Josh Gnaizda is the founder of Crypto Fund Research. The opinions expressed here are the author’s own. The
following article originally appeared in Institutional Crypto by
CoinDesk, a free weekly newsletter for institutional investors focused
on crypto assets. You can sign up here.
It’s one of the worst-kept secrets in the alternative investment
industry: net of fees, hedge funds struggle to outperform broad equity
markets.
In 2007, before bitcoin was even a glimmer in Satoshi Nakamoto’s eye,
Warren Buffet famously bet a prominent fund of hedge fund manager $1
million that over the subsequent decade, an S&P 500 index fund would
outperform any basket of hedge funds he could put together. Buffet won
handily.
It’s not that Buffet didn’t think there were capable investment
managers out there; Buffet’s Berkshire Hathaway has often been described
as a giant hedge fund. Instead, his confidence relied on his intuition
that between fees and trading costs, even the best hedge fund managers
would struggle to beat a low-cost index fund.
We might logically assume that crypto hedge funds, which generally
have a 2 and 20 fee structure similar to that of their traditional
counterparts, would suffer a similar fate.
But since the beginning of 2017, when reliable data became available,
the result has been quite the opposite. An equal-weighted index of
crypto funds significantly outperformed bitcoin and most other crypto
assets.
The CFR Crypto Fund Index tracks more than 40 crypto funds, mostly
hedge funds, across a variety of strategies. It shows that even as
bitcoin climbed about 1,000 percent between January 2017 and June 2019,
crypto funds gained more than 1,400 percent.
The outsized performance of crypto funds over this period might puzzle the Oracle of Omaha, a man who once described
bitcoin as “rat poison squared.” Even without Buffet’s bias against
crypto or hedge funds, there are a few reasons one might be surprised:
- Performance fees are by nature punitive to returns during bullish periods
- Creating a portfolio that can outperform skyrocketing single assets is no small feat
- Crypto fund managers tend to be less experienced than their traditional counterparts
Despite these apparent headwinds, crypto funds did outperform. So let’s examine these perceptions a bit more.
Performance fees are too punitive in bull markets
Few investment assets have ever experienced a 12-month bull run like that of crypto assets in 2017.
That’s fantastic for fund managers taking home 20 percent of profits,
but certainly eats away at returns. Several crypto funds returned more
than 1,000 percent in 2017 – meaning by year-end a fund manager could
have taken home more in fees than the fund had assets to start the year.
Still, most crypto funds have a 2 and 20 fee structure similar to
traditional hedge funds and many have high water marks (essentially to
ensure managers don’t get paid for performance when a fund is below
all-time high).
So while crypto fund performance fees have been staggering in
absolute terms, the fee structure is no more of a hindrance to crypto
funds than to traditional hedge funds.
Diversified portfolios struggle to keep up with single assets
It’s hard to imagine any asset overshadowing bitcoin’s 12x
performance in 2017. But that’s exactly what happened. Some other coins
were up 100x or more. The Bitwise CCI 30 Index, which measures the
performance of the top 30 cryptocurrencies by market cap, was up 42x.
So how exactly did crypto funds outperform during 2017? They didn’t. Not even close.
Crypto funds collectively returned a relatively underwhelming 1,000
percent. Sure, these funds returned more in 2017 than traditional hedge
funds have in the past 20 years. But everything is relative. And
relative to top cryptocurrencies, crypto funds had a disappointing year.
The story of crypto funds’ outperformance truly began when crypto
winter cast a chill over the entire industry in 2018. Philanthropist and
investor Shelby Cullom Davis said: “You make most of your money in a
bear market, you just don’t realize it at the time.”
It was one heck of a bear market.
In 2018, bitcoin lost nearly 75 percent of its value. The CCI 30
Index lost 85 percent. The CFR Crypto Fund Index, however, was down
“only” 33 percent. Or put another way, while crypto funds preserved 4/6
of their value, the CCI 30 maintained less than 1/6 of its value. As the
chart above shows, this ability to preserve capital during 2018
propelled the crypto fund index ahead of bitcoin and other
cryptocurrencies.
From Q1 2017 through Q2 2019, the CFR Crypto Fund Index has returned
1,430 percent. This easily bests bitcoin’s 1,022 percent return and
narrowly surpasses the 1,413 percent of the CCI 30.
Crypto funds lack experience
After overcoming their fee structures and whipsawing crypto markets,
crypto fund managers had a final hurdle to overcome: inexperience. It’s
difficult to directly compare the total financial experience of managers
across disciplines. However, we can look at the average age of funds.
A recent study
published by Loyola Marymount University (LMU) found the median age of
traditional hedge funds was 52 months. This is a lifetime in the crypto
world. No crypto funds in the CFR index have been operational for 52
months and the median age is just 16 months.
This inexperience should hurt crypto fund returns, right? Not
necessarily. Somewhat counterintuitively, the same LMU study found
traditional hedge fund returns decrease with age. And not by a
negligible margin. Hedge fund returns in year one were more than triple
those in year five. After year five, the study found, “some funds become
liquidated and the pattern is somewhat mixed.”
So inexperience, which would seem to be a significant headwind for
crypto fund managers, may actually have been a tailwind propelling their
performance past ahead of bitcoin and other benchmarks.
Reasons for caution
That crypto funds have outperformed various benchmarks is
encouraging. But there’s also plenty of reason for institutions to
remain cautious.
The index covers barely one market cycle. Buffet’s index fund didn’t
take the lead over hedge funds until year four of the ten-year bet.
The index has less than 50 constituent funds. While the largest in
the industry, it’s quite small compared to traditional hedge fund
performance indices which can include thousands of funds.
There are potential biases. Since reporting is voluntary, and the
index includes less than 20 percent of eligible funds, we can reasonably
assume that poorly performing funds are less likely to report. Funds
with particularly poor performance might have already closed, creating a
potential survivorship bias. Though not unique to crypto fund indices,
these biases shouldn’t be overlooked by investors.
Most crypto funds are quite small by traditional standards and it’s
quite possible some strategies that perform well in illiquid markets
will not support the same type of returns with more capital invested.
Bridgewater Associates, the world’s largest hedge fund manages over $100
billion. Crypto funds manage less than $20 billion collectively.
Despite the potential issues, it’s encouraging that crypto hedge
funds seem to have done more or less what they are supposed to, namely
preserve capital in bear markets. And with the majority of crypto funds
in the index now employing outside auditors, custodians and fund
administrators, the industry is becoming less haphazard.
The crypto fund industry is still very much in a maturation phase,
but with proper due diligence, crypto funds may present institutions,
particularly those unwilling or unable to directly custody cryptoassets,
an appealing way to get exposure to the sector.
Some decentralized architecture is said to have an “Oracle Problem”,
but at least so far, crypto funds don’t seem to have an Oracle of Omaha
problem.
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