Introduction: Professional Managers Have a High Bar for Entry, but No Dogma Against It Either
Let’s start with refuting a common myth that remains pervasive for much of the retail investors: the dream that institutional investors are going to come in and market-buy bitcoin and the rest of liquid cryptocurrencies without discipline or a long-term plan (or their own price targets at which they’d trim initial positions). At the same time, there is also a continued tendency for many digital asset enthusiasts to conflate all non-retail investors as “institutional”, despite major differences in appetite between family office, pension and endowment allocators, as well as the actual variation in the professional investment management firms (including mutual funds and hedge funds) who invest on behalf of these allocators who generally tend to diversify between a mix of outsourced strategies, while also retaining some flexibility to do direct investments (especially family offices).
The goal of this article is to provide a rigorous overview of the actual buckets of professionally-managed investment strategies that may eventually be ready to invest in digital assets, based on estimates of how well their strategies may map to the current market structure of the cryptocurrency universe, and if a decision is made to invest, how the establishment of a desired position would actually play out in the markets, with approximations based on actual recent data from the BCG Global Asset Management 2019 report that came out at the end of July, and 2Q19 hedge fund industry sizing data from BarclayHedge. At the same time, I try to get into the specifics of what building an investment case might look like for some of the traditional managers, in a way that’s reasonable while remaining true to their strategy.
Ultimately, investment managers compete for allocations against their peers, and if, as I believe, there are opportunities to generate outsized risk-adjusted returns for their allocators, competitive dynamics will force entry sooner, rather than later, with some strategies leading the charge. The final piece of the article maps out how this might look assuming they would want to limit their market impact, and the results surprised me despite my conservatism throughout the modeling exercise, so please read this one through until the end!
Hedge Funds: Macro / Emerging Markets (~$500B AUM)
I’ve put this category of strategies first given how it’s the easiest framework through which many traditional investors who are now cryptocurrency pioneers have arrived at understanding the unique value proposition of Bitcoin and subsequent projects. Whether it’s Dan Moorehead of Pantera (which used to be a pure macro fund) the former head of macro trading at Tiger Management, or Mike Novogratz of Galaxy Digital (former co-CIO of Fortress’ Macro Fund), the fact pattern clearly suggests there are fundamental reasons for why those who specialize in understanding economic cycles, global geopolitical power dynamics including monetary policy end up discovering the appeal of Satoshi’s white paper.
More specifically, macro managers tend to be especially focused on factors that include interest rate variation, political election dynamics, import/export trends and resulting trade balance effects, and FX exposure. Against that backdrop, it’s no wonder there are already those who ascribe some value to a super-national, politically-immune, fixed-supply asset class, especially as many macro managers already have day-to-day familiarity with the volatility and return characteristics of gold and the related exploration and mining industries. The urgency is likely to only increase in the near-term given the ramping rhetoric between China and the US, most recently with the talk of restricting US investment in Chinese companies, as an example. Thus, Bitcoin and cryptocurrencies in general are likely a good fit here, at least initially, compared to other strategies.
Hedge Funds: Multi-Strat / Market Neutral (~$400B)
Often lumped together, multistrategy and market-neutral hedge funds typically employ a wide array of diverse strategies that work together (along with fund-level leverage, also known as gearing), to deliver superior risk-adjusted returns, typically of the absolute return variety, meaning independent of market conditions. This may include sub-strategies that diversify across equity, debt, interest rate, or currency markets, yet not with any strong-enough concentration that the overall fund falls into any one of the larger buckets.
One specific function that multi-strategy and market neutral funds pride themselves on is extremely focused risk-management. Many of the largest hedge funds that exercise these strategies have invested tens or hundreds of millions of dollars since inception into proprietary factor-based risk models, data analytics, and other middle/back office support systems to specifically isolate idiosyncratic (alpha) generation opportunities, which then are able to be magnified through the use of leverage. We’ll get back to this point later, but on average, these funds have been known to run in the ~3–5x gross leverage range, when compared to the ~1.5–2.0x leverage of the more traditional and broader hedge fund universe. It is precisely this focus on risk management best practices that I believe enable these hedge fund strategies to take a closer look at where bitcoin and other digital assets may fit, as both I and others who write in the space have already covered the historic lack of long-term correlation between bitcoin and traditional asset classes (while being a source of alpha, unlike cash and equivalent balances), suggesting there should be future appetite for some inclusion into at least the hedging functions of these types of strategies.
At the same time, these are often the types of hedge funds who have the greatest flexibility to test out new strategies with a smaller segregated pool of capital (depending on how the master fund and feeders are set up). Hypothetically, it would not be very difficult for some of these investment managers to set up a beachhead by deploying a few $M of capital via side pocket or SPV structures to learn the ropes while also potentially improving risk-adjusted returns over the medium term (volatility can be controlled by appropriate sizing). The decision should continue to get easier over time as the ways to get involved improve in capacity and quality (applies to all the strategies listed here).
Hedge Funds: Quantitative Strategies (~$1T, overlaps w/ others)
Lastly from the hedge fund side of things, we have quantitative funds, also called systematic, or algorithmic investment strategies, at about $1T of AUM, which comprise about ~1/3 of the total Hedge Fund universe, itself a subset of the ~$12T bucket of “alternatives” universe that also includes private equity, real estate, and infrastructure funds.
Simplistically, quantitative models can vary dramatically in how they use data, statistical analysis, or machine learning algorithms (whether classifiers or for regression analysis) to tease out signals (sources of alpha). Quantitative strategies can be trend-following, counter-trend, or arbitrage-driven (of which there are many kinds). Overall, quantitative strategies, because they’re automated and more data-driven than discretionary strategies, have been a good fit for the world of crypto, at least within the context of emerging managers that focus just on digital assets. Although not fully updated for the latest quarter on a constituent-level basis, Crypto Fund-of-Fund Vision Hill’s 1Q19 report shows that more recent launches have tended to be quantitative strategies on a quarter-over-quarter basis from prior periods referenced in the report.
This make sense, especially as the glut of on-chain data is being wrangled by open-source websites, crypto-fund internal analyses, and third-party data services companies that have cropped up to offer everything from Twitter-based sentiment analysis to those selling aggregated historical price and volume frameworks stitched together from cleaning up the more dubious venues that do not report accurate trade-level data. Anecdotally, I believe some of the major quant players from the legacy financial world that specialize in this style of investing have already begun small-scale exploratory efforts or have investors that are personally looking at / investing in digital assets.
Before moving on, a vital caveat between the above Hedge Fund sections and the mutual fund (long-only / “vanillas” below): given hedge funds typically are flexible in their mandate to both take long and short positions, it’s overly optimistic to view incremental hedge fund participation in crypto as purely positive for valuation, since there are still plenty of overpriced assets along with underpriced assets, though it’s probably to be fair in thinking there would ultimately be net positive inflows compared to outflows, while liquidity should directly benefit. This reality is properly reflected and accounted for in the modeling exercise later.
Mutual Funds: Active Core Strategies (~$24T),
As you might have noticed, the mutual fund space (totaling $74T in global AUM or ~1/4 of global total wealth of ~$300T), dwarves the sum-total of hedge funds by several orders of magnitude, even taking into account that two classes of active mutual funds that we are looking at in this exercise don’t include some of more specialized strategies such as target-dated funds. These strategies are those that have long-time horizons, write large checkbooks and often stay with thesis-driven investments for years, if not decades (albeit with some rebalancing to stay at their desired sizing relative to market indices that they compare performance against).
There’s potentially two bites at the apple for long-only managers to take a look at digital assets, firstly in the context of potentially adding some flexibility and yield to the ~5% cash balance that most funds typically keep for day-to-day transactions and share redemptions (especially with stable-coin and other lending solutions helping bridge the cash-rich traditional world and the cash-strapped crypto world where stable-coin yields for depositors are currently ~8–9% per year despite being third-party custodied and fully insured). Secondly, and perhaps more importantly, there’s still room for the same fundamental thesis-driven price discovery for bitcoin and others to gain mindshare and result in net incremental buying demand (the whole “moving off of zero” idea).
Lastly, mutual funds contend not only with high net worth individuals, but also more directly manage the bulk of pensions, endowments, and 401(k)s of average people, and are ultimately beholden to these allocators. If what we’ve seen with a few early moves by endowments and pension funds is representative of early adoption, then it’s likely these active long-only strategies will in the future incorporate some element of exposure as client demand rises.
Mutual Funds: Passive, Non-ETF (~$14T)
In addition to the actively managed mutual funds, there are still roughly ~$14T of passive equity and fixed income products, including index funds. Indices and ETFs are both forms of passive investing, though ETFs are more retail friendly in some respects since they can be traded like stocks by individual investors, while the index-fund products are typically lower-cost and selected for as part of a 401(k) allocation, for example. While they’re not going to be the first to act (again, excluding the prospect of a BTC ETF), there’s still potential for passive strategies to eventual result in true index-fund products that mirror some of the large-cap cryptocurrency indices and see some allocation in a steady-state where digital assets comprise a meaningful share of wealth.
The Math: A Narrow Bridge to Get on Noah’s Ark
I’m going to be completely honest here — I didn’t expect to find results that were as positive for the long-term from a flow analysis perspective, though of course the onus is still on the technology to prove itself as a valuable sector for allocators to seek incremental exposure to. The base case analysis (outputs below) is fairly innocuous, namely taking the target markets identified above and inputting very baseline estimates (all 1% or below allocation) as an end-state, while also incorporating some simple gross leverage and net exposure (for those funds that can go short and also long) to estimate the gross market impact of a fully-allocated strategy. Given it’s unlikely that any new institutional investors want to dramatically impact price as they enter into the nascent market, I make some assumptions about the maximum percent of daily BTC volume they’re willing to be, and then estimate how many trading days it would take for this cohort of new institutional money to reach their allocation (marking an end to the tailwind from a price perspective).
What’s shocking to me, given my own institutional investing background and guessing most would like to stay under 10% of volume to minimize slippage on price, is that it’d still take between 3–33 years to get “fully sized” to the $110B area (in present day dollars), with my base assumptions. Lastly, I sensitize the results by flexing the allocation in basis points per the second table below, which widens the range a bit to ~1.4 years to as long as 51 years. My main conclusion is that even for traditional institutional investors who are likely well on their way in terms of the diligence process, a much greater urgency could manifest once competitors start getting in (especially as fully compliant on-ramps are continuing to come online for both spot and derivative markets), thus driving the potential for upside surprise from a market-clearing price perspective. Some assumptions that could offset this would include greater selling pressure over time (through the synthetic credit markets like cash-settled options), or just greater two-way volumes in general, as well as the simplifying assumption that I’ve made where early allocations in the space would go largely to BTC in the name of conservatism. Again, this is simply a matter of math — and makes the assumption (still tenuous) that institutions will see the appeal of the tech.
Bull Case: Adding in Family Offices, Sovereign Wealth, and Central Bank Demand
Finally, I augmented the above analysis with a realistic upside case (still specifically excludes any additional retail-driven FOMO that may be reflected in a brokerage-friendly ETF approval) by including the potential for some of the ~$5.9T of global family office wealth who haven’t yet allocated to crypto to start doing so, at the same time that sovereign wealth investors (who tend to also be more aware of macro and are likely following the space) and central bank decision-makers finally acquiesce and decide to acquire some bitcoin. When added to the base-case, this pushes out the time to buy (in the 1–10% of volume band) to 7.5–83 years assuming base allocation, which would actually give credence to the optimists who have talked about the multi-decade generational tailwind from adoption and development of this technology.
One last point I’d make is — ultimately I do not believe those who have made the decision to invest would necessarily follow this route, and may actually seek to more quickly put their funds to work either with greater urgency, or via adjacencies beyond just buying bitcoin (this could include direct investment in mining infrastructure, power generation, services, etc.) — at the same time, this scenario paints a pretty amazing picture of what the future could look like if the scaling, safety, and decentralization trilemma can be solved adequately and in-time.
Conclusion: Don’t Wait to Beat the Rush
With all the caveats mentioned already taken into account, the analysis above makes me incrementally more comfortable about the market dynamics supporting the potential for longer-term price appreciation through the combination of bitcoin supply scarcity but also actual trading / liquidity constraints that exist in actual markets. Nevertheless, I fully acknowledge that the real fight remains in the arenas outlined in the first half of this report, namely that of convincing existing institutional managers, and the allocators that they ultimately report to, to do the heavy lift of diligencing this new and emergent asset class that we call digital assets. However, since the math clearly shows that the early bird will get the worm (and a much lower cost basis than competitors), the question to them should be: why delay the inevitable?