Cryptoassets are notoriously volatile - but if used correctly, hedge fund managers turn this into an opportunity for beneficial investment strategies.
Does the recent cryptoassets devaluation impact their usefulness to institutional investors?
Cryptoassets are so volatile it creates an opportunity for hedge fund managers to use their advanced algorithms and technical analysis to take short positions and ‘beat’ the market.
Until recently, however, many traditional hedge fund managers have steered clear of these digital assets. Even those who have invested in crypto have been eager to ensure that these assets only represent a small proportion of their portfolios.
But while it might be a stretch to say that hedge fund managers are embracing crypto in its entirety, the proportion holding crypto in their portfolios has grown significantly in the last few years and there are growing advantages of crypto prime brokerages.
The recent crypto crash and it's impact on investing
Despite performing exceptionally well in 2021, crypto has seen a decline in 2022. For example, in November 2021, Bitcoin reached a record high before losing more than half its value by January 2022.
This is obviously bad news for crypto investors - but is it an opportunity for hedge fund managers?
With the prices of many other cryptoassets like Ethereum and Dogecoin falling so sharply, maybe you think that the crypto market is on sale? Some investors predict Bitcoin might rise to new record highs of $100,000+ by the end of 2022. Others suggest Bitcoin could fall to $10,000 by 2023, with global money supply, the 10Y TIPs US Treasury Yield, and US Fed tightening cycle all working against.
But, regardless of how volatile it is, crypto is here to stay.
Over a third of traditional hedge funds already have crypto in their portfolios
The PwC Global Crypto Hedge Fund Report 2022 - the fourth of its kind - revealed that 38% of traditional hedge funds invest in digital assets - compared to just 21% a year ago. Here’s some more interesting statistics from this report:
- The median crypto hedge fund delivered returns of 127.55% in 2020 and 63.4% in 2021
- 86% of these funds invested in Bitcoin
- 81% invested in Ethereum
- 56% invested in Solana
And more hedge funds are planning to allocate crypto into their portfolios
- Two thirds of hedge funds surveyed in the PwC report said they planned to increase their cryptoassets allocation by the end of 2022.
- Almost all hedge funds planned to allocate crypto in their portfolios by 2026.
It is worth pointing out that the PwC survey was conducted in Q1 2022, when the value of Bitcoin and other cryptoassets had already begun to fall sharply.
What is deterring hegde fund managers who aren't investing in crypto?
Regulations
An overwhelming majority (83%) of hedge fund managers not investing in crypto said the main barrier was regulatory uncertainty. Managers of traditional hedge funds want clearer regulation and tax laws before they invest in crypto.
Market infrastructure
pWc's report also found that less than 10% of hedge fund managers surveyed said they thought the crypto market infrastructure was adequate.
No fixed assets to recover losses
The dramatic fall in the value of Bitcoin is a key factor in the recent demise of cryptoassets in general, but the other issue, which is a serious concern for some hedge fund managers, is that investors have no fixed assets to recover a portion of their losses when the value goes down. The absence of regulation also means individuals or institutions that are responsible for these dramatic devaluation cannot be held to account.
The PwC report revealed that 27% of hedge fund managers who didn't invest in crypto said they would accelerate their involvement or investment in digital assets if these perceived barriers were removed, while others will be cautious because of the recent market turmoil.
Crypto hedge funds that have seen decline
Three Arrows, commonly referred to as 3AC, filed for bankruptcy in July, despite having about $10bn AUM just four months earlier. Bloomberg described it as 'the most important hedge fund in crypto', but the fund made one critical mistake: betting that the prices could only go up.
Su Zhu, the founder of the now-bankrupt fund, was sanguine when Bitcoin started to fall earlier this year, insisting that it would recover - instead, Bitcoin plunged below $20,000. By June, 3AC was missing margin calls, and it declared bankruptcy on July 1st.
What can we take from the crypto crash for investment strategies?
Crypto is always going to be very high-risk without the stabilising mechanisms of regulation, a central bank and a mature market infrastructure. But can the volatility of cryptoassets useful to institutional investors?
Hedge fund managers can monetise on the volatility of cryptoassets just like they do with some of the more-volatile shares, like tech stocks. In principle, this relies on betting that a fund or share will quickly fall in value before the rest of the market does. In practice, you will only be successful if you have the right strategy at the right time - we explain more about the success of these strategies when looking at how to use a crypto asset broker.
Computer-driven trading can work in your favour (if you bet correctly)
Crypto hedge funds employing computer-driven trading with complex algorithms have profited from rapid price swings, such as the $40bn fall in the cryptoasset Luna in May. For example, former Morgan Stanley and Lehman Brothers trader Jay Janer, a founding partner of KPTL Arbitrage Management in the Cayman Islands, made 'good money' from the recent Luna crash - obviously by betting that the price would fall.
Three key takeaways for hedge fund managers when adding cryptoassets to your portfolio
Time the market impeccably
Every hedge fund manager knows this already. But this rule needs to be magnified when you’re dealing with cryptoassets. In the KPTL example we referred to earlier, Jay Janer capitalised on about two thirds of the total fall in the Luna's price, by quickly placing short positions that were almost perfectly timed with Luna’s crash (its price fell from $80 to near zero in just days).
Use real-time data to execute orders quickly
Crypto hedge funds can use their sophisticated algorithms to execute orders using near real-time data, giving them an advantage on the rest of the market.
Use derivatives to outperform the market when it’s growing
Over 60% of crypto hedge funds use derivatives in their portfolios; in 2021, these funds delivered a marginally better (63.4%) performance than Bitcoin 's annual return (60%).
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