Is There Any “Hedge” In Your Cryptocurrency Hedge Fund?

There is a rush of hedge funds entering the Cryptocurrency space. According to Reuters, more than 100 crypto hedge funds are now in existence, with most created within the last several months.  And undoubtedly more are on the way.

But anyone researching the new crypto hedge funds is likely to be reminded of the old Wall Street sarcasm that “Hedge funds are a compensation scheme masquerading as an asset class.”

Like most hedge funds, the new cryptocurrency funds charge a management fee (typically 2% of assets under management ) in addition to an incentive fee, sometimes called a performance fee. Most crypto hedge funds are charging “standard” 2 and 20 management and incentive fees, but some are charging 30% or more if performance is especially good.

Such fees may seem steep, but for many high-net-worth investors, placing money with an astute hedge fund manager who will profitably navigate the “Wild West” of crypto markets may be a smart move. A crypto hedge fund could be well worth the incentive fees.

But here’s the thing -- you probably want to place money with a TRUE hedge fund, not a “compensation scheme masquerading as a hedge fund”.

What’s a TRUE hedge fund, you ask?

To answer that question, we go back to 1949 and one A.W. Jones, who started the first hedge fund. Jones had a background as a sociologist and writer, and in the course of researching an article for Fortune in 1948, he came up with a novel idea for a managed fund.

At the time, managed funds investing in stocks and bonds were long-only, and charged a simple management fee -- typically one or so percent of assets annually. But Jones created the concept of what he called “a hedged fund.” Here were its unique elements:

The hedge fund manager is compensated by an incentive fee.

Jones chose to take 20% of profits as compensation. He reportedly based this structure on the ancient Phoenician sea captains who kept a fifth of the profits from successful voyages.  With an incentive fee, Jones’s portfolio managers hustled harder than rivals at traditional money-management firms.

At the same time, his managers knew that if they made poor investment decisions -- if they lost their clients’ money -- they didn’t get paid. The fund and its clients’ interests were aligned.

A hedge fund is structured as a limited partnership.

By limiting his fund to less than 100 limited partners, Jones avoided having to register as a mutual fund under the Investment Company Act of 1940. Jones consciously avoided regulation. He was an anti-Nazi agent in WWII and keeping a low profile had served him well. Likewise, as a hedge-fund manager, Jones escaped the attention of regulators by never advertising his fund, and raising capital mostly by word of mouth. To this day, many hedge fund managers keep a very low profile.

A hedge fund seeks to lessen or hedge market risk. 

Jones knew stocks had an upward bias, but he also realized bear markets were inevitable and unpredictable. His hedged fund was designed to generate positive returns irrespective of general market direction. Unlike his long-only competitors, Jones’ hedge fund’s business model -- and his client’s wealth -- wasn’t solely dependent on the market going up.

Jones’ fund employed short selling. While he went long promising stocks, his fund simultaneously “sold short” stocks he deemed more likely to fall in price. This was the “hedged” part of his concept. Jones, and other hedge funds after him, later expanded on the kind of strategies that mitigate directional market risk, and help hedge funds generate “all-weather” profits.

Also, because the fund “hedged out” market risk, Jones felt free to embrace more investment-specific risk, and so he “leveraged” his bets with borrowed money. Between 1949 and 1968, Jones’s partnership earned a cumulative return of nearly 5,000%.

So back to the explosion of cryptocurrency hedge funds. Unquestionably, many investors have achieved stunning gains buying bitcoin and other cryptocurrencies. Returns north of 1000% in just the last year are claimed. Some of these ultra-successful investors have chosen to start hedge funds.

However, many (not all) of the crypto investors-turned-hedge fund-managers owe their success solely to a long only, buy and hold approach. No crypto manager has had to navigate a down crypto cycle. That’s because the oldest of the crypto hedge funds is barely two years old, and cryptocurrencies have basically gone straight up over that time.

Investing lexicon is full of trite sayings, and here’s an oldie: Don’t confuse brains with a bull market. Fact is, the wind has been at the back of long-only cryptocurrency investors for going on two years. Actually it's been more like a steady gale... How much of the “skill” of these new hedge fund managers can be attributed to the upward surge of cryptocurrency prices and the maniacal interest in ICOs? Hard to say.

Investing lexicon is full of trite sayings, and here’s an oldie: Don’t confuse brains with a bull market.

Meanwhile, many Crypto managers are counting on Bitcoin going to $20,000 and the ICO market staying hot. But the nascent, inefficient cryptocurrency markets offer many opportunities for the hedged, all-weather strategies employed by A.W. Jones in the first hedge fund. Some crypto hedge funds are generating stellar risk-adjusted returns without betting the ranch on a soaring crypto market.

One might view the cryptocurrency phenomena as comprised of two elements: There’s the underlying block chain technology -- a decentralized public ledger that contains a shared memory showing all the transactions of a cryptocurrency. This is a revolutionary technological development likely to gain increasing use – and make many people rich -- as its application accelerates in the years ahead.

However, there’s also the market aspect of cryptocurrency. Digital assets trade publicly, meaning they are subject to bipolar extremes of greed and fear like all markets. Boom and bust, bubbles and crashes. While cryptocurrency may be revolutionary, there is nothing new about how human behavior affects markets. As John Maynard Keynes pointed out, markets are driven by “animal spirits.”

Part two of this dichotomy is why the skills of a talented money manager who’s strategies include capital preservation may make all the difference.

If you think that the recent past in the cryptocurrency markets will be repeated in the future, and bitcoin, etc. is going into the stratosphere without looking back, then you don’t need to invest with an actively managed hedge fund. You can simply buy and hold assorted cryptocurrencies. Or maybe invest passively in one of the many crypto index funds sprouting up.

However, if you believe there is big money to be made in digital assets in the years ahead, but along the way there will be extreme volatility,  elevated risk, investment-specific winners and losers, ongoing regulatory uncertainty, and brutal bear markets,  then by all means invest with an experienced, risk-savvy hedge fund manager. The fees will be well worth it.

If you’re considering placing capital with a cryptocurrency hedge fund,  you’d be well served to choose a manager with a strategy for up and down markets -- a true “hedged” fund.

Mark Gaffney