Cryptocurrency investments are on the rise with interest booming in recent years - but what are the main challenges & opportunities facing crypto hedge funds.
Challenges & opportunities of crypto hedge funds
Cryptocurrencies are still a relatively new type of asset. In fact, 81% of existing crypto hedge funds were launched between 2017 and 2020, which demonstrates how new crypto is in the financial market.
Despite this, there’s no doubt that cryptocurrency investments are on the rise, with interest booming over the past few years. In 2021, funds investing in crypto led all hedge funds in performance with a 215% return.
As crypto is still so new, it comes with a high degree of risk. Hedge funds are inherently volatile as a high-risk high-reward investment pool, and crypto hedge funds are even more risky due to crypto’s volatile nature. This means it is vital for investors to do sufficient research into funds and their strategies before investing.
Is there a crypto investment fund?
There are over 400 crypto hedge funds now in existence, offering plenty of opportunities for investment. Examples include Pantera Capital, Coin Capital and Bitcoin Reserve. All of these funds have different things to offer – as well as different investment criteria – so it’s important to research thoroughly before choosing a fund to invest in.
According to a report by PWC, high-net worth individuals are the most common investor type in crypto hedge funds, with family offices coming second at 30%.
Can asset managers invest in crypto?
Asset managers can invest in crypto. In fact, many are being persuaded to thanks to the recent boom in the cryptocurrency market. Crypto hedge funds work in basically the same way as any other hedge fund, with investors pooling together funds toward a shared goal – in this case, the shared goal involves crypto exposure.
As well as crypto-focused hedge funds, traditional hedge funds are also choosing to include crypto assets in their portfolio.
One in five (21 per cent) of traditional hedge fund managers are now actively investing in digital assets, and this number is projected to continue to grow throughout 2022. In fact, around a quarter of hedge fund managers who are not yet investing in digital assets confirmed that they are planning to invest or looking to invest.
Cryptocurrency asset manager strategies
According to PWC’s 2021 crypto hedge fund report, crypto hedge funds generally operate under four broad fund strategies:
- Discretionary Long Only: These are funds that are long only, and whose investors have a longer investment horizon. These funds generally invest in early-stage token or coin projects, and also buy and hold more liquid cryptocurrency assets.
- Discretionary Long/Short: These funds cover a much wider range of strategies, including long/short, relative value and technical analysis, as well as some crypto specific strategies such as mining. This often involves hybrid strategies, with many funds investing in early-stage projects and involving a longer investment horizon for investors.
- Quantitative: Quantitative funds take a quantitative approach to the market, with strategies usually including market making, arbitrage and low latency trading. As liquidity is important for these strategies, these funds are restricted to only trading liquid cryptocurrencies and therefore have a much shorter investment horizon.
- Multi-strategy: As indicated by the name, these funds utilise a combination of all the above strategies. Traders may manage multiple discretionary long/short and quantitative sub-accounts.
Main Challenges for Crypto Hedge Funds
Competition affecting revenue
The growing number of crypto funds will most likely increase competition between fund managers, leading them to lower their fees in order to attract clients and investors. Investors are likely to benefit from an increased range of investment options, while funds will potentially lose profit due to this increased competition and lower margins.
Some funds are seeking ways to increase their revenue in order to combat this. For example, early-stage focused funds may take on an advisory role for a new project, while other funds may sell stakes in their General Partner in an attempt to raise capital.
Tax complications
Crypto hedge funds need to consider many of the same tax issues that affect traditional hedge funds. These include ensuring that the fund is set up to be attractive to investors with different tax attributes, managing fund and investor tax reporting, understanding the capital gains and withholding tax implications of different trades, and dealing with transfer pricing between any connected entities responsible for managing the fund.
As well as these traditional tax considerations, crypto hedge funds can present unique complications due to the current lack of clear guidelines surrounding cryptocurrencies. Many funds have tried to minimise their liabilities without really knowing what the rules are, and this could create issues now that governments are starting to scrutinise digital currencies more closely.
Due to the uncertainties currently surrounding crypto and tax, crypto hedge funds need to take extra care with this. Fortunately, the growth in the cryptocurrency market means we may receive more clarification in this area as demand increases.
Overall risk
As previously mentioned, crypto hedge funds are among the riskiest due to the volatile nature of cryptocurrencies. With such a volatile market, it’s important for asset managers not to underestimate the difficulty of creating a successful and profitable strategy.
The cryptocurrency market can be notoriously difficult to enter and understand, so it should really only be tackled by knowledgeable investors who are open to high levels of risk.
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