Prior to 2017, there were only a handful of specialized funds that invest in bitcoin and other cryptocurrencies. Since the start of 2017, however, digital asset hedge funds have started to spring up like mushrooms with the aim to capitalize on skyrocketing crypto asset values.
According to Autonomous Next Research, there are currently 251 hedge funds that invest in digital assets with an estimated $3.5 billion of assets under management. Out of the 251 funds, over 200 were launched since the beginning of 2017 when cryptocurrencies finally made it into the mainstream as a new digital investment asset class.
What Are Digital Asset Hedge Funds?
Hedge funds are private companies that aim to generate absolute returns for their investors. Unlike mutual funds, which are traditionally benchmarked against an index that they aim to outperform, hedge funds target the highest possible absolute returns each year. Hence, it is unsurprising that hedge fund managers are increasingly venturing into digital assets as bond yields are excruciatingly low and equity markets are in no way able to compete with crypto in terms of average annual returns.
Despite the lackluster start of the year 2018 for cryptocurrency investors, there seems to be nothing stopping the growth of the digital asset hedge fund space and their fundraising activities.
Autonomous NEXT partner Lex Sokolin said: “While the softer prices of crypto assets do create a more difficult environment for investors, I do not think it will pause the influx of funds and other financial institutions building products in the space. It would take the extreme case of the entire space contracting by 80 percent and high regulation before the flow of funds turns around.”
Crypto Hedge Fund Trading Strategies
While all crypto asset hedge funds aim to benefit from the booking crypto asset space, different funds apply different strategies to generate returns for their investors.
According to Thompson Reuters, some digital asset hedge funds invest exclusively in bitcoin, taking both long and short positions while others contract balanced portfolios of promising digital assets. There are also hedge funds that look to exploit arbitrage opportunities between digital currency exchanges while leverage artificial intelligence and bot trading to generate alpha. A small number of funds invest primarily in initial coin offerings and some use a passive index-tracking approach similar to stock ETFs.
The different types of hedge fund trading approaches in the crypto asset market are as diverse as the asset class itself.
What Will More Hedge Fund Activity Mean for Crypto Assets?
An increase in hedge funds in the cryptographic asset market will most likely lead to a jump in trading activity among the leading crypto assets, a surge in algorithmic trading, more leverage in the markets, and an increase in volatility.
Aside from the passively-managed index funds, most hedge fund managers like to trade. That means they want to enter and exit positions much more frequently than, for example, mutual fund or pension fund managers. This will likely lead to an increase in trading activity in the most liquidity crypto assets as hedge funds will be required to focus on the digital asset with the highest liquidity and trading volumes so that they can enter and exit large positions without pushing the market against themselves.
Furthermore, there will likely be an increase in algorithmic and bot trading activity as computerized trading is another favorite of hedge fund managers. The result of this can potentially be two-fold. Firstly, the potential for flash crashes increases if several bots have similar stop-loss limits, which can exasperate price drops as automatic sell orders are triggered. Secondly, there could be an increase in daily trading volumes as algorithmic trading bots enter and exit hundreds of positions daily to capitalize on small price changes.
An increase in the use of leverage — if regulators don’t crash the party — is another likely outcome of increased hedge fund trading in crypto assets. In financial investing, leverage refers to the borrowing of funds to take larger positions than an investor is able to with their own money down. Since cryptocurrency exchanges offer leverage up to 20x, professional investors use this type of trading to increase their returns. Having said that, when the market moves against a leveraged trade, losses also increase. The result of increased leverage can also mean an increase in volatility.
In fact, all of the above-mentioned effects of more hedge funds entering the digital asset space point to a surge in volatility. Increased trading activity, more automated bot trading and an increase in leverage will likely also lead to an increase in market volatility. After all, hedge funds are known for their aggressive trading approaches and sometimes less-than-gentlemen-like market behavior.
The massive jump in the number of digital asset hedge funds in the past twelve months is a testament to how fast the cryptographic asset market is maturing into a viable asset class that even institutional investors, such as hedge funds, are comfortable investing in. After bitcoin went mainstream as an investment asset in 2017 after BTC futures were listed on both the CME and CBOE, it is no longer considered “crazy” to invest in digital assets that are to some extent only strings of code on a computer. Instead, high-net-worth individuals, fund managers, and even some investment banks are now pondering whether they should purchase bitcoin, ether, or ripple next.