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Cryptocurrency hedge funds: Managing the risks of investing in this highly volatile asset class

The Eurekahedge Cryptocurrency Hedge Fund Index was up 238.40% over the first eight months of 2021, outperforming Bitcoin which returned 163.35% over the same period. In 2020, cryptocurrencies were undoubtedly the best-performing asset class in the market, with Bitcoin posting a 300.17% return during the year. Bitcoin unexpectedly benefitted from the ongoing COVID-19 crisis as investors perceived the coin as an alternative safe-haven asset during market uncertainties. As a result, the market value of Bitcoin increased by more than 600% from its March 2020 low to the end of August 2021. In the same year, the scarce supply of Bitcoin was also at play with its strong performance as its third halving takes place in May which cut the reward in half for mining the said digital asset. On the other hand, the US dollar - its fiat counterpart, had its value decline throughout the year, driven by the accommodative monetary policy of the Federal Reserve and massive fiscal stimulus by the US government, which exponentially increased the money supply circulating in their economy in a short period. In addition, growing support from institutional investors was also a key contributor to the meteoric rise in its price. As evidenced, the recently launched Bitcoin ETF breaks a record as the second highly traded ETF on its debut in history. In the same vein, the increasing institutional adoption of decentralised finance (DEFI) and the rising demand for non-fungible tokens (NFT) has been the primary driver of the gravity-defying performance of Ethereum. The second-largest digital currency recorded an accumulated return of 2,318.57% from the start of 2019 to August 2021, compared to 1,115.68% of Bitcoin.

Figure 1 below illustrates the performance of the cryptocurrency hedge fund managers since the end of 2017 compared to Bitcoin and Ethereum, the leading cryptocurrencies in the market. In addition to the comparison, we also added a passive portfolio with a composition of 80% invested into Bitcoin and 20% into Ethereum.

Figure 1: Performance of Eurekahedge Cryptocurrency Hedge Fund Index vs. comparable benchmarks


The figure above shows that the Eurekahedge Cryptocurrency Hedge Fund Index generated an annualised return of 25.96% since end-2017, compared to the 39.51% and 49.77% annualised return of Bitcoin and Ethereum. For additional comparison, a passive portfolio that has a composition of 80% invested into Bitcoin and 20% into Ethereum also generated a superior annualised return of 48.38% over the same period. In recent years, the underperformance of cryptocurrency hedge funds was driven by the diversification applied into their portfolio to minimize the level of risk as also seen in Figure 3, in which they exhibit lower annualised volatilities compared to their benchmarks. Table 1: Performance in numbers: Cryptocurrency hedge funds vs comparable benchmarks

Table 1: Performance in numbers: Cryptocurrency hedge funds vs comparable benchmarks
Eurekahedge Crypto-Currency Hedge Fund Index
Bitcoin (BTC)
Ethereum (ETH)
BTC 80% + ETH 20%

2018

28.19%

27.89%

18.18%

27.74%

2019

115.56%

187.59%

99.00%

167.63%

2020

300.17%

396.74%

564.90%

437.45%

2021 YTD

238.40%

163.35%

432.49%

208.91%

3Y Annualised Return

69.14%

88.52%

125.70%

102.16%

3Y Annualised Standard Deviation

58.34%

81.99%

104.87%

81.72%

3Y Sharpe Ratio (RF = 2%)

1.15

1.06

1.18

1.23


Source: Eurekahedge

Table 1 provides the detailed risk return statistics of the four indices shown in the figure above. Key takeaways include:
  1. During the 2018 bear market crash in the cryptocurrency market, digital asset hedge fund managers outperformed their comparable benchmarks by returning 28.19%, while Bitcoin and Ethereum posted returns of 27.89% and 18.18% respectively.
  2. In terms of annualised volatilities, cryptocurrency hedge funds recorded the smallest 3-year annualised standard deviation of 58.34% compared to the 81.99% and 104.87% of Bitcoin and Ethereum respectively. In terms of risk-adjusted return, digital asset hedge fund managers also outperformed Bitcoin, posting a Sharpe ratio of 1.15 compared to the 1.06 Sharpe ratio of Bitcoin. However, digital asset hedge fund managers underperformed against Ethereum and the passive portfolio as they posted slightly higher 3Y Sharpe ratios of 1.18 and 1.23 respectively.

Table 2: Correlation matrix

 

EH Crypto-Currency Hedge Fund Index

Bitcoin (BTC)

Ethereum (ETH)

BTC 80% + ETH 20%

EH Crypto-Currency Hedge Fund Index

1

0.82

0.83

0.87

Bitcoin (BTC)

 

1

0.69

0.98

Ethereum (ETH)

 

 

1

0.82

BTC 80% + ETH 20%

 

 

 

1

Source: Eurekahedge

Table 2 shows the correlation matrix of the Eurekahedge Cryptocurrency Hedge Fund Index and other comparable benchmarks. Cryptocurrency hedge fund managers displayed similar correlations against Bitcoin and Ethereum of 0.82 and 0.83 respectively.

Against the BTC 80% + ETH 20% passive portfolio, cryptocurrency hedge fund managers displayed a higher correlation of 0.87. This could be due to the fact that the more diversified nature of the passive portfolio is more closely aligned to the portfolios of cryptocurrency hedge funds, which contain a variety of cryptocurrencies rather than just Bitcoin or Ethereum alone.

Figure 2: 12-month rolling alpha of cryptocurrency hedge funds against Bitcoin and Ethereum
Figure 2 shows the 12-month rolling alpha of cryptocurrency hedge funds against Bitcoin and Ethereum since 2018. Digital asset managers started the year of 2018 on an excellent note, posting the highest positive Alphas during the investment horizon of 25.22% against Ethereum and 9.73% against Bitcoin. In the same vein, hedge funds also posted positive Alphas in the latter half of 2020. It is worth noting that cryptocurrency hedge fund managers usually outperform their benchmarks during bear markets when Bitcoin decline in value by at least 50%. On the other hand, they exhibited negative Alphas during market bull runs, such as in 2019 when Bitcoin gained 87.59%.


Figure 3: 12-month rolling annualised volatilities of cryptocurrency hedge funds and other benchmarks


Figure 3 shows the 12-month rolling annualised volatilities of cryptocurrency hedge funds and the two leading cryptocurrencies Bitcoin and Ethereum. Digital asset hedge fund managers consistently posted the lowest 12-month annualised volatilities, except for 2018 when Bitcoin outperformed the group by a small margin. The chart above demonstrates the ability of cryptocurrency hedge funds to minimise the level of risk for their investors, despite the unparalleled volatilities in the crypto space.

Figure 4: Quarterly outperformance of cryptocurrency hedge funds vs performance of Bitcoin


The chart above shows the quarterly outperformance of cryptocurrency hedge funds against the performance of Bitcoin. Similar to the previous charts, it shows that majority of the cryptocurrency hedge fund managers usually outperform Bitcoin when it is down, as seen in the first, second, and fourth quarter of 2018, the second half of 2019, and the second quarter of 2021. On the other hand, most cryptocurrency hedge funds underperformed the benchmark during a period of strong market performance. As evidenced in Q2 2019 and Q4 2020 when Bitcoin gained 194.62% and 167.26% respectively, around 95% of cryptocurrency hedge funds recorded smaller gains against the said virtual currency.

Despite the astonishing performance of cryptocurrencies in the recent period, the crypto space is still in its early stage of development as institutions are just beginning to adopt blockchain technology in their operations. Some financial institutions started to adopt smart contracts for their financial transactions which reduce the need for financial intermediaries and improve efficiencies. The growing application of blockchain technology by institutions is the driving force for the growth of the crypto space. On the hedge fund side, the higher volatility of cryptocurrencies remains the primary challenge for hedge fund managers. Having said that, the wider adoption of blockchain technology by institutions and governments bode well for the growth of the cryptocurrency mandate in the hedge fund industry and is expected to present exciting opportunities for crypto enthusiasts looking to be handsomely rewarded for their willingness to tolerate the high risks that come with investing in this asset class.