Managing downside volatility crucial for growth of crypto-focused hedge funds – Coinbase

August 8, 2024 (Preqin News) – Managing downside volatility is one of the most important factors in generating alpha for active cryptocurrency-focused hedge fund managers, according to a new report by Coinbase.

The crypto asset class is worth around $2.5tn, or about 2% of global liquid assets of $150tn. The cryptocurrency exchange platform’s Allocator’s Guide to Digital Asset Hedge Funds says about 300 dedicated crypto funds are open to institutional capital. Active managers include Brevan Howard, Man Group, and Millennium Management. The guide cites Preqin data that shows there an additional 400 traditional hedge funds with crypto exposure, mostly in Bitcoin only.

The report finds that the severity of drawdowns in cryptocurrency markets is greater than in other hedge fund categories. Active dedicated management strategies – including market neutral, multi-strategy, and quantitative active – have the lowest volatility and have tended to outperform the largest cryptocurrency, Bitcoin, in the longer term.

‘Volatility is a big distraction and exposes allocators to unwanted attention,’ Jeff Park, Portfolio Manager and Head of Alpha Strategies at Bitwise Asset Management, told Preqin News. ‘But I always make the point that volatility itself can be a feature that generates something worthwhile for investors. It's a little scary at first, but if you can harness it, volatility itself is a source of yield that can be monetized.’

‘When institutional investors say they're scared of volatility, they actually mean they're scared of downside volatility and drawdowns. We try to mitigate those concerns by bringing a multi-strategy approach to the marketplace.’

Increased transparency in the crypto market is highlighting the increased involvement of institutions. ‘While cryptocurrencies have been a part of many hedge fund strategies, the market became more transparent in the second quarter as 13F filings revealed that numerous funds had built up positions in newly approved spot-Bitcoin ETFs,’ Charles McGrath, AVP in Preqin’s Research Insights team, wrote in Hedged: Public markets power hedge funds in May.

The filings showed that established managers such as Millennium Management and Schonfeld Strategic Advisors had significant positions in BlackRock’s iShares Bitcoin Trust ETF and Grayscale’s Bitcoin Trust ETF.

The Preqin Crypto Currency Hedge Fund Index, a custom benchmark built in Preqin Pro, showed an annualized return of 80.0% from 2017 to the end of 2023, but with an extremely high-risk annualized risk score of 65.1%. This is a higher return than spot Bitcoin (71.6%) with a lower risk score (82.2%), but very different to more conventional indices, such as the Preqin All Hedge Funds Index (8.7% return, 8.0% risk) or the S&P 500 Index (13.4% return, 16.8% risk).

‘The benefits to portfolio construction are clear: adding even a small amount of bitcoin over a three-to-five-year period has meaningfully boosted returns, improved liquidity, and added diversification, with minimal impact to total portfolio risk or volatility,' the Coinbase report states.

It suggests that the crypto-focused hedge funds have strong portfolio diversification benefits. The two cryptocurrencies with the largest market cap, Bitcoin ($1.3tn) and Ethereum ($398.3bn), have low or negative one-year correlations to traditional public markets and commodities, including short- and long-term bonds, gold, copper, and the US dollar.

‘Crypto gives you one more chance to push out the efficient frontier because it's orthogonal in the constitution of its return profile to anything else that's available in the market,’ said Park. ‘So, your politics or personal view on crypto might become somewhat irrelevant when you recognize that the asset class is empirically additive to your investing effort.’

In May 2023, the EU’s European Securities and Markets Authority (ESMA) announced the Markets in Crypto-Assets Regulation (MiCA), covering unregulated crypto-assets, with key provisions including transparency, disclosure, authorization, and the supervision of transactions relating to the issuing and trading crypto-assets.

‘The new legal framework will support market integrity and financial stability by regulating public offers of crypto-assets and by ensuring consumers are better informed about their associated risks’, EMSA said.

Last November, the International Organization of Securities Commissions, an association of national financial regulators, made 18 recommendations for global rules managing crypto and digital assets, covering conflicts of interest, market manipulation, cross-border risks, custody and client asset protection, operational and technological risk, and retail access.

Preqin’s McGrath says that institutions remain wary, with thefts and frauds, including the collapse of FTX, still fresh in their minds: ‘Despite this promising data and growing regulatory acceptance of Bitcoin, institutional allocation, while increasing, is still in an early phase and remains a small fraction of the $1.4tn Bitcoin market.’

Want to know more? Preqin’s Charles McGrath, Anthony Bassili from Coinbase, and Jeff Park from Bitwise Asset Management shared insights to help allocators evaluate digital asset hedge funds and understand how successful managers generate alpha on the Allocator’s Guide to Digital Asset Hedge Funds webinar, available to watch now.

_{The opinions and facts included within the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin providing the information in this content accepts no liability for any decisions taken in relation to the above.}