2018 — The Year Crypto Hedge Funds Would Rather Forget

It wasn’t supposed to be this way.

As thousands of ill-informed and ill-equipped “investors” (and I use the term loosely) poured billions of hard-earned dollars into the initial coin offering (ICO) craze of 2017, minting themselves overnight fortunes, the steady, educated and even hand of professional managers were supposed to shine the light on the ignorant. As the cryptocurrency hype-cycle reached terminal velocity in the waning months of 2017, professional analysts, managers and moneymen from Wall Street started trickling into cryptocurrencies, following the lead of luminaries such as Blythe Myers (creator of derivatives and former JP Morgan executive), Mike Novogratz (former hedge fund trader and Goldman Sachs partner) and Dan Morehead (former Tiger Management head of macro trading) who had lead the way during a period of unprecedented growth and optimism in cryptocurrencies. Before you could say, “When moon?” cryptocurrency hedge funds of every stripe were setting up shop, but they would soon be confronted with the double whammy of an impending crypto-crash as well as a painful lack of infrastructure to support institutional-grade investment outfits. From custodian solutions to fund administration, Wall Streeters were out of their element and with limited reputation to bank on (or track record for that matter), they stayed to set up shop, for better or worse. And after a sordid 2018, many of these funds, in particular, those set up at the height of hype, are now appealing for patience from investors to stay the course.

Of the numerous crypto-focused hedge funds set up in late 2017, those that were long-biased were hit particularly hard as investors poured money into funds trading Bitcoin and other cryptocurrencies in 2017 and hoping to bank on a sector-wide boom. But Bitcoin bombed by almost 75% last year, a fall mirrored by countless other cryptocurrencies and many investors have been clamoring for the door — prompting funds to urge them to stay the course and in some cases even relying on gating clauses (clauses which prevent investors from redeeming their shares in the fund due to extreme market conditions) to lock investors in.

Particularly hard hit was San Francisco-based Pantera Capital, set up in 2013 and arguably one of the earliest cryptocurrency hedge funds. In a letter to investors in December, Pantera Capital acknowledged that 2018 had been a “difficult year for all cryptocurrencies and tokens.” But with over US$500 million in assets, the fund, set up by Dan Morehead, has been urging clients to look to the longer-term business case for cryptocurrency. Pantera Capital is perhaps one of the more successful crypto funds, having reported a 10,000% lifetime return as recently as July last year. While the fund reported a loss of 40.8% as of the third quarter last year, for investors who cashed out early, an investment in Pantera Capital would have been considered a highly successful one. As with all things in life, timing is crucial. Morehead and co-CIO Joey Krug wrote to investors,

“After such a prolonged drawdown in the market, it’s important to reflect and re-evaluate the thesis behind utility tokens.”

And it’s not like Pantera Capital didn’t deliver for investors when times were good. A separate fund dedicated to ICOs returned 350% in 2017, but fell 75% in the third quarter of 2018. Many other funds, especially those which were setting up shop during the boom were not so lucky to have even clocked wins, with many of them hemorrhaging from inception. To be sure, with the Net Asset Value (NAV) of many funds now well under water, if one took a long-term bullish view of cryptocurrencies in general, access to these funds could be purchased at huge discounts. And a large part of the longer-term success or failure of cryptocurrencies boils down to adoption and value generation. Morehead and Krug are bullish on the longer-term adoption of cryptocurrencies, writing,

“We firmly believe that tokens will achieve real world usage. In fact, it’s already starting to happen in the depths of this bear market.”

Morehead and Krug’s observations are not all public relations-speak. Because many of the scams and failed ICO projects have since been sidelined, those dedicated to generating value as well as the long-term sustainability of the blockchain and cryptocurrency ecosystem have had the opportunity to batten down the hatches and get on with the hard work of development. Morehead and Krug believe that blockchain networks could take two to three years to achieve scale, but given the complexity of the problems at hand, there is reason to believe these estimates are conservative at best. Even though some of the best and brightest developers have entered the blockchain ecosystem, given the inherent political as well as technical challenges faced by allcryptocurrency and blockchain projects, five years is likely an optimistic timeline, with a ten-year horizon perhaps overly conservative. 

And while crypto funds could have bet in both rising and falling prices, options for shorting were not readily available in the early days of the crypto-rush. Managers, some of them ideologically-driven in the long-term success of cryptocurrencies, were also reluctant to sell digital assets short and because of 2017’s unprecedented rise in cryptocurrencies, many were hit by the market crash, with limited hedging tools. According to data group HFR, crypto hedge funds were down 70% on average in 2018.

Even Mike Novogratz’s Galaxy Digital has not been spared. A cryptocurrency and blockchain focused merchant bank, Galaxy’s passively-managed Benchmark Crypto Index fund, which charges an annual 2.5% management fee was down 50.6% from May to October 2018. The fund holds a basket of cryptocurrencies including Bitcoin, Ripple, Ethereum and Litecoin and is similar in its operation to an index fund. In a November letter to investors, Novogratz wrote,

“The (cryptocurrency) asset class continues to show signs of maturity, as headlines that once would have led to frenzied trading sessions have given way to patient market participants who want to see and react to results, not headlines.”

Unfortunately for Novogratz and Galaxy Digital’s investors, most headlines for 2018 were regarding the spectacular fall in cryptocurrency prices. But Novogratz remains resilient, predicting a recovery this year when financial institutions move from investing in crypto funds to investing in cryptocurrency themselves directly. But many of the largest financial institutions who last year had announced exploratory teams to investigate cryptocurrency trading (to much fanfare) have also quietly shut down or downsized these operations. From Goldman Sachs to JP Morgan and Barclays, many of Wall Street’s biggest names have been quietly shuttering their cryptocurrency trading desks or taking staff off the exploratory operations.

Bears Make Money, Bulls Make Money, Pigs Get Slaughtered

But not everyone has had a rough 2018. Cryptocurrency funds which took a market agnostic approach were also the best performing given the market conditions. Whereas investors who shunned double-digit returns amidst a sea of thousand-percenters, it was the conservative approach of outfits like New York-based Systematic Alpha Management (SAM) which may have the last laugh. Systematic Alpha Management’s Cryptocurrency fund returned 4.3% in the first 11 months of 2018, an significant achievement given that almost every other fund took high double-digit hits throughout 2018. SAM’s algorithmic fund trades Bitcoin futures and tries to profit from both upward and downward trends in prices and was one of the few outfits which was able to profit during November’s 38% plunge in Bitcoin versus the dollar. But given the paucity of SAM’s profits, it is likely that the fund ended 2018 in the red as well, something which Peter Kambolin, SAM’s CEO also admitted — but all things being considered, SAM’s losses are likely nothing compared to crypto funds as a whole.

 

Part of the problem is that dollar values of cryptocurrencies, which are little understood by your average investor, are volatile at best. And with few institutional structures and an uncertain regulatory environment governing cryptocurrencies, a long-only approach is extremely challenging. Yet the inherent volatility means that investors who are able to exploit that volatility in a risk-managed and market agnostic way will likely be able to achieve alpha in the medium and long-term. Perhaps not on the level of thousands of percent return, but high double digits. And therein also lies one of the biggest challenges facing crypto funds. Part of the draw of crypto funds (at least in the very early days) was their promise of supernormal returns on investment funds. Nowhere else could you achieve thousands of percent returns. But the reality is that any instrument promising thousands of percent returns must be viewed with a discerning and skeptical eye — if it’s not a con job, it will not last. And as the cryptocurrency market matures, the days of thousand-percent returns are likely well behind us, which means that crypto funds are no longer in a special league of their own, but competing with traditional hedge funds which are also looking at double-digit returns. In such circumstances, the raison d’être for an investment in crypto seems a lot less attractive for investors. Given the uncertain outlook, lack of safeguards as well as regulatory uncertainty, the risk-reward ratio for investors may be out of sync for now at least. Moving forward, algorithmic funds like Systematic Alpha Management are likely to persist, but long-biased crypto funds may have difficulty raising larger pools of assets under management simply because the motivation (greed) of investors may no longer be satiable.