Price volatility driving crypto hedge funds to evolve

2018 was a year that most crypto funds would rather forget. The price of bitcoin lost over 70 percent in value, and many altcoins were down by over 90 percent. Unsurprisingly, crypto fund returns mirrored the performance of the overall market, and many funds struggled to convince their investors that the funds they raised were being put to good use.

The move to VC-style investing

To ensure they can continue to benefit from the crypto asset ecosystem without being so bound to market volatility, several digital asset hedge funds are venturing into the more traditional venture capital world

investing to capitalize on distressed buying opportunities and to avoid having to rely on a crypto market rally to generate a return on investment for their investors.

According to a report by Bloomberg, leading crypto funds Polychain Capital, BlockTower, and Arca Funds are looking towards venture capital-type investments.

Polychain has launched a new $175 million fund with a seven-year lock up period while BlockTower has hired former Goldman Sachs executive, Eric Friedman, to lead the investment company’s venture capital strategy. Arca Funds may start to take equity stakes in crypto startups as opposed to purely buying their tokens.

"There’s going to be a lot of opportunity in distressed buying and even activist investing. Often you can buy below even the cash value of the company." Jeff Dorman, partner and portfolio manager at Los Angeles-based Arca, told Bloomberg.

"Funds have silently transformed from hedge funds into venture funds as their liquid portfolios shrank in value, making a very high percentage of AUM illiquid," added Kyle Samani, managing partner at Multicoin Capital Management.

POS staking as a way to generate alpha

While some crypto funds are looking towards equity investments in blockchain startups, others are looking towards earning a (relatively) stable income through what is referred to as staking.

Staking is what holders of cryptocurrencies that utilize a Proof-of-Stake (PoS) consensus algorithm can do to validate transactions and help to secure the network and, as a reward, earn new tokens. Some of the largest Proof-of-Stake cryptocurrencies – measured by market capitalization – include EOS, NEO, Qtum, Decred, and Stratis.

Through staking these five digital assets or any of the over 125 POS coins currently available in the market, investors can earn de facto interest on their crypto asset holdings. Interest rates for the most established PoS assets can range from 3 to 30 percent p.a. while high-risk micro-cap PoS coins can generate a staking return of several hundred percent, according to POSList.

Staking, however, is not a risk-free affair. On the contrary, staking can be categorized as a high-risk investment approach as investors are required to lock-up their cryptocurrency holdings for a certain amount of time to receive staking rewards. This can create a scenario where investors can miss out on a rally or can’t sell during an aggressive market downturn.

Moreover, many of the highest-earning POS cryptocurrencies are volatile small-cap coins whose values can drop quite substantially as smaller altcoins are ‘high beta’ and, thus, have sharper moves than bitcoin (BTC).

Nonetheless, for long-term holders who have full faith in the future of the cryptocurrencies they are staking, it makes sense to receive extra returns since they are already holding these coins and tokens.

"Regardless of market conditions, staking provides returns denominated in the asset being staked. If you’re going to be long, you might as well stake," Kyle Samani, managing partner at Multicoin Capital Management, told Bloomberg.

What’s next for crypto funds?

Crypto asset hedge funds posted losses of over 70 percent on average in 2018 and 42 crypto funds (out of around 780 that were in existence last year) were forced to close their doors. Hence, it comes as no surprise that digital asset funds are looking for new opportunities in this highly-volatile new asset class.

If 2019 will not bring a substantial relief rally, it will be difficult for crypto funds to convince their investors about the validity of their investment strategies and more funds could stand to close down. At the same time, this will provide the best-performing funds with the opportunities to de-couple themselves from the rest of the pack and increase their assets under management, which will be an interesting development to follow.

Travis Kling, founder of Los Angeles-based digital asset fund Ikigai, agrees with this notion. "2019 is going to be the year of separating the wheat from the chaff, and that’s applicable to both projects and funds," he told Bloomberg.

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