Crypto hedge funds can deliver a new age of extreme alpha

Crypto hedge funds today potentially represent a revival of ‘the Golden Age of Hedge Funds’. The alpha available in the crypto markets represent a fertile opportunity for non-correlated portfolio returns in an era marked by increasing correlation risk.

Evolving asset class

At Syz Capital, our crypto hedge fund strategy has zero direct exposure to crypto assets. We harness the alpha through an allocation process to the best crypto hedge fund managers globally.

We are primarily exposed to market neutral funds, which address and benefit from the inefficiencies in this nascent market. Market neutral managers are generally looking at some other aspect of the market than straight directional exposure to crypto, like volatility, funding or a specific pattern.

As the crypto markets go through cycles, we use data embedded in the bitcoin blockchain to assess activity by large crypto whales and other market players to assess where we might be in the cycle and then subsequently increase or decrease allocations to CTA strategies. CTA strategies that are also referred to as ‘trend’ or ‘momentum’ strategies form part of our ‘directional allocation’.

Investors and allocators may be surprised to learn how many good fund managers are starting to emerge in this rapidly evolving new asset class. We are currently tracking over 300 managers that are implementing some level of trading strategy in crypto.

And while there are many managers, most remain far from investible. This is where deep due diligence plays a critical role. The reality is that a lack of maturity and brand-new types of risk mean there is a greater need for risk oversight.

Deep due diligence

With over 25 years of hedge fund selection experience and nearly a decade of crypto expertise, we deliver essential best practices in due diligence to this emerging industry. This consists of three key stages: investment due diligence, technical due diligence (for quantitative hedge funds), and operational due diligence.

Investment due diligence evaluates how the manager generates returns, their performance history, response to extreme market conditions, track record length, assets under management (AUM), team composition and tenure, and personal investments in the fund.

Technical due diligence examines the team’s model development and testing, use of diverse data sets, scenario testing, and live performance versus back tests.

Operational due diligence dives into specific risks for both traditional hedge funds and crypto, including wallet whitelisting protocols, service providers and risk controls, individual background checks (varying by regulatory jurisdiction), pricing, boards, key person risk, profitability, documentation, and side pocket rules.

While the due diligence process can be unpleasant for managers due to its invasive nature, it enables us to swiftly identify red flags from multiple perspectives and adapt to emerging risks. A manager’s behaviour during this process is also a valuable data point; those with something to hide may become difficult or react emotionally to persistent questioning.

If the right risk controls are put in place, fund selectors can navigate the digital frontier effectively – unlocking new alpha sources and capitalising on the broader acceptance and maturation of digital assets. 

Syz Capital aims to provide the gold standard for investor protections when investing in this space, much as we have done for nearly thirty years in traditional hedge funds.

Our preference tends to be for managers that understand what it means to be ‘fit and proper’, i.e., to have been regulated in a financial firm previously, and even better if that financial firm is a world leading Hedge Fund like a Citadel, Millennium or DE Shaw.

Glory days return

We believe that the crypto asset class today offers alpha opportunities akin to those harnessed by traditional hedge funds in the 70s, 80s, and 90s.

The options markets are nascent with wide spreads and tens of thousands of assets. There are hundreds of futures for top assets listed across numerous centralised and decentralised exchanges. Retail investors are willing to pay high premiums for leverage when markets show signs of upside volatility. This environment creates a literal feeding frenzy for alpha.

A strong manager can produce substantial and consistent returns. Indeed, current annual returns in crypto hedge funds range from around 10-12% in a bear market to well north of 30% in a raging bull market. 

While we don’t predict market movements, the crypto markets are currently experiencing a significant cleanse, likely paving the way for the next phase of the bull market. Factors contributing to this include post-halving miner capitulation, the return of billions of dollars in Bitcoin locked in a bankruptcy process for over a decade, and the German government selling coins confiscated from a piracy website.

However, this is temporary and will likely soon be eclipsed by the increasing adoption by corporates and the growth of ETF offerings. Listed companies like Semler Scientific (SMLR) and Japan’s Metaplanet have recently adopted the MicroStrategy playbook, making bitcoin their treasury reserve asset.

Some of the largest brokers in the US have just added new bitcoin ETFs to their offerings, and a top ten US pension provider has included bitcoin ETFs in their portfolio, with others expected to follow. Additionally, several upcoming elections worldwide, including in the United States, may be influenced by the respective parties’ bitcoin strategies. The next wave of adoption is beginning to resemble a rising tsunami.

Our portfolio is positioned to participate in the upside and protect against the downside. Our globally dispersed team continues to search out best-in-class managers the world over in this rich new asset class. Plenty of alpha lies in store for this emerging asset class and its rising stars as we begin this new Golden Age.

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