In the short period from 2014 through 2019, hedge fund management and strategy has varied significantly in response to market forces. Following the significant surge of cryptocurrency funds in 2017 and 2018, there has been a noticeable trend toward increased sophistication of participating fund managers and investors.
Digital asset hedge fund managers use a broad range of fundamental and quantitative strategies, which can be roughly divided into the following categories: index and token-specific funds, long-only funds, algorithmic quant funds, and node funds. Moreover, in addition to investing directly in crypto-asset tokens, funds can invest indirectly, using options and futures, as well as through income-generating assets inherent in the underlying technology. Hedge funds can also invest in liquid securities issued by public companies that hold crypto assets, but for the most part, equity investment is limited to venture capital and private equity funds, given the illiquid nature of most crypto-asset companies.
- Index/Token Specific
Early digital asset funds focused on holding long positions in pre-defined tokens in the largest capitalized crypto assets, including Bitcoin, Ethereum, Litecoin, and Ripple. At the time, these tokens were experiencing unprecedented price appreciation. However, this rapid price appreciation came to an abrupt end in late 2017 and early 2018. At the time, setting up accounts and purchasing direct tokens required a fair amount of technological expertise. With the emergence of hundreds of additional coin offerings, index funds have given way to more flexible strategies that allow funds to invest in new tokens experiencing rapid growth.
- Long-Only Funds
The next wave of cryptocurrency funds focused on modeling strategies that exploit various token investment opportunities on a long-only basis, with limited participation, usually via side-pocket instruments in high-risk initial coin offerings, with the bulk of investments focused on the largest capitalized tokens. During this period of unwarranted optimism, practitioners had to be especially careful in taking on cryptocurrency fund manager clients because many prospective fund participants included managers that, while highly versed in the emerging technology, lacked significant finance and fund management expertise.
- Algorithmic/Quantitative Funds
Following the tremendous losses in 2018 and resulting volatility, algorithmically driven quantitative strategies have risen sharply. Quant traders often employ a greater focus on smaller capitalized tokens and use various publicly available indicators to exploit pricing inefficiencies. Given the relative inexperience of crypto asset traders, as compared with traders in established markets, many algorithmic traders achieved substantial gains using strategies that would not have been possible in an established marketplace. The current low levels of competition should not be expected to hold steady in the long-term, as additional sophisticated players enter the marketplace, and asset information becomes more widely disseminated.
- Node Funds
Most centralized and decentralized distributed ledgers rely on node maintenance for the verification of various transactions. Unlike decentralized crypto tokens, which depend solely on gratuitous decentralized user participation for transaction verification on the distributed ledger, centralized crypto token issuers rely, to some extent, on incentivizing non-employee operators for certain transaction and maintenance functions. This primarily takes the form of bounties, which are sums paid to users who complete specific tasks, and compensation for certain node activity, such as compensation to “masternode operators.”
Nodes form the basic transaction verification function that allows a distributed ledger, including a blockchain ledger, to function. On various networks, there are both static nodes, which hold partial transaction data, and masternodes, which hold and verify comprehensive transaction data. Masternodes provide various services to distributed ledger network, typically comprising a digital wallet that keeps a complete copy of the ledger in real time. Node operators are compensated for their data verification and are usually required to hold a threshold number of coins as collateral security.
Unlike bounties, which are payments made for specific services, masternodes can produce passive income with proper investment and, when properly scaled, can form the basis of a cryptocurrency fund trading strategy.
- Increased Investor Sophistication
Due to the substantial market, regulatory, and technological inherent to investment in the developing sector, digital asset fund investors form an especially risk-tolerant and technologically literate investor base. We have seen a pattern of increased sophistication among investors and managers alike, requiring today’s crypto asset fund managers to carefully develop highly refined fund strategies with skilled and sophisticated management teams.
For additional information on hedge fund investment strategies, please see our blog post, “Common Hedge Fund Strategies.”