The amount of crypto funds has been increasing at a remarkable rate over the course of 2018. During the initial months of this year, for example, more than 90 different crypto funds have been introduced. If this pace were to continue, it's believed that by the end of 2018, there would be more than 165 crypto funds being added to the marketplace.
To put this figure into perspective, over 2017, there were 157 of these same funds established, and if we're using the number of ICOs and blockchain companies being developed from 2017 & 2018, it's very safe to assume that this 165 figure is a potential underestimation.
Along with this rate of growth, there are now over 500 different crypto funds that exist. So what's causing this emergence of new funds?
Well, one is the continued and current performance of the cryptocurrency market; considering that it is entering another bearish trend, the time is right for crypto funds to offer an alternative sort of exposure to the market without so much of the volatility and risk as is seen in the investment world.
And it's very good timing, currently the likes of Ethereum have seen their value cut drastically down by over half their starting value. And a myriad of bad developments have contributed to its sluggish downward slide, both the People's Republic of China and India are taking harder regulatory stances on domestic uses of cryptocurrency markets.
While this is the lay of the land in the US and Asia, regulations on cryptocurrencies in the western hemisphere remains relatively murky, the Securities and Exchange Commission (SEC), for one, has had to push back the decision date on Bitcoin-based Exchange Traded Fund (ETF) proposals from the likes of VanEck and SolidX this month as they need to come under deeper scrutiny.
The question persists, however, why is it that so many crypto funds and like related hedge funds and venture capital funds are being launched in this current climate? Before addressing this, it’s important to briefly discuss the three broad types of crypto funds.
What on Earth is a Crypto Fund?
One of the reasons for why there are so many different types of these crypto funds is that they come in a vast amount of shapes and sizes. But these three features summarize the majority of them:
- Crypto Hedge Funds primarily invest in a number of cryptocurrencies such as Bitcoin, Ethereum, Ripple, and Dash along with a number of smaller alt-coins.
- Crypto Venture Funds invest in blockchain companies either through an Initial Coin Offering (ICO), or by contributing to them via a seed capital or early-stage equity investment.
- Hybrid funds invest in a range of cryptocurrencies while also providing some level of capital for blockchain companies through Initial Coin Offerings or early-stage equity investment. While somewhat rare outside of the crypto world, hybrid funds are common in the crypto space.
While these encompass the vast majority of crypto funds that exist in the space, there are a number of conventional investment companies such as Sequoia Capital and a16z that also occasionally invest in blockchain companies, while also maintaining a larger portfolio of a diverse range of companies.
So, Why is the Cryptocurrency Market so Susceptible to Fund Formation?
The question itself points towards a very paradoxical situation, especially when we look at the current landscape for those that are already, or have yet to invest in the cryptocurrency marketplace.
Where it's already in a state of bearish downturn, the respective upswing to crypto funds sticks out. If we compare this to the global market crash which took place in 2008/9, when the stock market plummeted, so too did the number of hedge funds and venture capital funds.
By the last quarter of 2008, to get the truest perspective of this dynamic, there were 12 times more hedge and venture funds being liquidated as there were new ones to replace them.
So what makes the cryptocurrency market so special? Why are these funds continuing to not only launch, but launch in vast numbers despite the bearish conditions? Well, to answer this question, we must first consider the fact that it's based on a number of separate factors, including regulations, fund manager demographics, lack of competing products and a possible disconnect between retail investors and crypto fund managers.
The Regulations Might Favour Crypto Funds
Investors, as a general rule, despise uncertainty, not least from the investments that they want to make, but the same goes for regulations. And this factor may be contributing to the reason why these funds are being developed at a record pace.
While investors are waiting on a bit more clarity, the 70 year old ‘acid test' for securities, the Howey Test, has been playing a vital role for the market.
In its current state, the Howey Test acts as a four pronged test brought forward by the US Supreme Court back in 1946. Its goal? To determine what can be defined as a security. Those funds dealing in securities, as determined by this test, are subject to much stricter reporting and disclosure requirements than those that don’t.
During a speech in June, the Director for the Securities and Exchange Commission (SEC), William Hinman stated that the organization intended to treat most Cryptocurrencies and Initial Coin Offerings as some form of security, while major cryptos like Bitcoin and Ethereum would be treated as commodities.
This difference in distinction makes a profound difference in the way in which they're assessed. As previously mentioned, those funds dealing in securities are subjected to a firm hand when it comes to reporting, meanwhile, commodities are subject to a far more modest version. Because of this, fund formation is far easier than for traditional hedge funds, most of which trade securities.
In theory? Sounds great! When it comes to practice, however, it's uncertain whether all crypto fund managers are cognizant of this difference in regulation, or if they even care about it. This is where it gets complicated, simply because if the crypto funds are of a particular size or diversity, this would render a certain amount of regulatory filing redundant.
Meanwhile, most of the crypto funds are probably made up of a population of fully / or at least semi-compliant funds, there are a number of these funds that have no paper trail, which makes for a concerning issue and serious questions. The SEC subpoenaed several dozen crypto funds earlier in 2018 over similar concerns.
While these funds were only subpoenaed successfully on account of their residency and operation from within the US, the SEC has attempted to set a uniform and universal set of standards for those funds that operate outside of its jurisdiction as well. And to the extent crypto funds face less burdensome compliance than traditional hedge funds, it helps to explain some of the rapid rise in new funds this year.
Competition? Where's the Competition?
Setting up a traditional Hedge Fund is not something for the faint-hearted, you are beset by a number of highly experienced ones which are already in service, while also facing an intense amount of competition from rival products, including Mutual Funds, ETFs, and registered investment advisors such as ones that work in companies like JP Morgan or Morgan Stanley.
But while the conventional market is a highly experienced one, with more than $3 trillion under its belt, it's one that is currently, and has for some time, been dwarfed by its ETF, and mutual fund rivals. The latter types of which boast of assets totaling up to $17 Trillion and $30 Trillion respectively. Crypto funds, on the other hand, have extremely limited competition for investor wallets.
There are a few blockchain based ETFs in circulation, which is good, as they provide a certain amount of exposure to the industry, but this is only in a more broad way. Generally, they hold publically traded funds in their portfolios, these include companies like Overstock and Square, which, by themselves, can't generally be defined as purely cryptocurrency / blockchain investments. And while there are a number of futures contracts available for Bitcoin, these markets are not anywhere near a level of development that we'd see from other markets.
In a number of respects, the Initial Coin Offering is a competing product, the unique attribute they have is that ICOs may actually have made launching a venture fund based on cryptos far easier. Along with conducting a stringent amount of due diligence, the partners within a traditional venture fund would generally negotiate the terms of their investments directly with company founders.
Being an investor of an unknown venture fund often just results in not being considered at all for a table with aspiring and tempting startup companies. With ICOs, it's easier than originally thought, simply requiring reading a few whitepapers and purchasing one of 2018s more successful population of ICOs.
This approach on its own, may not make for a completely successful long-term strategy, but it does remove a major hurdle in starting and operating a lucrative venture fund.
Crypto Fund Manager Demographics
So who are the people running the majority of these crypto funds? Some of the exceptional figures that stand out to us as experienced investment managers include Mike Novogratz, who brought a wealth of experience with him when he joined the crypto fund, Galaxy Digital. But while funds would do great under a Novogratz, there are a lot of them with young founders at the helm with little to no experience in the field.
It was reported in April of this year by Bloomberg and a number of other outlets, regarding the launch of a crypto hedge fund which was founded by a number of undergraduate students from Harvard called Plympton Capital. Over the course of Four months, the company had transitioned from vibrant newcomer to non-existant, with nothing but an abandoned website on Wix to prove it existed.
While a general lack of knowledge and experience as an investment manager isn't essentially a deal-breaker on its own, having it certainly goes a long way. There are many crypto fund founders that do provide some scope of expertise that lie outside of the realm of investment management. For example, having a deeper understanding of programming, protocols and blockchain technology can prove to be unique substitutes for traditional experience.
But whereas a traditional hedge fund manager might have obtained decades of investment management experience and various professional designations, the outlying requirements for starting up a crypto fund can be significantly more vague and, on occasion, quite obscure.
Is the Crypto Fund Industry Getting Ahead of Itself?
With a far higher bar for entry and a more generous volume of youthful enthusiasm, these could explain the emergence of so many new crypto funds. But the important question remains unanswered: Is this pace of growth truly sustainable?
A straightforward measurement of demand for any investment product is assets under management (AUM). Through the use of this measure, crypto funds are nowhere near in as high a demand as the number of new funds may have us believe. Out of the current 500 crypto funds that are in existence right now, they manage roughly $7 Billion, roughly translating to around $15 million per fund. Statistically, nearly half of all crypto funds manage less than this. In contrast, half of all traditional hedge funds at the moment hold roughly $100 million or more in various assets.
It's important to note, however, that while cryptocurrencies and their specific values have declined over the past few months, crypto assets under management have steadily moved up.
Evaluating these assets which are under management is essential to do, simply because they are key drivers of revenue for hedge and venture funds, especially within bearish markets. Typically management fees range at around 2%, meaning that the average $10 million fund would only earn roughly $200,000 in these fees, and a bearish market would make these inconsequential.
This amount on its own is barely enough to sustain a fund with a bespoke team of specialists. Heck, these days a fund might need an entire team just to delete the thousands of ICO pitches in their inbox.
During the cryptocurrency bull market of 2017, when Bitcoin made a return of more than 1,000%, underlying performance fees dwarf management fees by a big margin. Hypothetically, a crypto fund that started in 2017 with $10 million that was completely invested in Bitcoin would have ended their year with over $100 Million, while generating tens of millions in performance-based fees.
Under these circumstances, it's not out of the question to theorize that the growth of new funds has been due to emerging fund management optimism for the future performance of crypto and its associated performance fees as from investor demand. In a bearish market, these funds may find it difficult to cover expenses on management fees alone.
Over the course of the last 18 months, there have been hundreds of managers which have taken the initiative to establish and launch crypto funds due to the low barriers to entry they have in comparison with other iterations. This is all done in spite of lackluster retail and institutional demand from consumers for their products, including the ongoing decline of crypto values and regulatory uncertainty. But these same low barriers to entry generally translate to a lower quality product, which does not inspire confidence.
If there's any direction we can look in order to see this theory in practice, it's from inside the ICO market, where a coin can be issued to a company in the space of less than a day. The ICO market is currently littered with hundreds, if not thousands of companies with dubious white papers and even more questionable business models. All of which have the freedom to compete with otherwise legitimate blockchain startup companies for the attention and funding of investors, leading to loss of funds from buying into a non-starter, while eroding the credibility of the entire ICO market.
In the same way, a continued move from the quality of ICOs to pure quantity can be seen from the emergence of more crypto funds, making the vast amount unlikely to be beneficial to the industry long-term.
This growth in the number of crypto funds has features that appear reminiscent of the ICO market: both appear to rely on a continuation of regulations that favour them, as well as an eventual end to the bearish trend that is currently afflicting the market, and an increasing volume of investor interest in cryptocurrencies and blockchain as a whole.
If any of these factors were to change, then the number of crypto funds we see and expect will certainly decrease in the near future. The future holds the answers to some of the questions we have, including which funds will weather the uncertain storms, and which ones will be leveled, leaving only placeholder Wix websites as their only remains.