Industry News The Murky Waters of Crypto Hedge Funds

The Murky Waters of Crypto Hedge Funds

February 12, 2019

If an entity looks like a VC, acts like a VC, then in all likelihood, it is not really a hedge fund. In spite of this, many crypto fund operators and managers who set up their systems in the previous period chose to use the hedge fund model. Instead, there is a clear argument that they should have used a venture capital structure. Usually, hedge funds were and continue to be measured regarding their performance over a discrete and short periods of time.

These are usually months, quarters and years. This is especially reasonable for long-functioning markets like stocks. Their price discovery is given – anyone can determine the price of Netflix or Apple stocks in no time at all. In theory, the same principle could also work for cryptocurrencies but only for those assets whose price can be determined quickly, like in the case of ETH and BTC, for example. Otherwise, the hedge funds would be better off using the same venture capital model as any other VC company working in the traditional financial domain.

A Faulty Setup

There is compelling evidence that a range of crypto funds got off the ground using an inadequate structure. Now, famous cryptocurrency hedge funds are launching their own venture funds. Some are even doing this while they are stopping investors from pulling their capital from the starting hedge funds. Additionally, several funds are using a process called side pockets. With them, there is no means of properly valuing any market because there is no such entity – side pockets are long-term and liquid investments.

Funds tend to invest in different tokens or find crypto companies and take equity stakes. This way, there is no way for anyone to value the same assets precisely or properly. The same is also connected to the fact that many crypto projects did not trade on an open market and in a free manner. With this, any hedge fund will start to slowly but surely take on the characteristics of a venture capital fund. Here, the problem is the simple fact that many crypto hedge funds exhibit a natural preference that pulls them towards a venture-type of operation rather than a fund-style of investment.

They show a strong tendency to mostly make investments in the long-term. This is a basic flaw of the setup that is in its essence focused on the short-term. This, in turn, results in a situation where most hedge funds are actually correct about their predictions but still get penalized for the same reason. A manager might be able to invest in a crypto asset that one day becomes a very wide-spread tool for something like distributed file storage.

But, their investment is destroyed using the metric like the basis of the yearly performance. This happened as the same crypto asset, now wildly successful, managed to fall multiple times over the cliff until it reached this position. The same definitely happened with bitcoin and it will continue to occur with different cryptocurrencies both new and old.

Crypto Hedge Fund Measurement of Performance

A fictive scenario: ABC is a fund run by an organization that includes a range of very accomplished tech experts coming from a range of Ivy League schools. Yet, in 2018 ABC managed to finish the year down by 70 percent. These managers do not have any experience in the profession of money management. What is more, they seem that have not been aware of the option that the technology they are interested in does not align with the sentiment of the market and the general bear period in which the crypto world is currently in.

If they did, the outcome could have been different for 2018 but at the same time, it could have been worse. There are not many big winners in the downturn of the market that took place over this period. On the other hand, DEF crypto fund is run by enthusiasts that support the technology with fervent enthusiasm. They see crypto not just as a financial technology but something that would be able to redefine the way people of the world live their lives.

What did happen to DEF fund during 2018? They still lost about 50 percent of the money and remained organized as a hedge fund. Everyone invested in any way in the crypto domain wants to see this manager success, but at the same time, things have to be called by their real names, no matter if the talk is about cryptocurrencies, esports, or any other domain of digital (or offline) venture.

A Challenging Domain

It is also important to recognize that it is notoriously difficult to figure out what type of structure is best suited for the different crypto funds. Looking back, anyone can have a 20/20 vision. But the problem is apparent. There is a big issue in having a target in a five to 10-year window and using a range of short-term vehicles to reach the same goal.

The promise of technology is huge, but the actual delivery of incredible short-term results is an unstable prospect. The fact of the matter is this – in the previous year, an average crypto hedge fund was down by almost 70 percent. But, not all crypto funds should take on the hedge model and there is no reason to force this decision upon them by the investors.

New Age, Old Principles

Market forces tend to even things out and sort any huge fluctuations over a prolonged period of time. But, this also means that those engaged in the crypto finance domain must attain a more realistic view of the field. Being hopeful about the future of a particular tech is good but it is also important to recognize that some principles of finance survived for centuries for good reason.

Economic forces tend to stay similar no matter the money is fiat, digital or something else. They cannot be resolved by coding and there is no way to over-engineer them. This is why anyone who wants to invest in a cryptocurrency must realize that they are defining a venture capital plan and not a hedge fund option.

Source: CoinDesk