Crypto hedge funds are funds that specialize or have additional expertise in crypto investments. Cryptocurrencies are volatile assets by nature. Due to the unknown future demand for them, their values fluctuate significantly more than your typical currencies.
What makes these funds stand out is their performance. Most recent numbers show that while typical hedge funds returned +11.6% in 2020 (as measured by the HFRI Fund Weighted Composite Index), cryptocurrency funds racked up a whopping +192.91% in 2020 (as measured by the HFR Cryptocurrency Index).
Investors find funds with an AuM (Assets Under Management) of more than US$20M attractive. In this article, we shall focus on five such funds that specialize in blockchain and crypto.
Grayscale Investments ★★★★★
As of February 2021, Grayscale, a crypto hedge fund established by the Digital Currency Group in 2013, reported $37.8B AuM. Grayscale invests heavily in Bitcoin and several large-cap cryptocurrencies. Any news of Grayscale buying a crypto asset inevitably results in a spike in price.
They offer 14 investment products, and the minimum investment for most of them is $25,000, and annual fees are 2.5%. Their Bitcoin Trust, Ethereum Trust, Bitcoin Cash Trust, Ethereum Classic Trust, Litecoin Trust, and Digital Large Cap Fund are publicly traded on OTC markets.
Grayscale’s Bitcoin and Ethereum trusts are regulated by the SEC, which means they file their financial statement, quarterly and annual reports with the SEC. Based on the figures, Grayscale leads the pack at the moment.
Invictus Capital ★★★★✰
Invictus Capital’s C10 hedged fund uses a unique cash hedged strategy that protects against drawdown risk. The algorithm buys and sells the top 10 best-performing coins every week.
Launched in 2017, the C20 fund is the world’s first tokenized cryptocurrency index fund that tracks and invests in the top 20 best-performing currencies, similar to the S&P 500 tracking the top 500 US companies. Your investment yields a single C20 token that you can buy and sell as you wish.
The Invictus Bitcoin Alpha tokenized fund focuses only on long-term returns on BTC. With tokenized funds, there is no minimum investment restriction – a major drawback with the other crypto hedge funds.
In January 2021, the C20 fund performed better than Bitcoin, with a 51.2% growth. I consider this a good fund based on its performance and the possibility of investing small.
Polychain Capital ★★★★✰
Polychain Capital specializes in protocols and other blockchain-based asset investments. This was the first crypto hedge fund to exceed $1B in AuM in 2018. Coindesk reported that those who invested with Polychain at the beginning enjoyed a 1,332.3 percent return in four years. An investment of $25,000 would have paid you $333,000.
Polychain’s second venture fund opened in December 2020, intending to raise $200M. Eligibility for the second fund is a minimum of $1 million locked in for up to three years.
Founded in 2016 by Olaf Carlson-Wee, the first employee at Coinbase exchange, Polychain has more than 300 high-profile investors. Polychain Capital does not serve short-term investors and requires a minimum lock-in period of six months.
BlockTower Capital ★★★✰✰
Trading, investing, portfolio, and risk management services are offered exclusively for cryptocurrencies. It offers five funds with lock-up periods of one year for individual investors and three years for institutional investors.
While the firm initially focused on liquid assets, it has recently raised $25M for DeFi projects. In March 2021, it acquired a $20M stake in Fantom, indicating a willingness to invest in more illiquid longer-term assets.
BlockTower was founded in 2017 by Matthew Goetz, a Goldman Sachs executive, and Ari Paul, a trader and portfolio manager. One of the best things about BlockTower Capital is the highly experienced team, many of whom are ex-Goldman Sachs employees.
Galaxy Digital ★★★✰✰
With over 1.2B in AuM, Galaxy Digital offers many services, but the main focus is on blockchain and cryptocurrency investments. It has three cryptocurrency funds for short and long-term profits: Galaxy Bitcoin Funds, Galaxy Ethereum Funds, and Galaxy Crypto Index Fund.
The minimum investment for the Bitcoin and Ethereum funds is $500k and $250k, respectively. The Crypto Index Fund is a portfolio of investment products, trading the most liquid crypto assets based on the Bloomberg Crypto Index, and the minimum investment is 25k.
Founded by Mike Novogratz, the popular Wall Street legend, Galaxy Digital is based in New York and publicly traded on TSX Venture Exchange, Toronto.
How do crypto hedge funds work?
Cryptocurrency hedge funds operate by hedging their bets and longing or shorting crypto assets. Once you invest, the decision on how or where the money is invested remains with the fund manager.
Investors make profits with successful investments, and fund managers make money through fees.
Crypto funds invest in any or all of the following:
- Passive index funds
- Active trading funds
- Initial coin offerings (ICOs)
- Lending and others
With the increasing investor interest, funds are improving their management techniques and strategies. According to PWC, fund managers today use a broad range of fundamental and quantitative strategies.
- Fundamental: Long-only funds with a longer investment and lock-up periods. They invest in projects in the early stages, including pre-ICOs. They buy and hold more liquid cryptocurrencies.
- Discretionary: They are based on the discretion of the fund manager and employ a variety of strategies, such as going long/short, news-based, technical analysis, mining, and may also invest in pre-ICO’s and ICO’s. You can expect the lock-up period to be similar to fundamental strategies.
- Quantitative: The most popular is the quantitative approach, where funds use directional or market-neutral investments. Strategies include arbitrage, market-making, and low-latency trading. Only the most liquid cryptocurrencies are traded. High liquidity ensures a short lock-up period of around 6 months.
Crypto funds may use some or all of the above trading strategies either manually or using advanced algorithmic trading tools to achieve their goals.
Initially, investor assets remained in the custody of the funds, but PWC reports that 80% of funds now use third-party or exchange custodians. Many jurisdictions have made custodians mandatory and forbid funds from holding investor assets.
With regulation slowly creeping in, fund managers have additional expenses such as paying third-party custodians. The average management fee is 2%, and the performance fee is 20%. Management fees are charged to cover the running costs of the funds.
Many funds shut down because of the increasing costs. Only funds with a large number of investors or those adding additional revenue streams are able to survive.
Taxes and regulations
While other funds are easily classified either as securities or futures, crypto hedge funds are not categorized as a single asset class. There is still a lot of confusion leading to regulatory and tax problems.
If the fund invests in Bitcoin, Ether, or other popular cryptocurrencies, the SEC (U.S. Securities and Exchange Commission) considers them non-securities. What about the other cryptocurrencies? The answer lies with the SEC and the jurisdiction. State laws also vary widely.
Offshore jurisdictions like the British Virgin Islands and the Cayman Islands are very popular with crypto hedge funds, as they can legally obtain relief from direct taxation for a minimum of 20 years.
The following questions need to be answered for tax purposes:
- Are the fund’s investments treated as securities, commodities, or something else?
- What is the source of income? Is it trading, staking, lending, mining, airdrops, or token rewards?
- Where is the fund established?
- What are the jurisdictional tax rules?
The crypto platform Gemini proposed a self-regulatory organization (SRO) called the Virtual Commodity Association to regulate the crypto spot markets. It would be interesting to see if anything comes of this.
While it is easy to worry about the regulatory and tax issues, why not enjoy the competitive advantage? Future regulations may treat crypto funds as other hedge funds or may come with stricter regulation. For now, the lack of or limited regulation gives funds the ability to multiply profits for their investors.
Find a reputed crypto fund that has been posting good results for the past four or five years. Perform due diligence on the fund’s focus, fees, strategies employed, tax, regulation, and associated risks. Knowledge is power, more so with investments as volatile as crypto hedge funds.