How Durable are Dedicated Cryptocurrency Funds?

How Did We Get Here?

In the midst of the 2017 bull market, awareness toward Bitcoin and other cryptocurrencies reached phenomenal levels. All of the large mainstream media outlets started their own investigation and research efforts into the space to try and cater to the curiosity of their readers. What ensued was a dramatically bipolar situation that saw these outlets simultaneously call for the banishment of cryptocurrencies and encouragement toward exploratory efforts into the space. Big media is possibly the prime reason we are where we are in terms of the public perception of cryptocurrency; but that’s a topic for another day.

Cryptocurrency became the new Amazon and Netflix for the investment management industry. Every hedge fund, mutual fund, pension fund, family office, private wealth service, brokerage, individual, and institutional investor quickly embraced research into cryptocurrency. Some of them halted their efforts almost immediately seeing regulatory and ‘ethical’ hurdles. Others who truly saw fundamental promise or were eager to make a quick buck off market exuberance continued their research. But what nobody saw coming and what now seems like it was bound to happen was the sheer number of ‘cryptocurrency hedge funds’ emerging in the space. In October this year, CNN reported that 20% of hedge funds opened in 2017 and 2018 were cryptocurrency funds. The first thing that goes through a cryptocurrency enthusiast’s head when they read this is “adoption”. But is this really the adoption we need and are these funds even functioning correctly?

The Biggest Problem With ‘Crypto Funds’

A majority of the funds that opened with a focus on cryptocurrency have one huge and unique flaw that none of the traditional hedge funds have; lack of diversification. I’ve gone through the portfolios of numerous cryptocurrency focused funds that were transparent enough to publish online factsheets. The most astonishing finding that nobody in the industry seems to be talking about is the complete and utter lack of diversification. Their cryptocurrency diversification alone is questionable since their prime focus seems to be liquidity and investing in top market cap based cryptos. But their holdings are fully held in either cash or cryptocurrencies. For a large amount of funds, complete investment exposure into one asset class is a recipe for disaster. I have personally attempted to convince people cryptocurrency exposure is necessary, but 100% exposure is a colossal catastrophe. Anthony Pompiliano, the head of digital assets at Morgan Creek, advises mutual funds and pension funds to open a 100 basis points or a 1% exposure to Bitcoin. By rationalizing the logic behind the advice he gave pensions, he might suggest an aggressive investor with a large amount of capital give a 5–10% allocation to the same.

It’s no surprise to me that some funds are down 80–95%, are downsizing, or completely closing shop. It actually serves them right for the kind of aggressive action they took in an infantile and high volatility market. Traditional and existing hedge funds from Soros and Bridgewater to Renaissance and Third Point most definitely have an exposure to cryptocurrency that they’ve not actively disclosed (from what I’ve gathered). But they haven’t been wiped out because they’ve had the wit to allocate a small amount of their total holdings towards it; there was no question of a large allocation for them. This is because they understood the high risk of the size, age, and volatility of the market. Bitcoin was indeed in what modern economists would call a bubble. But this doesn’t mean Bitcoin is dead. Bitcoin sees a bubble every 3–4 years or so; the market rationalizes and the prices stabilizes much lower before it goes on a massive bull run all over again, shattering its previous highs.

The Inability to Identify Sound Opportunity

Coming back to the cryptocurrency diversification in itself, what is the obsession with market cap? I understand the need for a hedge fund to have a certain degree of liquidity in every asset they invest into, but the kind of crypto selection they’ve engaged is truly questionable. One particular fund that I won’t explicitly name had a whopping 68% allocation to Bitcoin! A fund manager who chooses market cap weighted portfolio allocation for a cryptocurrency fund in 2018 is either incredibly inefficient in risk management or has no clear knowledge of cryptocurrency market dynamics. I’m sorry to say it, but if a dedicated fund manager or their research and analysis division cannot find more than 30 projects worth investing in then they deserve to close shop. Instead of making allocations of astonishing 60 and 30 percentages in one crypto, a competent fund would be able to make .1 — .5% (or even lower) allocation to a certain internally formulated list of cryptocurrencies they see future promise in. Despite it being crystal clear that most projects will not make it to 2025, there are some projects solving real world issues in such a dazzling yet sensible manner, you can see their potential success rate well outperforms the crowd.

If we ignore whether stocks and fixed income securities are a good buy at this point of time, we come to a very logical assumption that the best performing fund, even with an astoundingly aggressive stance on cryptocurrency, would not have more than 20–30% allocation toward it. The argument that this is part of the shift away from traditional assets is dubious. At this point of time, we have to embrace harmony between traditional and contemporary investment methods. This will create true portfolio balance rather than overweighting one particular asset class.

Revolutionizing the Structure of Investment Companies

Now while all of this holds for the hedge funds, crypto based VC has been immense in propelling development in the space. The likes of Andreessen-Horowitz, Naval Ravikant, Pantera Capital, and Blockchain Capital have been true pioneers of the space by providing much needed funding to cryptocurrency and blockchain projects with huge potential. The future is undeniably bright for Blockchain based VC as well as blockchain/crypto hedge funds, but improvements to the latter are much needed for them to ascend as true competitors to existing hedge funds.

The future of large scale cryptocurrency investments lies in a hybrid theory of sorts. I believe the future of cryptocurrency funds will be to provide the dual value and function of both venture and hedge funds. They will invest in private projects at a seed level as well as trade and invest in tokens of companies in spot and future markets. This will create exposure to both trading income and to cash flow from the project’s operations. For this, these companies will need to employ research professionals with the expertise to run a hedge fund as well as a VC firm i.e. individuals with knowledge of blockchain business development and marketing as well as experts in technical and fundamental analysis, portfolio construction and rebalancing, examination of ICO’s, and other specific roles that fit into the strategy of that particular entity.

Digital assets will become a huge part of our everyday lives. Even if in the form of centralized digital assets that work based on cryptography, the benefits in comparison to paper cash are immense. The developments into digital payments are progressing with every passing day with the help of companies like Square and Circle that have positive public perception. The decentralization revolution is in its early stages. When the use cases are visible to the general public and the benefits are put out into a public domain for them to formally witness, they will understand the opportunity and potential that these assets hold. Cryptocurrency investment has only just started; the future is bright and its true promise is yet to be fully unleashed.