Hedge Funds Remain Cautious Over Crypto
A new study finds that while the number of traditional hedge funds investing in cryptoassets fell last year, from 37% to 29%, allocations to crypto funds increased from 4% to 7% and no fund surveyed says it plans to decrease cryptoasset exposure over the next year.
The study, the fifth Global Crypto Hedge Fund Report published by AIMA, PwC and CoinShares, finds that confidence in the value proposition and long-term sustainability of cryptoassets appears robust among managers.
The report notes that traditional hedge fund respondents that are currently invested in cryptoassets say they will either increase or maintain exposure, regardless of underlying market volatility and regulatory barriers that have weakened confidence in the asset class.
The survey also found that 23% of traditional hedge funds are reassessing their crypto strategy due to the regulatory environment in the US, and 12% of crypto hedge funds are considering relocating from the US to crypto-friendly jurisdictions.
Not unsurprisingly, given their focus, 93% of crypto hedge funds expect the market capitalisation of cryptoassets to be higher at the end of 2023 than 2022 – the latter being a year in which crypto markets were shaken by a series of high profile bankruptcies and a slump in the price on many cryptoassets.
The survey also finds that 31% of traditional hedge funds view tokenisation as the biggest opportunity in 2023; 25% of traditional hedge funds – including those not currently invested in crypto – say they are exploring tokenisation.
When asked about plans to increase exposure, more than one-third (37%) of traditional hedge funds that do not invest in crypto-assets say they are curious but are awaiting further asset maturity – an increase from the 30% reported last year. Reflecting the polarising nature of the asset class, however, 54% of respondents say they are unlikely to invest over the next three years, this too is an increase from 41%.
“Despite market volatility, a fall in digital asset prices and the collapse of a number of crypto businesses, investment in crypto-assets is expected to remain strong in 2023,” says John Garvey, global financial services leader at PwC in the US. “Traditional hedge funds, committed to the market in the longer term, are not only increasing their crypto-assets under management, but also maintaining – if not increasing – the amount of capital deployed in the ecosystem. However, it’s clear that regulatory uncertainty and barriers increasingly weigh on investment decisions of many funds, with more than half of those surveyed noting they would likely invest/invest more in digital assets once greater transparency, regulatory certainty and risk management is in place.”
The survey picks up on efforts by the crypto industry to establish what it sees as effective regulation to help boost confidence in the asset class with respondents demanding greater transparency and regulatory requirements. These demands include the mandatory segregation of assets (highlighted by 75% of all survey respondents), mandatory financial audits (62%), and an independent statement of reserve assets (60%). Liquidity – once considered the dominant factor when selecting a trading venue – is now considered as important as platform security: 21% of crypto hedge funds surveyed selected this as their most important consideration – up from 10% last year. Following the market events of 2022, it was also noted that just over half (53%) of crypto hedge funds surveyed have upgraded their counterparty risk management processes.
Some observable resilience in investor interest in the crypto space, especially in newer areas like tokenisation, will provide a foundation for industry participants to rebuild confidence among institutional investors and traditional hedge funds seeking to allocate to this asset class
Traditional hedge funds who have exposure to crypto-assets have also expressed apprehension about the evolving regulatory environment – in the US – with 23% noting it will have a material impact on them or lead them to reconsider the viability of their crypto asset exposures. Just over half (54% of traditional hedge funds not currently investing) confirmed they would change their approach and become more interested in the asset class if perceived industry barriers and uncertainties were resolved – an increase from 29% last year. In contrast, crypto hedge funds seem relatively less troubled by these regulatory developments, with only one-third expecting greater legal and compliance costs and 12% remarking that the current regulatory environment in the US may lead to them moving to more crypto-friendly jurisdictions.
Last year’s crypto market events – including the collapse of a number of crypto-asset service providers – were seen as overwhelmingly negative by traditional hedge fund respondents, with 57% stating their outlook was negatively or strongly negatively impacted. Of those funds, 70% manage more than $1 billion.
More than two-thirds (71%) of the traditional hedge funds surveyed are not currently invested in crypto-assets – up from 63% last year. The four main reasons for not investing in crypto-assets among traditional hedge funds – consistent with last year’s responses – include: (1) client reaction or reputation risk, (2) lack of regulatory and tax clarity, (3) insufficient or unreliable third-party data, and (4) outside the scope of current investment mandate.
Conversely, crypto hedge funds surveyed seem undeterred by recent market volatility, with half (50%) noting no impact. Almost one-third (27%) feel positive about the current market – likely as a result of greater investment opportunities as a result of a broad decline in crypto-asset valuations. In light of last year’s events, 53% of crypto hedge funds reported updating their counterparty risk management processes.
As noted, traditional hedge funds have demonstrated a greater degree of curiosity in tokenised assets and securities – with one-quarter exploring tokenisation – compared to crypto hedge funds, of which only 15% of respondents reported exploring investments in tokenised securities. Tokenisation of funds holds the promise of increased efficiency and reducing friction by enabling faster settlement times and minimising operating costs, with around one-in-three (31%) traditional hedge funds surveyed noting tokenisation as the biggest growth opportunity in the crypto-asset space in the coming year.
“General diversification” or “long-term outperformance” are the most common reasons given by traditional hedge funds for including crypto-assets in portfolios. More than half (54%) of traditional hedge funds who are currently investing in crypto-assets intend to maintain the same levels of capital deployed this year. 46% say they intend to deploy more capital into the asset class by the end of 2023 – down from 67% reported last year.
The vast majority (91%) of traditional hedge fund investors who have crypto-asset exposure say they are invested in the two largest crypto assets by market capitalisation and exchange volume – Bitcoin and Ethereum – up from 67% last year, indicating a shift to large cap coins and reflecting a more conservative investment approach.
No respondents report being invested in non-fungible tokens (NFTs) – compared to one in five traditional hedge funds last year – a considerable cooling since the NFT peak in 2021.
Among crypto hedge funds surveyed, the Market Neutral strategy remained the most popular strategy – although its usage declined from 30% to 20% compared to the last survey. In contrast, the use of Discretionary Long Only Crypto rose from 14% to 19%, while the usage of Quantitative Long/Short Crypto fell from 25% to 18%. This evolution likely has more to do with the current market environment than a longer-term shift in overall trading strategies. All crypto hedge fund strategies – with the exception of Market Neutral – experienced losses.
“The digital assets space has had to reckon with short-comings in its fundamental operations, including risk management, as well as allegations of corporate malfeasance,” observes Jack Inglis, CEO of AIM. “Some observable resilience in investor interest in the space, especially in newer areas like tokenisation, will provide a foundation for industry participants to rebuild confidence among institutional investors and traditional hedge funds seeking to allocate to this asset class.”
Alexandre Schmidt, index fund manager at CoinShares, adds, “Crypto hedge funds have shown remarkable resilience in 2022 amid a challenging environment. The majority of the surveyed funds generated positive alpha, underscoring the essential role that these firms have in the digital asset ecosystem. As we navigate through 2023 and beyond, regulators are introducing near-term hurdles which shall pave a clearer path to investing in digital assets in the longer run, fostering higher adoption from investors across the whole spectrum, from small retail to large institutions.”
