As a lot of investors are relatively new to the asset class, it is a common and reasonable choice to outsource the active management of crypto assets to a hedge fund. For those already familiar with, and invested in, the traditional hedge fund space, it also makes good sense to consider crypto hedge funds as an alternative or a complement to their hedge fund holdings.
With the phenomenal performance of the crypto market year-to-date, investor interest in the asset class has increased exponentially. Meanwhile crypto hedge fund returns have consistently exceeded traditional hedge fund returns by a wide margin, and this remained the case in Q1.
However, selecting a fund in this young asset class is more difficult than in traditional asset classes.
Challenges of investing in crypto hedge funds
Choosing the strategy is the first challenge. Some of the traditional hedge fund strategies do not work well in the crypto market, or are not feasible at all. Some strategies have particular challenges or opportunities due to the peculiarities of the digital asset market, and without understanding the landscape well, choosing the right strategy may be difficult. In addition, because of the fast evolving nature of the market, the opportunity set changes over time, new viable strategies arise, and funds may drift or pivot towards different substrategies.
Another choice in fund selection is how much exposure to the crypto market is acceptable or desirable. Some funds are entirely market neutral, and target only alpha generation. Others manage their exposure to the crypto market, or run token selection strategies where being long is often the only way to have exposure. Funds also target different segments of the market – large, mid or small caps, early stage projects, only regulated instruments, etc.
The liquidity to redeem is also variable, with the most common being one-year lock up and quarterly redemptions. However, some strategies are more liquid and some less.
The greatest challenge when selecting the specific fund is that a lot of the funds are young with relatively short track records. This offers fewer quantitative pointers, and requires more qualitative judgement.
A lot of the funds are also still relatively small, and this means that certain operational risk factors cannot be avoided. For example, independent governance for risk, or strict separation of certain functions is not possible when the headcount is very small.
Choosing the best in class crypto hedge fund managers
Ultimately, assessing manager skill and the validity of their unique advantages (edge) requires deep expertise in traditional finance/investments, a reasonable understanding of the technology and the remaining challenges, as well as being familiar with the idiosyncrasies of the digital asset market, and having a strong network with an informational advantage.
Fund of funds as an alternative to single strategy funds
One solution to the fund selection challenge, especially for those still relatively new to the digital asset market, is investing in a fund of funds where the investment selection, asset allocation to various strategies, operational risk assessment, and ongoing monitoring is outsourced. Fund of funds have the added advantage that they offer diversified exposure to multiple types of excess returns which through their limited correlation with each other limit the overall risk. Fund of funds are also resourced to perform detailed due diligence on the investments, and the exposures are actively monitored and managed.
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