Why I should start a Cryptocurrency Hedge Fund
I would like to say that I have entrepreneurial spirit, but there’s really no evidence of that so far. I have a traditional educational pedigree, stable career advancement, and work for an old, boring financial firm. Don’t get me wrong, I love what I do, but when I explain it to the average techie, the blank stares inform me of it’s boridity™. I get very excited about new business ideas though, so after brainstorming ideas that I should pitch for my entrepreneurship MBA class this fall, I felt like two of them were important enough to pursue, so I’m going down that road to start building my portfolio of side-gigs. Idea #1: Start a crypto hedge fund.
Crypto Landscape
Basics of crypto can be found here and here to name a few along with many weekends of deep rabbit hole dives. If you think that bitcoin is still an underground libertarian attempt to overthrown the U.S. financial system, stop now and get caught up. If you think there is at least some fundamental merit to cryptocurrencies in the future, read on. The topic of this proposal is the state of cryptocurrency capital markets, outlined here and below, and where one might be able to add value.
How can wealthy individuals invest in crypto today?
1) Like hobbyist, they would open one or many accounts at the various exchanges (Poloniex, Bittrex, Kraken, depending on the coins they want to buy). There are several problems with this:
a. These exchanges are new startups that have significant credit risk, regular trading interruptions, and less than professional customer service. Growing pains abound.
b. You must go through a lengthy verification process that feels janky (involves taking a picture of yourself holding your driver’s license and a hand-written statement).
c. If you want broad exposure to many coins, you will need to do this at three or more exchanges since they all trade different coins.
d. These do not provide tax statements, bank protection, etc. like other brokerage accounts might have. Not to mention comfort in a name like Schwab, Fidelity, Vanguard, etc.
e. If you want to protect your coins, you must take them off of the exchange, which requires some tech savviness to get them in “cold storage”.
f. Anyone with real money that isn’t a “crypto guy” is not comfortable with most of this.
2) Buy Grayscale’s bitcoin trust (Ticker GBTC) or ETFs that are likely upcoming. A few problems:
a. This only gives you exposure to bitcoin
b. Tracking error is pretty bad (0.6 correlation with bitcoin)
c. Expense ratio is 2%, just for bitcoin exposure
i. To a crypto person, this is nonsensical. It’s like buying an ETF with a 2% fee that only buys Apple stock. But $1.4bn in GBTC shows the demand for exposure to this market in a “comfortable” or “traditional” way (i.e. people are willing to pay for something they understand — a publicly listed security that trades on normal exchanges and can be purchased through their broker). Based on this, a fee of 4+% for a diversified investment like ours seems appropriate.
3) Go long crypto indirectly
a. Angel invest in Coinbase or other crypto-exposed companies
b. Buy stock in GPU manufacturers like NVDA or AMD as an expression of mining volume increasing
Opportunity
Launch a private fund (private client/hedge fund) that allows investors to comfortably access beta (and later alpha) in the crypto markets. Beta (exposure to the broad market) in crypto requires all of the steps outlined in #1 above which are time consuming and overly technical for the average investor. In the equity markets, you wouldn’t pay a financial advisor 3% to put your money in an S&P ETF with a 4bps expense ratio, but in crypto you don’t have cheap access to beta, so you would easily pay that much (at least I would). So I think that simply providing beta, reporting, tax documentation, and cold storage requires no coin-picking expertise but is worth at least 3% to the average investor. This is similar to the wealth management approach with no performance fee.
The idea to get started is to invest private capital in a diversified coin portfolio (perhaps via a proprietary index). Follow on products would include an actively managed coin hedge fund (with performance fee), an actively managed ICO fund (VC style, with lockup and performance fee), etc. These could all be started now with friends and family money (since it’s already essentially being done) which will build a track record for each new product launch. Maybe just focus on one and do it well or do them all, but I think they all have value and are worth pursuing.
Target Customer
- Wealthy individual investors (and later institutions) that like the crypto space but aren’t comfortable with the barriers to investing. This is likely a 1–5% position for the average wealthy client, part of their speculative portfolio along with angel investing and private partnerships. They essentially get VC-like exposure that is much more liquid.
- Friends and family
What would the passive portfolio look like?
- In this type of market it makes sense (it seems) to diversify the inherent volatility and also be exposed to unforeseen/underappreciated opportunities (a la VC seed investing).
- I envision a rules-based index holding ~50 of the top coins weighted in a way that makes sense in (at least) the current landscape (i.e. don’t want 50% bitcoin).
This could be something along the lines of the below:
- Top 50 coins by market cap that are trading on Poloniex and/or Bittrex, weighted something like this:
- This would currently weight bitcoin at 9% and ether at 5%.
Benefits
- This is a hot new market that is just getting started. This is talked about in serious circles of thought leaders as “Web 3.0”, “the new internet”, “the future of money”, and plenty of other hyperbole. It is my belief that at the very least cryptocurrencies replace existing clunky financial infrastructure to reduce transaction costs and fraud and increase speed and security. At most it replaces all global digital transactions, replaces a big part of venture capital, disrupts every industry that has any inefficiency it can solve… aaand replaces the U.S. Dollar, just kidding.
- As a result, with a relatively fixed supply for most coins and increased demand over the years, potential returns are silly high, correlations to traditional markets are low (R2 to S&P 500 of 0.007), and best of all, it’s liquid (relatively speaking)!
- Let’s assume everyone starts doing this. Hedge funds like this, this, and this continue to launch. Indices like this and this continue to be created. This is where I say there is $42tr of individual investable assets in the U.S., so even if 1% of that moves to crypto, that’s $420bn. Sure, whatever, the point is there’s room for everyone and private client money is relatively sticky.
Risks
- Bear market, massive selloffs, volatility is too much for people to handle or for redemptions, etc.
- Security (requires significant hacking protection and cold storage).
- Can’t raise enough money to sustain the business (need at least $10mm to even get this going).
- Index approach ends up not working. For this reason we create both passive and active vehicles.
- Future regulations become burdensome.
- Crypto ends up being a tulip market, another hyped up tech bubble created from literally nothing that makes for great cautionary tale literature and business school case studies.
- I can keep going all day on this list.
Conclusion
Ultimately, there is a lot going on in crypto that you could spend years researching. Plenty of extreme bull and bear cases, crazy examples of excess fundraising, and general mania abounds. I think there are plenty of irresponsible and/or terrible businesses being born, many more Beenz.coms than Googles. But I also think that crypto is going to grow and there will be some Googles that come out of all of this.
So far there is a huge gap between the tech-savvy nerds running (and profiting from) this world and the rest of the investment world (which has all the money). This is where I think there’s a good opportunity to try and bridge that gap. This is after thinking about it for about three days so don’t take it as anything more than a preliminary rough draft.
Dustin Seely (although these guys are the real brains of this space off of whom I just pawn ideas)
