The bear market of 2018 led to dismal returns for crypto hedge funds, but a report suggests institutional investors have continued to invest.
A report from auditing and consulting firm PwC finds that institutional appetite for cryptocurrency investment continued to increase in 2018, even as the median return for crypto hedge funds dropped to -46 percent.
According to the report, crypto hedge funds were able to double their Assets under Management (AuM) in 2018, with the median crypto hedge fund AuM growing from $2.1 million in January 2018 to $4.3 million at the end of the first quarter of 2019.
The hedge fund landscape
In total, the report identifies around 150 crypto-focused hedge funds that control about $1 billion in assets. The figure only includes funds operational in Q1 2019, excluding those that failed during 2018.
The one hundred funds with the most assets held an average of $21.9 million under management, making them tiny when compared to even the smallest of traditional hedge funds.
According to PwC, this small size raises concerns about their long-term viability:
"The median fees charged by the crypto hedge funds we surveyed are 2% management fee and a 20% performance fee, as stated in their Private Placement Memorandums (PPMs). Therefore, if the median crypto fund manages US$4 million and charges a 2% management fee they have US$80,000 in annual revenue. This is unlikely to be sufficient to sustain a business operation, especially considering that the median fund has six employees who need to be paid."
Though the lowest 60 percent of funds held assets less than $10 million, a small minority have become more established. The largest ten percent of funds held around $50 million, and a select few players managed to amass assets worth more than $50 million.
These large firms include San Francisco-based Pantera Capital, which found success as a global macro hedge fund before pivoting to focus exclusively on blockchain in 2014, and crypto-native firm Polychain Capital, founded in 2016 by Coinbase’s first employee Olaf Carlson-Wee.
Quantitative strategies outshine fundamentals
The most successful crypto hedge funds of 2018 did not invest based on fundamentals — like Polychain which looks for novel technologies to fund — but used quantitative strategies.
Despite the limited amount of historical data to draw from, firms like Pantera have begun to develop complex quantitative models to predict opportunities in the crypto market.
According to PwC, fundamental and discretionary funds achieved median returns of only -53 percent and -63 percent in 2018, compared to quantitative funds which made a median return of eight percent in the same period.
By PwC’s definition, fundamental funds "are long-only and cannot take short positions," which explains their poor performance during the bear market.
As the market matures and the crypto lending industry develops, more funds are taking a quantitative approach and adding short trading to their armory.
Custody and Governance
The PwC report identifies two key barriers stopping crypto hedge funds from appealing to larger institutional investors.
Insecure custody methods continue to prevent institutions from being comfortable enough to make big-ticket deals. Unlike the traditional fund management space, where using an independent third-party custodian is mandated by law, many crypto hedge funds still rely on multisig wallets that are vulnerable to theft, and only 52 percent use an independent custodian.
As regulators move in and traditional financial firms provide digital asset custody solutions, crypto hedge funds are expected to become more accessible to these larger investors.
The lack of independent directors is another barrier preventing the inflow of institutional capital.
75 percent of crypto hedge funds do not have independent directors on their boards, which in the world of legacy finance is seen as a necessary expense to ensure decisions are made for the benefit of investors.
As hedge funds look to raise more capital from larger institutional investors, PwC expects this situation to change. Speaking at a press release, PwC crypto leader Henri Arslanian said the crypto hedge fund industry is just getting started and can be expected to evolve significantly.
“The crypto hedge fund industry today is probably where the traditional hedge fund industry was in the early 1990s," said Arslanian. "We expect the industry to go through a rapid period of institutionalization with the implementation of sound practices over the coming years.”