Expect More Bitcoin Funds to Launch

How to best access crypto assets remains an outstanding question. Investors are wise to approach ICOs with caution

Flynn Murphy 29 January, 2018 | 11:54AM
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Unlike other alternative investments, crypto currencies such as bitcoin are more accessible to retail traders compared to institutional investors because cryptos’ small market caps and thin trading volumes make it difficult to efficiently build sizable positions.

Barriers remain high for traditional hedge funds to begin trading bitcoin, ethereum and other crypto assets, but they are beginning to fall. An increasing number of exchanges have begun offering custodian services compatible with asset managers’ regulations. Options and futures exchanges the CME and the CBOE began listing bitcoin futures in December, while the NASDAQ has announced that it will list futures linked to crypto assets in the first three months of 2018.

However, these vehicles are cash settled and therefore merely represent side bets on the price listed on a group of exchanges. To that end, the thinly veiled secret of investing in crypto assets at scale is that it is extremely difficult to actively deploy more than around $100 million without concentrated positions in bitcoin and ethereum.

What is the Best Way to Invest?

How to best access crypto assets remains an outstanding question. According to the new HFR Cryptocurrency Index produced by industry research firm Hedge Fund Research, hedge funds that invest in crypto assets returned 16.4 times net of fees in 2017 to the end of November 2017. In context, the price of bitcoin rallied roughly 11 times during this period while ETH jumped a whopping 54 times, which would imply that a number of funds in the sample were passively holding BTC.

This calls into question why investors should pay performance fees to a hedge fund that is just holding an asset. While the initial performance of crypto hedge funds in aggregate leaves something to be desired, that does not mean that active management is without merit in the crypto space.

Arbitrage – the simultaneous buying and selling of options – is a potentially profitable strategy for well-capitalised traders who possess the proper infrastructure across various exchanges and fiat currency pairs. Major discrepancies pop up between the spot values of bitcoin depending on the currency pair

In the last month, discrepancies in the range of 3% to 7% persisted between the spot price of BTC priced in Korean won and US dollar. These spreads are significantly wider in failing states with strong capital controls, like Venezuela and Zimbabwe, where bitcoin has at times traded for the equivalent of two times the US dollar spot price.

Explicitly passive vehicles are also opening up for investors who want exposure to crypto assets and are willing to pay for the convenience of letting others deal with the operational headache of wallets, keys, etc. Pantera Capital was the first mover into this space in 2014 with the launch of Pantera Bitcoin Partners, a partnership with Fortress, Benchmark Capital and Ribbit Capital that invests in the crypto asset.

Grayscale’s Bitcoin Investment Trust, launched in 2015, was the first publicly quoted vehicle to track the price of bitcoin, though the fund charges a 2% annualised management fee and often swings wildly in relation to its net asset value due to liquidity issues that arise when trading large sums in relatively shallow markets.

Other players like the Bitwise have attempted to bring the passive investing concept to a basket of crypto assets, charging a 2.5% management fee and periodically rebalancing. These fees dwarf those charged by passively managed equity and fixed income ETFs, but the newness of the market and the premium placed on credibility has limited competition for these new vehicles.

Venture Capital Funds

Given the technical complexity of blockchain technology, private investment in the space has been dominated by a few niche venture funds, as well as several personal investments by venture GPs and super angels.

These early movers into the space invested in the broader ecosystem that enabled non-technical users to access bitcoin and propagate blockchain technology. During the internet revolution, value accrued to companies around the application layer such as Facebook, Google and Netflix; the blockchain revolution allows value to accrue around the protocols themselves. This would be tantamount to dotcom-era investors having been able to invest in the internet itself.

However, early investments in cryptos have mirrored the evolution of the internet, with application-layer companies dominating the list of VC-funded crypto start-ups. These companies provide tools and services, including wallet software, various flavours of payment services, and enterprise blockchain development. However, in spite of the exponential growth of interest in crypto assets and blockchain, venture capital investment has been more or less flat; the $512 million invested in the fourth quarter 2017 was the first quarterly figure to exceed the previous high-water mark of $382 million invested in the first three months of 2014.

ICO Funds

One of the biggest technology stories in 2017 was the newfound popularity of the controversial mechanism for blockchain projects to self-fund. ICOs (initial coin offerings), or token sales, are a method for projects to fund themselves by launching their own crypto asset.

Some of these events are conducted by established entities or teams who’ve spent several years building a product; however, these comprise a small minority of projects. Many of these ICOs represent the promise to distribute future tokens for use on a yet-to-be released distributed platform.

Furthermore, given the massive returns for early holders of the more popular crypto assets, investors have developed a severe fear of missing out, which has only increased speculation in the underlying tokens. To be sure, investors are wise to approach ICOs with caution. The established best practices for equity IPOs don’t exist for token sales e.g., lockup periods and disclosure mandates, however, since it often takes a month or more between an ICO and a token being listed on an exchange, most ICO investors are bound by an implicit lockup.

Despite the apparent risk, an analysis by Luxembourg-based venture firm Mangrove Partners found that investing in 204 ICOs with known returns would have delivered a 13.2 times return, despite a number of these offerings declining to 0.

The Big Picture

While investors are being presented with new access points to crypto assets, the industry is still nascent and investors generally remain under-allocated on a risk-adjusted basis based on the return profile of bitcoin over the last several years.

Illiquidity makes it difficult for funds to efficiently allocate capital to cryptos outside the mainstream, and these issues even persist with the likes of bitcoin and ethereum, which have relatively deep markets. But these hurdles are not insurmountable, particularly as crypto assets are likely to comprise an exceedingly small portion of a diversified institutional portfolio. As new funds enter the space and crypto exchanges are enhanced, we expect more crypto-focused funds to be launched with both active and passive strategies.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Flynn Murphy  Flynn Murphy is a mutual fund analyst with Morningstar.

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