The traditional financial market's hedge funds are struggling. According to Hedge Fund Research (HFR), annual returns for hedge funds have declined from a peak of 18.3% in the 1990s to just 3%. In the first seven months of 2019 alone, $56 billion was withdrawn from these funds, marking the fastest outflow rate since 2016. Increased competition and evolving trading environments have made it harder for hedge funds to deliver on their promises. This mounting pressure has led to changes in fee structures, including reduced management fees and, in some cases, a heightened focus on performance-based incentives.
Despite this being their worst year since 2011, hedge funds managed to outperform the S&P 500 for the first time since 2008. While this victory may be short-lived, it reinforces the belief that hedge funds can thrive in volatile conditions. Data from Investment Cache indicates that the S&P 500 has only consistently outperformed active funds during bull markets and in the years following 2009. During market crises since 1990, the S&P 500 has suffered significantly greater losses than active strategies. This has led many hedge funds to reposition themselves: their primary role is no longer just to ensure high returns, but to minimize losses during periods of volatility and bear markets.
Does This Trend Apply to the Cryptocurrency Market?
In the cryptocurrency market, most indices and funds are compared to the performance of Bitcoin (BTC), which, at the time of writing, holds a 69.4% market dominance. 2018 was widely considered a devastating year for cryptocurrencies, with BTC posting a return of -72%. In a PwC study of 100 hedge funds, researchers found that cryptocurrency hedge funds were able to mitigate losses compared to the BTC benchmark, with a median fund return of -46%. Hedge funds employing quantitative strategies performed the strongest, posting a positive return of +8%, compared to fundamental funds (-53%) and discretionary funds (-63%).
In 2019, with the market on an upward trend, the opposite result emerged: hedge funds were unable to exceed BTC's performance during the bull run. A Vision Hill report showed that Bitcoin achieved a return of +162.4% in the first two quarters of 2019. In contrast, their Crypto Fund Index (VH-ACI) returned only +66.9%. Among different strategies, fundamental strategies performed most strongly at +81.6%, compared to opportunistic funds (+65.2%) and quantitative funds (+45.0%).
Despite the apparent disparity in gains, the ability to preserve capital during bear markets has led to a 1400% growth in cryptocurrency fund performance since December 2016, compared to a 1000% growth for Bitcoin, according to the Crypto Fund Index (CFI). Vision Hill reported similar results to both CFI and PwC, showing that when including 2018 data, all active strategies outperformed Bitcoin, with quantitative strategies being the most robust.
On the other hand, passive indices and index funds have not yet convincingly outperformed BTC. The exception is the Bitwise 10 Index, which, based on backtested hypothetical data, outperformed BTC in 2017. Aside from the Bloomberg Galaxy Crypto Index, which outperformed hedge funds from the start of the year until June 30, 2019, most active strategies have outperformed passive indices.
Therefore, mainstream literature on active asset management in the cryptocurrency market appears to echo trends in traditional markets: while active strategies struggle to outperform benchmarks during bull markets, they excel during crises and periods of market volatility.
This finding should be of particular interest because the emerging cryptocurrency market remains highly volatile. High volatility and inefficiencies across trading platforms can offer attractive returns for active strategies, particularly quantitative funds like arbitrage funds. Coupled with increased institutional services handling cryptocurrencies in areas such as custody, over-the-counter (OTC) trading, and insurance, these conditions may attract more institutional investors to the market.
While current data seems to support the strength of cryptocurrency funds, it is crucial to note that cryptocurrency asset management is still a relatively new service. There is no guarantee that these funds will perform well in a mature cryptocurrency market. Bitcoin itself is only a decade old, so it is premature to conclude that cryptocurrency hedge funds can consistently beat the market. Investors should exercise caution during due diligence, especially since some hedge funds require long lock-up periods and charge high fees. We must also remember that while hedge funds may perform best in turbulent markets, they themselves must survive those conditions. Although traditional hedge funds outperformed the S&P 500, they are currently struggling. Strategies that minimize losses during bear markets may not translate into high profits for asset managers, particularly when losses are still significant and investors withdraw their funds. With over 60% of cryptocurrency funds managing less than $10 million in assets, it remains uncertain whether their business models can survive a prolonged bear market.
Nonetheless, the current trend in cryptocurrency asset management is promising. For institutional investors seeking exposure to cryptocurrencies, hedge funds present themselves as a compelling entry point.
Frequently Asked Questions
What is a cryptocurrency hedge fund?
A cryptocurrency hedge fund is an investment fund that pools capital from accredited or institutional investors to trade a portfolio of digital assets. These funds employ various active strategies—such as quantitative, fundamental, or discretionary trading—aiming to generate returns regardless of market direction, often while trying to mitigate downside risk.
How do crypto hedge funds perform compared to just holding Bitcoin?
Performance varies by market condition. During bear markets, many crypto hedge funds have historically limited losses better than a passive Bitcoin holding. In strong bull markets, however, most have failed to keep up with Bitcoin's explosive growth. Long-term, some indices suggest active funds can outperform, but this is not a guaranteed outcome.
What are the main strategies used by these funds?
The three primary strategies are quantitative (using algorithms and arbitrage), fundamental (based on deep value analysis of projects), and discretionary (relying on a fund manager's decisions). Quantitative strategies have shown particular resilience during market downturns.
What are the risks of investing in a crypto hedge fund?
Key risks include high fees (management and performance fees), long investor lock-up periods, the inherent volatility of the crypto market, and the relative novelty of the asset management space. There's also the risk that the fund's strategy may not perform as expected.
Why consider a fund instead of buying cryptocurrencies directly?
Funds offer professional management, diversified exposure across multiple assets, and sophisticated risk-management strategies that may be difficult for individual investors to implement on their own. They can be a way to gain managed crypto exposure without needing to become an expert in trading.
Are cryptocurrency hedge funds regulated?
The regulatory landscape is still evolving and varies significantly by jurisdiction. While some funds operate under traditional financial regulatory frameworks, others exist in a grayer area. Thorough due diligence into a fund's regulatory status is essential before investing. For those looking to explore regulated digital asset platforms, understanding the compliance framework is a key first step.