Markov Processes International

Crypto Hedge Funds – Where is the Value?

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The jury is still out on whether crypto hedge funds can generate meaningful alpha, but many investors seem content to test the waters by investing for the beta instead. And why not? Correlations have been low enough and returns high enough, that some portfolios got a boost even despite the well-documented drawdown losses. And if the past few weeks have taught us anything, it is that the extreme risks inherent in crypto aren’t going anywhere anytime soon.

Today’s news is that Three Arrows Capital founder Su Zhu took to Twitter to try and manage investor fears about insolvency on the tail of the ongoing losses in the crypto markets. Unfortunately, this seems to be a familiar tale these days, and there’s no telling if the next story will come from a small player or a major hedge fund that isn’t normally associated with crypto exposures.

Some investors still see crypto as a path to alpha opportunities lacking in more efficient, mature markets – despite not only the volatility, but also a real question as to any real diversification benefits they may be seeking. For example, these investors may find disheartening articles suggesting that the average hedge fund in the Eurekahedge Cryptocurrency Index is mostly in Bitcoin, or charts like the one below.

There are legitimate reasons for the EH crypto index to look so remarkably close to bitcoin; as recently as 2017, bitcoin represented over 80% of the crypto market. But with the market maturing, it now takes the 10 largest cryptocurrencies combined to approach the 80% mark, and as of this writing, there are somewhere between 13,000 (coingecko) – 20,000 (coinmarketcap) cryptocurrencies, with a total price in the ballpark of just under one trillion US dollars[1].

But what have the hedge funds been making of this? It seems like new ones come out of the woodwork every day, offering an attractive risk mitigation scheme for crypto exposure through arbitrage (facilitated also by a growing number of exchanges) and hedging opportunities. But have these funds and their investment schemes been able to deliver the goods?

We set out to create a group of hedge funds that represents active crypto managers.  We limited our search to funds with at least 3 years of data as of March 31st out of a combined set of Eurekahedge and HFR crypto hedge funds, eliminating duplicate share classes and single coin index funds.  We were left with 51 distinct hedge funds.  The number is smaller than the actual number of crypto hedge funds but is representative enough to make inferences about performance and risk in general for the group.

Extending our data to the start of 2018[2], we see enormous dispersion in the annual performance of individual cryptocurrency hedge funds.  The smallest full year interquartile range over this period is 39%.  The largest is almost nearing 200%.  The dispersion fundamentally dwarfs that of other Hedge Fund categories, or even Private Equity.  Surely these crypto funds can’t all be investing the same way.

We then created three equally weighted averages (portfolios) of the top 10 funds by Sortino Ratio, Total Return, and AUM respectively, over the 3-year period from which we created the universe.  We then compared these averages to both the Eurekahedge and HFR benchmarks as well as Bitcoin alone.  We used Sortino Ratio because of our focus on the downside risk. The diagrams below show both the averages, indices and individual funds over the trailing two- and three-year periods through April 2022. They obviously include only survivors, meaning the funds that are active and continue to provide their returns to the respective data vendors.

What we see is that, on a risk-adjusted basis, the averages of top funds in each screening category and the Hedge Fund indices improve on bitcoin as a standalone investment. Many funds have posted similar results (North-West quadrant) while only a handful of individual funds clearly underperform (South-East quadrant) – this is not counting 15 funds that either liquidated or stopped reporting over this time period. The top risk-adjusted Sortino portfolio posts similar returns with ~25% of the downside volatility; the Hedge Fund indices and top-AUM portfolios also show similar returns with less volatility than bitcoin, while the top-Return group boasts both higher return and lower volatility.

Delivering performance similar to direct coin investment, but at lower risk? There’s no question that is an attractive proposition. But even then, this all begs the question of how the top performing funds might achieve these results[3].  Certainly, diversification must play a part but beyond that does each group employ a common strategy? Are institutions going to have a clear picture of how each crypto-exposed fund is riding this high wave of volatility, or will they be taking some of it on faith?

Digital assets may have just gotten Morningstar validation as an official Category, but everything about this space is new and complex. Institutions and investors looking to tap into the opportunities here – and there are opportunities – may find that under the glossy surface, these funds present a due diligence nightmare that is every bit as much an outlier as their dispersion. What have the best funds done differently – and how certain is it that these methods will work in a shifting crypto market? Is the difference between the top and bottom funds just coming down to their exposures to specific coins, as in the Terra (LUNA) collapse?

Answering questions like these is a daunting task when it comes to coins themselves – and that’s before you add in opaque funds, complex strategies, and ‘what if’ scenarios that seem to happen a lot more than anyone should be comfortable with.

Suffice to say, institutions should consider estimating and managing the true risks of their crypto hedge fund portfolios a cornerstone of their due diligence efforts. In our next research piece, we’ll use factor analysis to show you how to find answers to the questions above – and solve the true mystery of your crypto hedge fund beta picture.

[1] Different values from different data aggregators (CoinMarketCap, CoinGecko, Messari)

[2] Here we include all funds, including dead ones, to avoid survivorship bias  This chart may include duplicate share classes or funds reporting in both databases.  For the risk-return diagrams we include only currently active funds.

[3] We should emphasize that the “top 10” averages are chosen in-sample, for the stated period.  They were chosen to illustrate that there are opportunities in the space, not to indicate that we would have identified them prior to the analysis period.


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