Will 2023 be the year of the crypto hedge fund?

In 2022, the traditional hedge fund re-emerged as an important component of a balanced portfolio. While bonds and equities slipped at the same time, hedge funds provided their investors with positive returns across a multitude of different strategies, from macro to trend following to credit long short and volatility arbitrage.

One asset class that was even more turbulent than stocks and bonds was crypto. A market with little oversight and limited regulation, crypto also has no support from central banks providing liquidity when things become acutely distressed. 

The year saw a complete unravelling of some of the biggest names in the industry. Borrowing and lending platforms Voyager and Celsius are going through painful bankruptcy proceedings after taking unreasonable risks with client assets in a fight to preserve elevated yields. 

The year concluded with the spectacular implosion of FTX, one of the world’s largest exchanges. FTX evaporated into thin air overnight after using client funds to make ridiculous bets and fund the extravagant lifestyles of their management team. 

While the founder and CEO of FTX, Sam Bankman-Fried is being tried for a number of different frauds, the industry is waiting with bated breath to see if this ‘Lehman moment’ for the crypto industry will have further fallout. However, as many remain anxious, there is a small niche of investors who are starting to pay close attention: hedge fund managers. 

Hedge fund titans flock to crypto

Crypto already had a number of hedge funds specifically focused on extracting returns from the immense volatility, liquidity fragmentation, and volume on the core assets of bitcoin and Ether. Yet the end of 2022, has seen the largest influx of players from the traditional hedge fund space, start to focus on crypto.

Teams from Citadel, Two Sigma, Point72, Brevan Howard and others have either created crypto arms or spun out completely abandoning the traditional world at a time where the higher-octane world of crypto seems to be on the verge of total collapse. What on earth is attracting some of the world’s biggest names in hedge funds at a time when hedge funds themselves are performing well?

The domino effect of collapsing companies has provided such sensational headlines that one would be forgiven for assuming that the end of the crypto industry was not far away. However, since the pandemic low in March 2020, bitcoin is actually up nearly 500% to where we are today. When an asset class goes through so many trials and is still holding a significant level of performance, it is unlikely to be going anywhere.

In fact, the rapid removal of criminal and fraudulent operations allows the industry to rebuild and emerge in a more constructive fashion. This, combined with the ongoing uncertainty and immense volatility, is a recipe for rich, and nicely risk-adjusted, returns in the coming years.

Today, there are as many as a thousand hedge funds active in the crypto space drawing a comparison to the emergence of the original hedge fund industry. In the early 80s, hedge funds were able to make remarkable returns taking advantage of inefficiencies in global stock and bond markets; returns were huge, often 30-50% in a single year, but hedge funds were new and with these new structures, new risks were introduced to their investors. These operational risks opened the door to a new type of fund manager: the fund of hedge funds.

The need for adults in the room 

Funds of hedge funds served their clients by providing oversight, guidance and diversification to the hedge funds they invested in. They watched for signs of fraud, mismarking of positions, abnormal return profiles or ‘style drift’ that demonstrated that managers were not disciplined in their approach to risk taking. 

They also strive to reduce operational risks through fund selection as solutions come available. Tri-party agreements with custodians, which are being further developed, are one of them. They are more in line with institutional needs and offer more security for asset safeguarding, especially considering the recent scandals.

As many traditional hedge funds today are institutions in their own right, with huge operations, compliance and risk teams keeping an eye on things, the need to mitigate risk through funds of hedge funds has become less salient.

With the platform fragmentation and volatility in crypto, arbitrage strategies can be extremely lucrative presenting similar return profiles to traditional hedge funds in the early 80s. However, as crypto emerges as a new asset class, it brings with it many more challenges around wallet management, smart contract risk, insufficient hedging tools, and younger managers who have had typically little experience in traditional finance.

This lack of maturity, and brand new types of risk means that, once again, there is a very strong need for ‘adult supervision’. A fund of hedge funds that can bring traditional operational due diligence to this new industry, spotting red flags but also adapting to the new risks in those diligence assessments, provides valuable protection to investors looking to benefit from the extreme alpha available in crypto.

2023 is likely to be a year where the crypto industry takes time to rebuild, but out of the wreckage of a disaster, it is clear that some of the world’s sharpest investors are seeing opportunities.

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