How Cryptocurrency Funds Work

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Cryptocurrency funds are a new type of investment vehicle that parallels traditional portfolio investments, like hedge funds, but are composed entirely out of digital assets. Because of this, they play by slightly different rules than their legacy counterparts. Knowing how they differ and where to get involved is key for those who want to jump into this intriguing new world, so we’ve outlined the main points in this helpful guide.

What are cryptocurrency funds?

The term “cryptocurrency fund” refers to a portfolio containing a variety of different digital assets and is usually managed by one or a few individuals. Investors are then able to buy into these funds so that they can share in the profits as the value of the fund grows. According to data from Crypto Fund Research, a little over half of these act as venture capital funds, while the rest are predominantly hedge funds. 

Venture capital funds involve a variety of investors pooling their money in order to buy into smaller businesses with high growth potential. Of course, in cryptocurrency funds these businesses are new projects and altcoins. Once the asset or assets have grown by a sufficient amount, they are usually sold off and investors take a cut of the profits. 

Hedge funds act as portfolios that are actively managed and work to minimize risk in the market, hence the name “hedge.” These can be made up of any assets, but different assets are typically used in both long and short strategies, diversifying the portfolio in order to make the fund resistant to, or even profitable during, high volatility. Again, these funds are usually managed by small teams and are often only available to high-end investors, with minimum investments ranging in the tens to hundreds of thousands of dollars. 

Traditional hedge funds also usually have minimum time constraints attached to them, so investors would be committed to keeping their money in the fund for at least one year, for example. They also tend to have fairly high fees, around 20% of profit, as incentive for the managers to provide solid performance. On that note, this entails putting trust into the team managing the strategies, and there is no guarantee that the fund will ultimately see a return. If poorly managed, the market volatility that these funds are supposed to protect against can also quickly wipe them out. This was seen in March with the sharp drop that came amid the coronavirus market panic. Some cryptocurrency funds weren’t prepared for such a sudden drop, and collapsed as a result.

Common strategies used by cryptocurrency fund managers

At this point, we should explore the strategies that fund managers use to grow their investments. One common tactic often invoked is called “long/short equity.” In this scenario, fund managers look at the assets they believe are undervalued and overvalued, and then place long and short positions accordingly. If their analysis is correct, then their portfolio should see gains whether the market is rising or falling. 

A similar strategy is known as “market neutral.” Here, the goal is for the long and short positions to balance out, so that the market exposure nets to zero. Therefore, a manager may take a 50% long and 50% short in the same industry or asset in the hopes of reducing risk from volatility. It should be noted that reduction of risk generally means lower returns as well, which is an acceptable trade-off for some.

Another common strategy used is arbitrage. There are many types of arbitrage, but the general idea is to buy assets on one exchange and then sell them on another that is offering a better price. This is common in traditional hedge funds, but the cryptocurrency market often offers more lucrative opportunities due to its young and volatile nature. It is common for different platforms to offer slightly different prices on various assets, and if the move can be made fast enough, then making a profit can be relatively easy. That being said, speed is key, making this strategy a common favorite among high-frequency traders.

There are other strategies as well, such as “global macro,” which looks to take positions based upon larger trends within a market, and “short only,” which basically focuses on explicitly shorting assets that the managers feel are overvalued. Lastly, there is “quantitative,” which focuses solely on models, data and research to craft the portfolio. Realistically, it is not uncommon for multiple different strategies to be used, but it is essential that the fund managers understand what they are doing in implementing whichever one and are transparent about it with investors.

A variety of different ways to invest

This is generally the largest risk involved with investing in a cryptocurrency fund: clients need to put their trust into those behind it, which is why it is important to do research. The more information the managers are willing to share about who they are, how they are managing and what their track record is can help determine if they are right for an investor. That’s why, for many, partnering with a reputable firm is an essential part of the trust that they will see a return on their investment. Some of the biggest names in cryptocurrency funds include the Digital Currency Group, Galaxy Digital and Pantera Capital, among many others. All focus specifically on cryptocurrencies and other digital assets.

Of course, these will still generally require large, upfront investments from qualified individuals. However, retail investors who want to be in on this type of action might want to look at projects like Tokenbox. In addition to acting as a general wallet and exchange, Tokenbox allows users to “tokenize” their portfolios as well as invest in the tokens attached to the portfolios of others. This acts as a streamlined way to either begin a new cryptocurrency fund or get involved in an existing one. The tokens that are tied to winning portfolios can themselves be bought and sold, and their value is tied explicitly to the performance of their fund. Managers can then showcase their success to try and attract more backers. All of this is possible without the need for a massive initial investment, but rather acts more like purchasing any single cryptocurrency on an exchange.

What can this market look forward to?

The cryptocurrency fund outlook is fairly bright these days. According to a report by PricewaterhouseCoopers and Elwood Asset Management Services Ltd., the overall value of Assets Under Management in these funds grew from $1 billion in 2018 to an impressive $2 billion in 2019 — doubling the market’s size in a single year. On top of that, the median return on these investments in 2019 was 30%, down a little from 2018 but still far above most traditional hedge funds. This is, of course, due to the room for upside that is available in the market. Though a wide variety of cryptocurrencies can be found in various offerings, the study found that 97% offered Bitcoin (BTC), followed by Ether at 67% (ETH) and others such as XRP (XRP), Bitcoin Cash (BCH) and Litecoin (LTC), all being offered by about a third of the funds available. 

This all points to a market that is really only beginning to be explored. As cryptocurrency grows into mass adoption, it is only logical to assume that the number and value of these investment vehicles will continue to rise. Risks will always be present, which is why investors must always do their homework, but the untapped potential of digital assets looks promising. If more retail investors can be brought into this realm as well, then the story of cryptocurrency funds may be just beginning.

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