Every epic tale needs a tragic hero, and one of the top candidates for that role in this century’s dramatic passage so far has to be the hedge fund manager. Toppled from their masters-of-the-universe pedestal in the early 2000s, they now eke out meager gains, dodge investor recriminations about fees and occasionally attempt to stay relevant by explaining to the rest of us where the current confusion is taking the global economy. True, there are some formidable brains and admirable initiatives among the former kings of finance. But so far, after a promising legacy and the occasional shining moment, this has not been their decade.
This week Eurekahedge, which monitors industry health through a series of hedge fund indexes, reported average performance for July of 2.6%, and a year-to-date return of 1.7%. This significantly underperformed the S&P 500 (+4.7% for the month), Nasdaq Composite (+5.3%), gold (+10.3%), bonds (the long bond TLT index is up 4.4%) and, of course, bitcoin (+22%). The underperformance year-to-date follows a similar pattern.
But here’s an interesting twist: The Eurekahedge Crypto-Currency Hedge Fund Index was up 21% in July, and 50% over the first seven months of 2020. That’s a nice performance. But aren’t hedge funds supposed to outperform the industry benchmark? The YTD performance of bitcoin to the end of July is 55% – in other words, the leading cryptocurrency by market cap outperformed crypto-focused hedge funds by five basis points, or 10%.
You’re reading Crypto Long & Short, a newsletter that looks closely at the forces driving cryptocurrency markets. it goes out every Sunday and offers a recap of the week – with insights and analysis – from a professional investor’s point of view. You can subscribe here. In hedge fund terms, that’s significant, not least because one of the main points of hedge funds is to take extra risk, get extra return and make benchmarks look boring.
So, is the story here the outperformance of crypto hedge funds compared to their traditional brethren? Or is it the underperformance of crypto hedge funds compared to the industry’s benchmark? I think it’s the former, that crypto funds are outperforming non-crypto funds, a trend that is likely to continue given evolving market developments and sentiment.
The relative underperformance to bitcoin (and even more so to other crypto assets such as ether) does not dim the prospects for crypto hedge funds going forward. Investing in a crypto hedge fund instead of directly in the market is going to be a more attractive option for many investors even if the returns are slightly lower, because using a vehicle run by seasoned management is probably safer than direct market participation. Investors don’t have to worry about custody, best execution and liquidity crunches. And some recent developments point to more favorable tailwinds for crypto hedge funds as the year progresses.
First, we have growing awareness of crypto as an asset group. Mentions of bitcoin in the press got a bump with the halving in May, and have remained high since, as this chart from The TIE shows:
This exposure is likely to intensify over the coming weeks as inflation concerns spread. This week, listed business intelligence firm MicroStrategy chose to invest half of its $500 million of excess treasury in bitcoin, as an inflation hedge. Also, this past week Grayscale Investments* launched a TV ad that positions cryptocurrency as a natural evolution of money, and investment house Galaxy Digital took out a full page ad featuring bitcoin in big letters in the Financial Times. For an audience growing increasingly uneasy about monetary policy, price pressures and market fundamentals, these are hard to miss.
Second, volatility is back. In the case of bitcoin, volatility was until recently trending sharply down from “typical” levels. While still lower than its 2019 average, the metric has turned upward again. This may deter some investors, but hedge funds typically seek out volatility. Its return could entice more mainstream hedge funds to set up a crypto arm. According to a report in the Financial Times this week, some “blue-chip” names are looking to do just that. What’s more, until recently, correlations among crypto assets were relatively high. By betting on bitcoin, you could with one investment pretty much count on a large part of the market’s performance. Over the past few weeks, however, correlations have fallen, and given the growing attention on individual projects emerging in decentralized finance and other applications, this trend is likely to continue.
support for professional crypto investing is also an encouraging factor. Institutional-grade prime brokerage services for crypto investors are still in their infancy, but some big names with sizeable balance sheets and professional street cred have entered the space. And some finance giants such as Goldman Sachs and Fidelity seem to be carefully moving towards offering similar services. When names that hedge funds are already familiar with start to offer support for crypto investments, we are likely to see even more traditional hedge funds try the crypto market on for size.
Furthermore, July’s OCC statement that banks can now custody crypto assets is another strong step forward in getting hedge funds comfortable with the asset class. Public comments submitted by industry participants, including banks, think tanks and crypto companies, indicate an interest but also a need for further clarification. As this clarification emerges over the coming months and years, we are likely to see first a trickle and then a flood of traditional financial institutions eager to cater to those hedge fund clients that are becoming active in crypto markets. And in a virtuous circle, any type of service that reduces settlement and trading friction is likely to boost hedge fund interest.
Are these trends enough to restore the hedge fund manager to his or her former glory? Will crypto hedge fund managers become the new kings of the market? It’s unlikely, at least not in the same money-to-burn way. With markets undergoing a profound transformation in their underlying philosophy and with fundamentals no longer a driving force in valuations, beating the market no longer has the same intellectual cachet that it had in previous decades. Yet there is still cachet in spotting winning trends before the mainstream, and in being insightful and brave enough to back nascent technologies. The redeemed hero of the 21st century may end up being a hedge fund manager after all – only the heroics will not just be based on wealth. They will be based on the courage to see beyond the typical manager’s toolbox, to acknowledge one’s own limitations when it comes to understanding finance, and to understand that change can be harnessed for good.