Using Blockchain to Invest in Hedge Funds

Weathering the volatility storm

Trade wars. Interest rates. Oil prices. If you are scratching your head on where to invest your money given the volatile stock markets, join the club. This year has seen volatility return with a vengeance, changing the dynamics of the calm of the last few years. The massive sell-offs of the equity market, coupled with uncertainties created by a global trade war, have left investors panic-stricken.

Now, more than ever, diversification is paramount. No bull run lasts forever. The S&P 500 index has been up 50+% over the last 5 years, but the inevitable correction — normal or extreme — is just waiting around the corner. With a potential bear market looming, we can all use some exposure to hedge funds.

If we are only exposed to the long side of the market, then a stock market plunge can have a catastrophic impact on our net worth. When the stock market falls, almost all long-biased asset classes see a high correlation — stocks, bonds, real estate — and value decreases correspondingly. Anyone who is invested in only these correlated asset classes does not enjoy true diversification.

During high volatility or bear markets, one of the few categories of investment management that manages to survive — sometimes even thrive — are hedge funds. Hedge funds are only one of many alternative investment opportunities, that can yield potentially high (but also risky) returns for investors.

The returns from alternative assets are remarkable, and as of 2018, “private market investments such as Private Equity, Direct Property investments (i.e. excluding REITs), Infrastructure and Private Debt have outpaced all but equities over three and five years and everything over 10,” according to a Fidante Partners report in September. These attractive returns are attracting vast amounts of asset inflows to the space, so that by 2020, global assets in alternative investments will reach US$ 18.1 Trillion.

Limited access to hedge funds

But what makes hedge funds so valuable also makes them inaccessible — for retail investors. And with good reason.

Bank of Singapore advocates a 14% asset allocation to alternatives, but access to this space is limited to high net worth individuals and large institutions. Only a fraction of all wealth in Asia is tapped into the wealth management industry and affluent investors have virtually zero access to the above market returns and performance of alternative investments.

Since the downside risk of unsophisticated investing is so high, the regulators restrict the access of these vehicles to only ultra-high net worth investors and institutional investors, as they have access to expert advice and enough capital to weather volatility.

Institutional investors have allocated over $2 trillion to hedge funds, and represent 58% of capital invested in the industry today, according to Preqin. Top-performing hedge funds strongly prefer institutional investor capital, given their long-term investment horizons and “sticky” capital. This makes it highly unlikely to get access as an individual investor, even as an ultra-high net worth investor.

What does this mean for the rest of us? Until now, there has been no way for affluent investors to access top-performing hedge funds directly. On top of that, liquidity is near impossible as there are long lock-in periods.

The Asian affluent investor (worth $43.3 trillion in assets by 2020) today is underinvesting in wealth management in an environment of ground-breaking technology such as artificial intelligence, robo-advisory and blockchain.

Bringing liquidity and access to alternatives with blockchain and smart contracts

Blockchain technology and Smart Contracts provide a solution. Blockchain stores data in a secure, decentralized ledger; Smart Contracts are the underlying codes that automatically execute given certain conditions. Applying this technology to hedge fund investing (not to mention alternative investments more broadly) enables access and liquidity for affluent investors.

Investors can own a Security Token in a hedge fund, which represents a digital certificate of ownership much like a stock in a company. Through Security Token Exchanges, investors can freely trade these Tokens for immediate liquidity. This allows affluent investors to have even a small exposure to top-performing hedge funds, and exit as the need arises without being subject to the often years-long lock-in periods of most top hedge funds.

It has been less than a year since Security Token protocols and exchanges have started emerging, and we have yet to see a real use case with relevant licenses or track records. However, the space is moving very quickly.

For this space to progress, we as wealth management technology providers need to work hand in hand with regulatory authorities. There needs to be a regulated offering of security tokens in alternative investment funds through a regulatory sandbox license combined with a fund management license.

This will provide affluent investors with access and liquidity to alternative investment funds — such as hedge funds, commodity funds and private equity funds. Much of this development is underway with advanced discussions with regulatory authorities and can occur as early as end of 2018.

This will be a big step to usher in the next-generation of wealth management powered by blockchain and tokenization for the utmost transparency, liquidity and return on capital.

About Xen

Xen is the first-of-its-kind wealth management platform enabling affluent investors access to alternative investments to achieve active returns. Founded by a strong management team of former investment bankers, traders and fintech veterans in 2018, Xen envisions a future of wealth management powered by blockchain and tokenization for the utmost transparency, liquidity and cost efficiency. https://www.xen.net