AKJ Crypto: Hedge Funds & Crypto Asset Investing Q&A

To generate meaningful returns at scale, large AUM hedge funds need to enter sizeable positions. Considering that most altcoins have very small market caps comparatively (for the hedge fund world), can small market cap coins still be relevant as part of a portfolio’s strategy?

Absolutely. A selection of interesting small-cap assets can combine to form a significant part of a larger fund’s strategy and AUM. Having said that, prudent fund management and spreading of risk mean that a position can’t be too big in relation to either market cap, liquidity or AUM. Managing this is a challenge for bigger funds today, especially when recent markets have been bearish, and many altcoins have shrunk significantly. Which is also one of the main reasons most crypto funds are relatively small. Finding enough solid, trustworthy projects with sufficient market cap and liquidity is a challenge facing today’s crypto funds.

A lot of people say that crypto has a tendency to track together. Is there such thing as diversifying a crypto portfolio if altcoins so closely track Ethereum?

This has certainly been the case lately, but I think that’s to be expected in such an embryonic market. As it matures, you’ll begin to see market sentiment less driven by ‘crypto assets in general’, more by the merits of individual projects. Even now, it is possible to diversify based on different parameters; though only up to a point. For the immediately foreseeable future it’s going to be hard to spread risk in a portfolio based on fundamental analysis and long positions. In time, this will change. Current market sentiment tends to be general, and driven by general issues – new regulation, or rumours thereof, and market sentiment over whether blockchain, web3 and cryptocurrencies will work at all. Once such basic elements become a given, individual market valuations of specific assets will more closely follow those assets’ fundamentals.

Do you see hedge funds adopting strategies along individual coins or will they tend to view cryptocurrencies as a bundle, not really differentiating one coin from another?

This is very different from fund to fund and from strategy to strategy. We will see, and already see, both on our platform. For example, some fully automated funds develop their strategy based on data from one specific asset – currently pretty much always Bitcoin – and then later adapt the same algorithms to other assets with smaller market caps. We have yet to see a fund trading only one or a few specific altcoins, but it could well be that we see, for example, market making strategies being exposed mainly to a few specific assets. Many funds, if not most, do have particular interest in particular projects that they follow closely. In that sense, many crypto funds are really venture funds, at least partly.

For traditional hedge funds that seek to expand into crypto, what kind of skills from the equity and commodity world are transferable into the crypto space? Is good performance in the traditional space an indicator of a hedge fund’s ability to perform in the crypto space?

A lot of knowledge, experience and psychology is transferrable from the traditional space. And just as every asset class has its specific metrics for analysis, so do crypto assets. Early, successful crypto investors benefited from a general enthusiasm for this emerging market.  Even if they guessed crypto was going to be big in 2011, or even as late as 2016, it isn’t hard to be successful when a herd instinct is driving everything through the roof. The test is whether you can outperform the market over time, in different market conditions and over several cycles. No pure crypto manager has yet had the time to meet or even take that test.

The transferability of skills also depends on the strategy a fund is running.  I believe some strategies can run just like they do in traditional markets, while others require more specific crypto knowledge.  One could, for example, run a ‘fork strategy’, analyse mining activity or look at incentive schemes of different utility tokens. We at AKJ offer all of the necessary regulatory and operational infrastructure, whether running a general strategy or one that is more crypto-oriented.

We may see traditional hedge funds pivot into crypto to diversify their asset range. Do you think we could see some kind of convergence where crypto specific hedge funds reach into equity or commodities assets to diversify as well?

Yes, I do believe there will be a lot more of a mix as crypto assets become more mainstream. Long term, we could even see the difference disappear, as all assets become digital. For now, funds need other service providers if they invest in crypto, and they are charged a premium for it. This may prompt some to separate a mixed strategy into two different funds today, in order to avoid paying higher fees for all related services just because they hold some crypto assets.  We, however, have been able to benefit from our economies of scale to offer our fund managers substantial discounts on formation and transaction fees.

I think it’s fair to say that right now crypto trading is still largely inhabited by retail traders. What will happen to the market as hedge funds and high frequency houses start to take up more of the trade volume? What kind of structural changes might we see? Will their entrance feel like a whale in a pond?

Certainly, today’s market is dominated by retail; obviously we look forward to welcoming institutional players to the space. And we expect it to begin happening soon, not least thanks to the offering of institutional security grade custody services for the crypto space, institutional crypto trading platforms like those of our strategic partners Caspian, and improving regulatory clarity, enabling us to drive the market proactively by developing a first-to-market, best-in-class service. We expect to see the arrival of such services encourage rapid take-up by institutions, driving asset values higher. What we expect to see going forward is a more mature market with declining volatility.

Hedge funds have a lot of tools at their disposal, requiring mature and stable information channels, including expert networks to make well-informed investment decisions. It’s arguable that this ability to receive high quality real-time information is the difference between investing and gambling. Does this level of information infrastructure exist in the crypto world yet? If not, how do PMs justify their investment decisions to their MD?

This is pointing back to a previous question; currently the market is dominated by retail, so we feel that as the market matures, becoming more institutionally dominated, the service providers in place today in the traditional hedge fund space will develop to cater to these new crypto hedge funds. Again, we feel this will be a gradual process whereby the marketplace evolves from retail dominated to institutional over time. But there is always a lot of information out there. The question is what information you can access, how you process it and what conclusions you draw from it.

Hedge funds are not designed to outperform aggressive bull markets. We are seeing the opposite phenomenon occur in the crypto space, however. It’s hard to ignore that in crypto, markets are still currently fairly bearish (in March 2019). Do hedge funds see this is an opportunity or a risk?

Judging from our discussions with funds on-boarding on our platform, most of them have so far taken a kind of ‘wait and see’ approach. Of course, current sentiment expects falling prices, and assets becoming cheaper is a big opportunity over the long run. We still think there is very little doubt out there with regard to the long-term viability of this new technology. So, for the long-run business, the feeling is that the current bear market is a positive opportunity, though the steep downtrend last year has inevitably left many hesitant about the timing of any re-entry.  But there is light at the end of the tunnel now, as fund managers are realising that the ‘time is now’ to get their infrastructure set up in advance of the expansion to come.

Hedge funds often rely on financial instruments that would seem quite advanced in the crypto world. For example, hedge funds in the traditional space have access not only to spot markets, but also to forwards, futures, options and swaps. Does this level of sophistication already exist in the crypto markets? Do you think it will exist in the mid-term future?

Yes, again as the space starts to attract institutional interest, we expect the level of sophistication to increase with regard to services/instruments, and pretty rapidly: markets tend to be quick to adopt new, better products. We’ve seen the start of this in the traditional markets, in terms of the CME offering Bitcoin futures. We also see several ETNs being offered in different jurisdictions, and more exotic instruments being offered on the direct crypto exchanges. It will be interesting to see if any of the actors emerging from the crypto space manage to become real institutions, comparable to actors in the traditional space. These companies have a golden opportunity to disrupt incumbent players in the market. We expect this kind of increased sophistication to continue, as institutional interest grows and companies in the space gain trust and stability.

Let’s say we’re looking at a hedge fund with the following portfolio allocation:

  • 40% Equities long/short – directional
  • 15% Equities long/short – arbitrage
  • 25% Credit long/short
  • 20% Discretionary macro

What percentage of a hedge fund’s portfolio do you think is reasonable to allocate to crypto at this stage? 5%? 10%? 15% for a very aggressive crypto strategy?

We get this question quite a lot from our traditional hedge fund clients, and our standard response is that there is definitely value in adding crypto to traditional funds, not least on account of the low correlation between crypto and traditional markets, and the general performance in some of these assets. So, for diversification purposes, but also because we must assume that today’s depressed prices mean greater potential for higher asset valuations in the future, we could definitely recommend such a fund to keep up to 10% of their portfolio in crypto assets.

Let’s look at the operational level of implementing crypto at a hedge fund. Should one PM specialize in crypto or should crypto exposure be distributed among multiple PMs? What are the pros and cons of both approaches?

We see both approaches as viable. And which to choose really depends to a large degree on the strategies employed, and how the individual PM decides he or she wants to create alpha. The advantage of specialization is deeper knowledge and experience, something that can prove valuable in such a complex and dynamic sector. The risk of course is a narrower view, and with the magnetic appeal crypto seems to have on some individuals, it could be a good idea to distribute responsibilities and encourage active discussions between PMs. There is still a lot of debate around what the ‘killer app’ is for blockchain, what asset will be successful over time, and how one builds both businesses and currencies in this space. Maybe taking the wide approach could be the better start. However, as mentioned previously, using crypto assets for diversification in traditional asset funds is also a viable approach. In such a case, with the top assets being so dominant in the market, the question is rather whether a fund should go into this segment, rather than how.

Given the highly volatile nature of crypto, are hedge funds likely to take very aggressive and opinionated positions in the market? Is it possible that hedge funds will simply dedicate a small portion of their portfolio to very risky trades in the crypto space to boost short term returns? Or do you believe that hedge funds will formulate longer term strategies around crypto?

While this will largely depend on the specific strategies being followed, there appears to be a growing belief among many funds in the long-term potential.  We see cryptocurrencies, blockchain and related technologies as very important for the future. We expect these technologies to drive the expected long-term decentralization of the web (web3) and financial markets. We think that from here on in, investments in this space should primarily be seen as fundamental and long-term.

As mentioned earlier, we also expect this space ultimately to become less well defined as a separate part of the markets – we expect these technologies to become mainstream, both with regards to securities markets infrastructure, but also in terms of being able to create large-scale productivity gains in many traditional businesses. So again, it depends on the strategies of the fund in question – in today’s bear market we of course notice some hesitation among traditional funds. But we believe initiating long-term strategies right now will be nicely rewarded in the long term.

For traditional hedge funds, does ‘crypto’ mean Bitcoin and Ethereum, or do you think that there will be demand for other coins as well? Given the number of coins in existence, what kind of coins do you think hedge funds will prefer the most? Those with the highest volatility? Those with long term growth potential? Those with the highest volumes?

In our experience, this again differs depending on the strategy of the fund in question. For passive investors in crypto, or for funds that are mainly invested in traditional assets, the coins you mention are often seen as synonymous with ‘crypto’. So, for traditional funds seeking diversification in crypto, these are the go-to coins. However, for specialized crypto funds we see much more focus on fundamental analysis of each coin, and really each business case – and of course the long-term growth potential is where the focus is. We also see specialized crypto funds that focus more on volatility and the technical aspects of price patterns of individual coins.

In a panel from the Milken Institute, there was mention of hedge funds diversification into the private markets (VC and PE). How do you think STO can help hedge funds tap into what could be a novel market for them? What kind of role do STO have in the evolving strategies of hedge funds?

We think STOs will play a much larger role over time compared to unregulated ICOs, as institutional level regulatory demands begin to permeate the space. We expect STOs to play a similar role to that of IPOs in the stock market today, offering funds early access to promising projects. As such, the potential is huge. And it may over time even prove to evolve into a more efficient model compared to today’s, for primary security offerings generally. We tend to see the securities markets, both primary and secondary, as ripe for innovation based on these new technologies.

AKJ Crypto

AKJ Crypto comes from the team behind the AKJ Hedge Fund Platform, launched in 2012, and winner of the HFM European Services ‘Best Hedge Fund Platform’ Award in 2016 and 2017, and ‘Best Hedge Fund Platform – Emerging funds’ Award in 2018.  AKJ Crypto’s turnkey platform for crypto hedge fund managers provides fund formation, legal and regulatory infrastructure, trading systems, back office support, and seed capital services.

AKJ Crypto plc is a subsidiary of AK Jensen Group Limited, a financial services firm that serves hedge fund and institutional clients in 35 countries around the world, and is owned by shareholders who manage a combined US$18 billion in assets under management.

For more information about AKJ Crypto visit: https://www.akjtoken.com