Crypto Hedge Funds: Exploring Alpha Gains, Adoption, and Challenges in the Digital Asset Landscape

In the tumultuous year of 2022, the crypto market went through its share of ups and downs, presenting both challenges and opportunities. Despite a prolonged bear market, traditional hedge funds remained undeterred, showing a growing interest in embracing the world of digital assets.

According to the Digital Assets Outlook survey by Coinbase in 2022, respondents anticipate that crypto will be among the top three markets for generating alpha gains in 2023. Of those who identified crypto, 41% of investors expressed a preference for crypto hedge fund strategies as the most effective means of gaining exposure to the crypto market.

In this article, we will explore the factors driving traditional hedge funds into the crypto space, the evolving landscape of digital assets, and the challenges that both traditional and crypto-native hedge funds face. From regulatory uncertainties to the pursuit of alpha gains, this article sheds light on the fascinating journey of hedge funds in the crypto sphere.

Traditional Hedge Funds Embrace Crypto: Diversification and Alpha Potential

Traditional hedge funds are no longer on the sidelines when it comes to crypto investments. There are several compelling reasons why traditional head funds are exploring crypto assets, including:

Diversification: Hedge funds are diversifying their portfolios to minimize risks associated with individual markets.

Alpha Potential: Crypto assets offer the potential for generating alpha. Alpha, or the excess return of an investment relative to the return of a benchmark index, acts as a significant draw for fund managers seeking higher returns.

Client Demand: Growing client demand for exposure to digital assets is a key motivator.

Maturing Market Infrastructure: As the crypto market infrastructure matures, it becomes more appealing to traditional financial institutions.

But that doesn't mean that it doesn't come without uncertainty. The crypto asset category remains a puzzle for regulators worldwide. With its inherent volatility and unique characteristics, it challenges traditional definitions of assets and securities. The key questions revolve around the regulation of crypto tokens, particularly in determining whether they should be classified as securities.

The Evolving Landscape of Digital Assets

Venturing into digital assets comes with its share of challenges, especially during bear markets. Liquidity constraints can be particularly daunting, affecting both traditional and crypto hedge funds. Investor redemptions, reduced market liquidity, and valuation uncertainties have taken a toll, leading to trouble for some high-profile players in the crypto space, such as crypto exchanges like FTX, Celsius, and hedge fund Three Arrows Capital (3AC), who all went out of business in 2022.

Taking into consideration the challenging market, financial experts in the space stress that hedge funds can't afford not to diversify to minimize unpredictable and non-systemic risks in individual markets. For this reason, hedge funds are adopting a strategic approach to digital assets, allocating a portion of their portfolios to digital assets, typically ranging from 1% to 5%. The exact percentage is ultimately determined by the fund's investment thesis, market assessment, and the specific goals and preferences of the fund managers.

However, recent macroeconomic developments, such as increasing debt ceiling and traditional banks facing bankruptcy, paint a bullish picture for the crypto landscape. Notably, stablecoins like Tether have undergone audits to bolster investor confidence and claim that it is spending up to 15% of its net profit on Bitcoin, widening its already big position on the hard money asset.

Nevertheless, the concept of crypto tokenization gains traction as a tool for decentralization, potentially challenging traditional fiat systems currently ravaged by monetary debasement. Compared to traditional fiat systems, crypto tokenization aims to bridge the information gap between retail, regular, and institutional investors, making the market fairer and more accessible.

Migrating From the Traditional System to the Digital Realm

Comparing the performance of crypto hedge funds with traditional finance reveals the fragility of traditional finance. According to a Forteus study, crypto portfolio managers have consistently outperformed their traditional counterparts by consistently delivering higher absolute returns for at least 36 months.

And perhaps this isn't surprising.

The Forteus study demonstrates that Wall Street strategies have experienced a gradual decline in returns and the ability to generate alpha for the past 20 years. In fact, HFRI data shows that for the better part of the last decade, these strategies have generated close to 0% of alpha compared to the S&P 500.

So, what's driving the decay of traditional finance systems? Technology, primarily.

Old and inefficient banking systems struggle to compete against friction-free, irreversible blockchain transactions that prevent double-spending. In addition, markets are realizing that digital newcomers like CBDCs and stablecoins offer an alternative to the legacy dollar-based system.

But it's more than that.

The inefficiencies of traditional bank procedures are also generating attrition in the industry. The study also shows that there has been a recent emergence of 'hundreds of new funds' that are propelling the 'migration of talent from traditional finance into digital assets.'

As a result of the changing tide, established asset managers and up-and-coming hedge funds are bridging the gap between old and new markets. In 2022, Blackrock partnered with Coinbase to develop crypto-trading capabilities to 'help clients more easily manage and trade their Bitcoin.'

The Regulatory Challenge: Clearing the Path for Adoption

As the tokenization trend grows and evolves, clear regulatory guidelines become crucial for investor safety and to establish standardized categories and disclosure requirements for crypto tokens. Without further regulatory clarity, the number and use cases of tokens are expected to accelerate, further complicating the existing landscape.

For traditional hedge funds, regulatory uncertainty represents the greatest hurdle for the institutional adoption of digital assets. According to PWC, audit and accounting, risk management and compliance, digital assets as collateral, and fund administration will all need to be improved before adoption can be fully realized.

However, the latest spot Bitcoin ETF filings indicate we might see a legal framework in the coming year. This filing would give investors exposure to Bitcoin without having to own it. If the ETF passes, they will be able to invest with a proper regulatory tax regime approved by their investment mandates, paving the way for further adoption.

Seizing Alpha Amid Volatility and Growing Adoption

Institutional investors might worry about volatility in digital assets, but it isn't necessarily a bad thing for fund managers. Crypto markets offer inefficiencies and abundant arbitrage opportunities that can be acted upon and capitalized. Often, there is potential for outsized risk-adjusted returns from skilled managers, and these opportunities are more easily found than in traditional asset classes like bonds, stocks, or real estate.

Technical advancements are a ‘thriving jungle’ in the crypto ecosystem. The usual principles that determine the value of assets in the traditional economy are not applicable in the world of cryptocurrencies, and few people can really tell if there´s intrinsic value in a crypto project. This explains the tendency of technical factors on a blockchain or a crypto token to push prices up and down.

A large portion of crypto transactions are attributed to retail investors, often highly leveraged, rather than institutional ones, making the atmosphere susceptible to greed, anxiety, and other behavioral biases that cause patterns that systematic trading algorithms can exploit.

3 Tactics to Mitigate Risk

For the past several years, investors and hedge funds have been following crypto events and taking notes.

The following guidelines are useful for investors and fund managers who use counterparts for their trading operations and asset storage and look to avoid counterpart risk by running operational due diligence.

1. Collateral should be the hardest asset. Considering Tether's position in BTC and Microstrategy's profitable performance as big indicators of where to allocate funds. For example, maintaining a significant allocation in the 'hardest' digital asset, Bitcoin. By holding a significant position, you will achieve diversification in your investment portfolio and mitigate the risk associated with having exposure to a less established asset or an altcoin that remains to be proven regarding long-term price appreciation.
2. Focus on decentralization in an asset. In the present digital information era, the more immutable, distributed, and publicly accessible ledger will prevail. Trustless transactions, enhanced security, censorship resistance, network resilience, good scalability, and community governance are among the ironclad traits that will make a digital currency asset outperform its peers in the coming decades.
3. Choose a transparent exchange. In the midst of the fallout of FTX and Celsius, we learned it's important to pay attention to exchanges. The popular phrase 'not your keys, not your coins’ remains as prevalent as ever. If you are using a centralized exchange like Binance, consider taking custody of your assets to avoid rug pulls or cyberattacks. Plus, consider the exchange's auditor or surveillance partner as part of the exchange. Lastly, do not ignore the reputation of the people running the exchange, and be cautious with the exchange's own currencies.

The Path That Lies Ahead

New opportunities bring a new set of challenges. We should look at the crypto market as a new prospect to capture robust alpha opportunities but within a familiar hedge fund structure. With a risk-adjusted performance over two- to five years, digital assets can be a good alternative for diversification in an existing hedge book.

The race for a Bitcoin spot ETF approval in the US is on, with fillings from WisdomTree, Valkyrie, Bitwise, Fidelity, ARK, Invesco, and now Blackrock. The approval of a spot ETF paired with rate cuts from the Federal Reserve could be the ideal catalyst for the next bull, starting in 2024 to 2025.

However, there have been some hard lessons learned in the market. The recent demise of crypto hedge funds like FTX and 3AC exposed the actors who were ‘swimming naked,’ further cleansing the industry. It also revealed due diligence entities and more withstanding assets in the space, helping to simplify future asset allocation.

A new due diligence kit has become necessary as operational and investment risks continue to evolve. Specialized crypto hedge funds have earned significantly, and they stand for a great investment opportunity, but they also represent counterparty risk. Although alternative digital assets will continue to make a splash, Bitcoin continues to offer trusting, long-lasting, decentralized, and robust network protocols. Time continues to show it is not to be put in the same category as other crypto tokens due to having the strongest network effect and being a hedge against inflation.

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