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Do Crypto Hedge Funds Produce Alpha or Just A Beta Expose?

Hedge funds have begun to dangle their proverbial toes in the cryptocurrency waters. Indeed, the large increase in crypto hedge fund launches this year could be a defining feature in the industry. However, there is a discussion in the industry regarding whether crypto hedge funds can actually generate alpha in a market where many traditional hedge funds merely give beta exposure, according to the data.

In hedge funds, there’s a little bit of cryptocurrency

Cryptocurrency is undoubtedly moving into some of the hedge funds Apex Group serves, according to Jason Meklinsky, head of Americas Business Development at financial services provider Apex Group. Apex manages more than $2 trillion in assets.

In an interview, he added, “It’s the exception to the rule.” “Because not everyone understands it, some people are simply trying to cash in on the craze.” It’s fine in our opinion as long as it’s a pure-play crypto fund. We look at the manager’s background, the auditor’s background, the counselor’s background… “We are the ones who have to answer for our actions.”

Meklinsky also stated that they have 10 to 15 pure-play crypto opportunities in the pipeline, with half of them being fund managers with prior experience in the industry.

He stated, “They understand how to control portfolio volatility.” “It’s not for the faint of heart, but what we see in general are long/short equities funds with a carve-out of maybe 5% to 10% of assets dedicated to that market.” It’s only a toe-dip, not a full-fledged dive. They have a stronger commitment to the multi-strat community.

According to Meklinsky, a smaller portion of a larger portfolio has a lower influence from volatility. He also believes that legislation coming in the next 18 months will change people’s perceptions of cryptocurrencies and investors’ willingness to take on the dangers they entail.

Hedge funds are becoming increasingly interested in cryptocurrency.

Crypto hedge funds handled around $4 billion in assets at the end of 2020, according to a survey conducted by PricewaterhouseCoopers in 2021. In comparison, the entire hedge fund business manages $3 trillion, while the combined cryptocurrency market is worth $2 trillion.

Hedge fund interest in cryptocurrencies has surged rapidly since alpha from traditional markets has been “nearly fully arbitraged away,” according to FactorResearch founder and CEO Nicolas Rabener in a recent essay for the CAIA Association. He went on to say that virtually all traditional hedge fund tactics are being used in the crypto market, with quant funds accounting for 37% of all crypto hedge funds.

However, Rabener believes that, like in most traditional markets, this will erode alpha.

More crypto funds are expected to start in the near future.

With Intelligence observed a considerable increase in the number of crypto products that entered development last year, notably during the fourth quarter, in its 2021 Hedge Fund Spotlight. This trend is expected to continue in 2022, with additional, higher-quality launches fueled by growing institutional interest.

According to Marc Bernegger, co-founder of crypto hedge fund AltAlpha Digital, there are currently over 400 active crypto hedge funds around the world, excluding those focused on venture capital, following last year’s boom of crypto hedge funds throughout the world. He went on to say that the number of crypto hedge funds is increasing every day.

Crypto strategies and hybrid funds, according to intelligence, “may come to characterize the hedge fund launch market in 2022.” One change investors may notice in the coming year, according to the business, is funds that presently sell shares in different currencies but subsequently add a bitcoin share class.

Despite China’s prohibition on all cryptocurrencies, the crypto industry reached $3 trillion in assets in the fourth quarter, according to intelligence. Peltz International claimed in a separate whitepaper that many of the hedge funds formed last year were crypto funds, indicating significant institutional interest.

Increased institutionalization of the crypto infrastructure is being driven by the rise of established exchanges, the advent of digital custody solutions, and specialized storage and security systems that preserve assets, according to the firm. Peltz also mentioned that “regulatory clarity” is linked to increased cryptocurrency use by hedge funds.

A new cryptocurrency hedge fund has opened its doors.

The return profile of cryptocurrencies is less connected to traditional asset classes, allowing for considerable upside and alpha generation. Only 1% to 2% of hedge fund assets, according to Peltz, are committed to cryptocurrency. Several additional crypto funds were also launched in 2021, according to the business.

Pantera Capital, which was established by Tiger cub Dan Morehead, has raised $600 million for its Blockchain Fund, which is slated to complete with $1 billion in assets in March. It invests in venture capital and cryptocurrency tokens, with institutional investors accounting for roughly 75% of its assets.

With $310 million in assets from its $3 billion flagship fund, SkyBridge launched its Bitcoin Fund in January 2021. Valkyrie Investments, one of the most well-known crypto managers, has launched a DeFi fund aimed at institutional investors. The On-Chain DeFi Fund keeps its assets on the blockchain so that it can earn yield and passive income from them. Ethereum, Binance Smart Chain, Polygon, Avalance, Solana, and Fantom are among the crypto assets that the firm invests in.

Marshall Wace is interested in blockchain technology, payment systems, and stablecoins, while Brevan Howard began investing in cryptocurrencies and digital assets in April 2021. It also plans to build a portfolio of privately held digital finance firms in the final phases of development.

New funds from Galaxy Capital, CrossTower, Graticule Asset Management, and Argentium Digital Asset Management, among others, are highlighted by Peltz.

Hedge funds that invest in cryptocurrency have a bright future.

Bernegger predicts that tighter rules will effect crypto hedge funds and institutional interest in them in the future.

In an email, he said, “I personally believe that regulatory clarity, including a framework, is helping the crypto hedge funds market since institutional investors need it.” “On the one hand, this will raise the entry hurdle for new crypto hedge funds, but on the other side, it will establish a long-term sustainable ecology.”

Bernegger points out that there are still challenges with working with digital assets in a fully regulated environment, such as storage, bank contacts, and investor onboarding. He did say, though, that the situation has improved in the last year and that he expects considerably fewer roadblocks in the future.

Bernegger says, “It’s still a highly interesting environment with many unique options.” “We’re seeing a slew of new crypto funds concentrating on hot topics like NFTs and the metaverse. On the other hand, more established crypto hedge funds are rapidly increasing their assets under management, which benefits the entire industry. I believe we are still in the early stages, and we are witnessing the creation of a new alternative asset class that will grow significantly in the future.”

Crypto hedge funds have a number of difficulties that need to be addressed.

It’s critical to examine the performance of crypto hedge funds as hedge funds and institutional investors become more interested in the crypto markets. Many alternative assets have failed to be “different enough and offer returns uncorrelated to traditional asset classes,” according to Rabener’s blog for the CAIA Association.

As a result, he examined the performance of crypto hedge funds in comparison to the overall market. Between 2015 and 2021, he noted, the correlation of crypto hedge funds to the S&P 500 was 0.03. During the same time period, their correlation to the top 50 hedge funds was 0.22. In 2020, however, crypto hedge funds had a 0.8 connection with both asset classes.

Despite this stronger correlation in 2020, Rabener feels that crypto hedge funds provided significant diversification benefits to investors. He also looked at the association between crypto hedge funds and bitcoin and discovered a virtually same performance between 2015 and 2021, with a correlation of 0.88.

This shows that crypto funds represent cryptocurrency beta rather than alpha, according to Rabener. He does, however, point out that the storey is the same for the whole hedge fund business, which has likewise failed to produce alpha.

What’s the difference between alpha and beta?

Between its establishment in 2004 and 2021, the Credit Suisse Equity Market Neutral Index, which Rabener described as “the adequate index for evaluating the alpha generation of hedge funds,” has earned a 0% return, according to Rabener. He noted that managing a hedge fund is becoming increasingly difficult since markets have “become highly efficient, with few arbitrage possibilities available to exploit.”

As a result, he claims that most hedge funds have started to provide beta exposure merely because alpha has become scarce as equities have risen. But, according to Rabener, investor analytics and data have improved, allowing allocators to recognize that most hedge fund strategies are “simple beta plays.”

Moving to the crypto markets, he believes, “looks like a logical strategy for hedge funds looking for greener pastures.” However, because most of these funds only provide beta exposure, it becomes evident that alpha is “less easy to harvest than popularly assumed,” according to Rabener.

Bernegger is skeptical about crypto hedge funds, despite his belief that they only provide beta exposure. He believes there are still prospects for alpha generation.

“When compared to traditional markets, crypto hedge funds are a young and inefficient asset class,” Bernegger remarked. “While most traditional markets have become very efficient, trading cryptocurrencies still offers a variety of opportunities to produce alpha (from tried-and-true strategies like arbitrage to new domains like yield farming in DeFi protocols).”

Despite Rabener’s assessment of crypto hedge funds as merely beta exposure, he believes they have a place in investors’ portfolios.

“However, just because cryptocurrency hedge funds do not have a compelling investment thesis does not indicate that exposure to cryptocurrencies is unfavorable,” he concludes. “There has never been a stronger justification for diversification.”

 

Disclaimer: These are the writer’s opinions and should not be considered investment advice. Readers should do their own research.

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