asset segregation and other focus areas
Another interesting take on the state of crypto hedge funds is the type of assets and platforms the managers rely on. Or we can term it as the general investment plan. In 2023, the focus is primarily on sticking with the same amount of already invested capital. If you look at 2021, hedge fund managers were too eager to infuse more at every turn — all thanks to the ongoing bull market.
Also, here is how the token and asset-specific cryptocurrency investments look in 2023.
It isn’t surprising that BTC takes center stage whenever the respondents are unsure about other cryptocurrencies and crypto assets.
Another interesting thing to look at is the ETF space. With BTC ETFs being talked about in plenty, 2023 has seen an uptick in the ETF-powered exposure to crypto assets. The derivative space has simmered down a bit due to the extended spells of cryptocurrency market volatility.
Also, fund managers in 2023 have started prioritizing decentralized exchanges (DEXs) for alpha generation, with Uniswap and dYdX being the leading platforms.
Finally, the tokenization of real-world assets has stood up as a force to reckon with in the hedge fund space.
How are crypto hedge funds regulated?
2023 hasn’t been the best year for crypto hedge funds. We all remember how deep the U.S. banking crisis was, a contagion that ensured 13% of the hedge funds shut shop. The currently functional ones are awaiting regulatory clarity to become commonplace across the crypto space.
As for the current regulatory landscape, the crypto hedge funds in the U.S. are scrutinized at two levels — the issuer and the adviser. At the issuer level, the state and SEC regulate the investment, whereas, at the adviser level, the onus is on the CFTC, SEC, or neither, depending on the type of assets the fund is invested in. Even though the SEC has an active role to play in the regulation of crypto hedge funds, the standards aren’t as stringent as other funds like an ETF.
Per PWC’s detailed report on the state of crypto hedge funds in 2023, only 4% of respondents feel that the new wave of regulations, if and when it arrives, will need them to change the existing custodians — bodies associated with loss prevention.
Even the hedge fund handlers are asking for regulations to make the process even more transparent. A majority of these handlers are concerned about regulations relevant to asset segregation followed by financial audits and statements of reserves.
Pros and cons of these hedge funds
Crypto hedge funds started as alternatives to the capital erosion happening in the TradFi space. People started realizing that legacy markets weren’t as easy to extract alphas from. And thus, crypto hedge funds became popular. And while they come with several incentives, here are the best reasons to consider them as a form of wealth creation:
- These are globally distributed funds.
- Bolstered by large retail-specific trading volume
- Rapid innovations, despite increasing complexity
- They offer diversified exposure to the world of crypto
- The space is currently filled with highly experienced fund managers
Yet, they are not with their share of inherent issues, which include:
- Cryptocurrency market volatility
- Reputational risks
- High fees
- Complex learning curves
- Low entry barriers make them less exclusive
- Uncertainties around regulatory compliance
- Counterparty threats
- Operational issues
- Unreliable data
Note: Catastrophic events like the Terra-Luna crash and the FTX collapse did push several willing hedge funds away from crypto in 2022. As you can see, the negative impact outweighed other emotions.
Despite these barriers hindering global adoption, traditional hedge funds in 2023 are showing optimism and have shown interest in exploring the space if the challenges get less threatening.
The way forward for crypto hedge funds
A lot is happening in the crypto hedge fund space. While the percentage of traditional hedge funds moving to crypto has dipped, the AUM has increased since 2022. Also, tokenization has charmed many fund managers as the new theme. Still, these developments pale in comparison to the massive potential of this space to emerge as the next big thing in web3, provided we get clarity on regulatory compliance.
Frequently asked questions
Which are the biggest crypto hedge funds?
What is the first crypto hedge fund?
Is there a fund that invests in crypto?
Does Warren Buffett own a hedge fund?
How do crypto hedge funds manage market volatility?