A new report published this week shows that while the median return for crypto hedge funds was a staggering -46% last year, quant funds managed a median return of 8%.
The data contained in the report, which was published by PwC and Elwood Asset Management, was collected within the first quarter of 2019 across the largest 100 global crypto hedge funds by assets under management (AUM). It is worth noting that this data was self-reported by each fund and has not been verified by an independent fund administrator or third party.
The report notes that 2018 was a challenging year in the crypto markets, with the price of bitcoin down 72% for the year. Although crypto hedge funds using bitcoin as their benchmark did generally outperform, with a median beta coefficient of 0.82 to bitcoin, these funds’ returns were closely linked to the price movements of bitcoin and thus the vast majority of them reported negative returns last year.
But interestingly, the report drilled down into the performance of different types of funds to reveal some stark disparities in terms of returns. It found that the median return of funds employing fundamental strategies in 2018 was -53%, with funds employing discretionary strategies producing an average return of -63%.
According to the report: “The outperformance of the fundamental funds relative to the discretionary funds in 2018 was due to the fact that these funds had invested a larger proportion of their assets into Initial Coin Offerings (ICOs) and early stage projects. These funds managed to exit some of these positions in the first half of 2018 and profit from the outsized returns. Discretionary managers had generally less exposure to ICOs and so missed out on these returns.”
Shorting the market
Given the losses of these funds, it is particularly notable the median return of quantitative funds was 8% last year. The report does not directly comment on how these quant funds were able to produce such markedly better returns, but data elsewhere in the report allows some educated guesses. Unlike the discretionary and fundamental funds, the quants had a massively negative beta of -2.33 to bitcoin and, again unlike these other funds, 86% of them said that they have the ability to take short positions in the cryptocurrency markets.
Fundamental funds, according to the definition used by the report, are long-only, and while 80% of discretionary funds said that they can take short positions according to their legal documentation, the reality is that many of them said that they have never actually taken a short position and do not anticipate doing so.
“In many cases, these funds have not built the infrastructure and over-the-counter (OTC) relationships in order to borrow cryptocurrencies and put on short positions. Therefore, this 80% figure is likely lower in practice for discretionary managers,” says the report.
Another interesting aspect of the report is that it contradicts previous beliefs about the size and number of crypto hedge funds in existence. Pre-existing web-scraping methods estimated that there were over 350 cryptocurrency hedge funds, yet the report claims that this figure is a gross overestimation, with the real number being closer to 150 active crypto hedge funds managing around $1 billion in total.
Distribution of AUM in crypto hedge funds follows a similar pattern to that of traditional hedge funds, according to the report, with a small number of larger funds managing a large portion of the total AUM and a long train of smaller funds managing smaller portions. Indeed, 60% of crypto hedge funds surveyed had less than $10 million AUM, while the median AUM of these funds at the end of 2018 was $4.3 million.
Struggling for profits
Given that the report notes that the median AUM at fund launch last year was $1.2 million, it seems that the funds surveyed have been relatively successful in fundraising considering that the Bitwise 10 index has fallen ~75% over this period.
Yet, despite this success in fundraising, the report suggests that many crypto hedge funds have had difficulty generating profit as most of the surveyed funds charged a 2% management fee and a 20% performance fee. The fact that the median crypto fund manages $4.3 million means that they have $80,000 in guaranteed annual revenue, which the report says is “unlikely to be sufficient to sustain a business operation, especially considering that the median fund has six employees who need to be paid”.
As a result of this, the report states that some funds are exploring ways to increase income in order to cover costs. One example that it gives is that some quant funds are diversifying their approach by becoming market makers, and another is that some early stage focussed funds are taking on advisory roles for new projects.
“Other funds remain focused on their core strategy and hope to cover costs via the performance fee. However, in a market which has collapsed ~75%, this is perhaps a risky approach to take and may not be the most viable long-term strategy. Other funds are seeking to raise additional capital by selling stakes in their General Partner (GP),” says the report.
Custody solution still lacking
There is also some non-investment data of note in the report, which highlights comparisons and contradictions between crypto and “traditional” hedge funds.
For example, while it is common practice amongst traditional hedge funds to have an independent third-party firm custody their assets, only 52% of the crypto funds surveyed have an external custodian, with the other 48% self-custodying their assets. The report says that this is at least partially due to the fact that the largest “traditional” custodians remain unwilling to offer custody services for cryptoassets, forcing crypto funds to use multi-signatory wallets, hot/cold wallet set-ups or other innovative ways to hold the private keys for its assets.
“While there is no perfect fix to this custody problem yet, the good news is that many players globally are now working on it and we expect to continue to see solutions come to market in the short and medium term,” says the report.
Likewise, 75% of crypto hedge fund teams lack independent directors on their boards, as is common with traditional hedge funds.
“This is critical, especially when difficult decisions need to be made that will impact investors, such as whether a side pocket needs to be set up to hold certain assets or whether some restrictions need to be imposed on investor redemptions. These issues are likely to be even more relevant when dealing in crypto assets which are volatile or relatively illiquid,” notes the report.
One potential reason given why these funds generally lack independent directors on their boards is simply a lack of existing directors with the relevant level of crypto expertise. Observing that institutional investors are unlikely to invest in a fund which does not have proper governance, the report predicts that crypto funds will increasingly focus more on governance.
Replicating traditional models
A lack of crypto expertise is also suggested in the research space. Just 7% of survey respondents said that they use third-party research, which could be because proprietary valuation models are relied upon and many funds conduct their own research, but also because – given how nascent the asset class is – very few dedicated crypto research providers currently exist.
Elsewhere, the report shows that the size of the average crypto hedge fund team is seven to eight people and that the cumulative average investment management experience at these funds is 24 years.
“This may indicate that an increasing number of experienced investment professionals are moving into the crypto asset space. Having an investment team with ‘traditional’ asset management experience will likely give not only investors, but also regulators, greater comfort as they seek to absorb the regulation of digital assets into existing frameworks or create bespoke frameworks…We expect many more ‘traditional’ asset management professionals to join crypto hedge funds in the short and medium term as the space continues to ‘institutionalise’ and grow,” says the report.
On the non-investment side then, the picture painted by the report is that although crypto funds currently lack much of the infrastructure and governance of traditional hedge funds, they are looking to replicate this where possible and therefore increasingly, the two will look more similar.