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Traditional hedge funds are warming to the idea of crypto investments, with continuously larger numbers wanting exposure to the space. According to a report by EY conducted in May 2021, almost one in four (22%) hedge fund managers is looking to increase exposure to crypto-related assets in the next one or two years.
While the average portion of the hedge funds’ total Assets under Management (AuM) invested in digital assets is only at 3%, 84% of respondents have aimed to deploy more assets into crypto by the end of 2021.
Among others, the emergence of institutional infrastructure in the crypto space is a significant factor drawing in more institutional investment. With more institutional-grade service providers, such as crypto custodians, hedge funds feel somewhat safer investing in this new, alternative asset class.
At DeFi Consulting Group, we advise our clients, such as family offices and funds, on questions related to setting up the necessary crypto infrastructure and one of the central points is choosing the right custodian to best suit their needs.
The expectation of more regulatory clarity emerging in 2022 further reduces some of the uncertainty evident in the crypto space.
Why Are Hedge Funds Looking to Increase Crypto Exposure?
There are several reasons digital assets have become an “area of focus”, as deemed by the EY report. One reason is that crypto, as a new, alternative asset class, offers a way to diversify an investment portfolio. Secondly, macroeconomic factors, such as concerns surrounding high inflation, further boost interest in crypto as a potential inflation hedge. Thirdly, investors turn to crypto assets due to their alpha-generating potential, with crypto hedge funds having achieved an average return of 128% over the last year, as stated in the 3rd Annual Global Crypto Hedge Fund Report 2021 conducted by PwC and the Alternative Investment Management Association (AIMA).
Barriers to Adoption
However, while investments in crypto assets by regulated investors, such as hedge funds, is increasing, there are still several significant barriers to institutional crypto adoption.
According to the 3rd Annual Global Crypto Hedge Fund Report 2021, regulatory uncertainty is by far the main barrier, with 82% of respondents citing it as an obstacle to investment. Even those funds already invested in crypto cite it as a significant challenge. Other major barriers include client reaction/reputational risk, as well as digital assets being outside the scope of current investment mandates.
However, with regulatory frameworks being discussed and established around the globe, and more reliable, institutional-grade infrastructure being built in the crypto ecosystem, DeFi Consulting Group expects these barriers to investment to decrease and institutional adoption of crypto to accelerate further in 2022. To find out what else DeFi Consulting Group expects to see in 2022, read our crypto trends blog post here.
Crypto Hedge Funds
Aside from traditional hedge funds entering the crypto space, it is also interesting to discuss the emergence and growth of pure crypto hedge funds. These are funds that invest 100% in crypto assets.
Crypto hedge funds offer a good way for institutional investors, such as family offices and asset managers to enter the crypto market, as they can allocate capital via crypto hedge funds. DeFi Consulting Group is helping its clients – family offices and asset managers – construct their crypto strategy and identify relevant hedge funds to allocate capital to. One of the key takeaways is that allocating capital to crypto hedge funds is a viable way for institutional investors to enter the crypto market.
The report by PwC and AIMA estimates that the total assets under management (AuM) of crypto hedge funds globally increased to nearly US$3.8 billion in 2020, up from US$2 billion the previous year. The average AuM for this year’s surveyed funds increased from US$12.8 million to US$42.8 million, while the median AuM increased from US$3.8 million to US$15.0 million. The median AuM at fund launch is US$1 million, indicating that funds have generally seen an impressive 15X increase in AuM. While these figures are still relatively small when compared to traditional hedge funds, they show the impressive growth of crypto hedge funds over the last couple of years – a trend that is reflected in the wider crypto market.
According to the report, the vast majority of investors in crypto hedge funds are either high-net worth individuals (HNWI), making up 54% of investors, or family offices at 30%. DeFi Consulting Group explains: “One of the reasons being that high net worth individuals and family offices often have less regulatory compliance to deal with than other regulated financial institutions”.
Although institutional interest in the crypto space has been increasing steadily, institutions are not yet prevalent investors in crypto hedge funds. Going forward, however, this is expected to change, with the investor mix between HNWIs, family offices and institutions evening out.
How Are Crypto Hedge Funds Allocating Capital?
According to the PwC report, crypto hedge funds generally use four main investment strategies: discretionary long/short, discretionary long-only, quantitative and multi-strategy. Quantitative is the most commonly used strategy employed by 37% of crypto funds surveyed, followed by discretionary long/short (28% of funds), discretionary long-only (20%) and lastly multi strategy (11%).
Aside from simply holding cryptocurrencies as investments, crypto hedge funds use them for a variety of activities, including to trade, lend, borrow and stake, with the highest percentage of funds using cryptocurrencies for staking activities at 42% as of 2020. At DeFi consulting group, we are increasingly seeing client demand around questions regarding how to generate yields on crypto assets. Lending, borrowing and staking are just three options to achieve that.
Crypto funds in the survey also actively trade crypto derivatives, with options being the most commonly used tool, followed by futures. Short-selling, on the other hand, has drastically reduced from 2020 to 2021, reflecting the bullish sentiment in the larger market.
In terms of the most common cryptocurrencies invested in by crypto hedge funds, Bitcoin sits at the top of the leader board – 56% of the funds in the PwC survey reported that at least half of their daily cryptocurrency trading volume is BTC, while 15% of the funds are pure Bitcoin funds, meaning they trade Bitcoin only. Aside from Bitcoin, the top traded altcoins in these funds (excluding stablecoins) as of 2021 were Ethereum (ETH), Litecoin (LTC), Chainlink (LINK), Polkadot (DOT) and Aave (AAVE).
DeFi Consulting Group is currently in the process of finalising a market study on pure crypto hedge funds, which we will be happy to share soon.
Overall, we are seeing both the emergence of larger numbers of crypto hedge funds, as well as relatively high growth generated from their crypto assets. However, it is also important to keep in mind that the crypto market overall grew steeply in 2020 and 2021, thus putting the growth experienced by crypto hedge funds into perspective, as it is partly a reflection of the growth trend seen in the larger market.
Ultimately, a hedge fund’s purpose – be that a crypto or a traditional hedge fund – is to ‘hedge’ against bear markets, not necessarily outperform a good market. The takeaway from this article shouldn’t be that crypto hedge funds can significantly outperform the market, but that there is large growth experienced in the sector – as is the case for the wider crypto space – and that they offer a viable way for institutional investors to start allocating capital to the space. And not only are more crypto hedge funds emerging, traditional hedge funds as well are slowly venturing into the crypto space, increasing both capital deployed in crypto assets as well as the variety of assets invested in.