Crypto currencies, such as Bitcoin and Ethereum, have emerged as a popular alternative asset class investment for hedge fund managers in recent years. While there are certainly opportunities in investing in crypto currencies, there are also some potential pitfalls that hedge fund managers need to be aware of. These have been further dramatized with the increase market volatility, rising interest rates, and regulatory tightening. This will cover some of the considerations as fund managers evaluate cryptocurrencies as an alternative investment class.
The recent interest rate hikes have impacted the relative attractiveness of cryptocurrencies as an alternative investment for hedge fund managers.
Firstly, on the positive side, higher interest rates can lead to increased inflation and a devaluation of traditional currencies, which can make crypto currencies a more attractive investment option for those looking to diversify their portfolios and protect against inflation. This has been a contributing factor to the recent surge in interest and investment in crypto currencies. However, on the negative side, rising interest rates can also increase the cost of borrowing and reduce liquidity in the markets, which could make it more difficult for hedge funds to access capital to invest in crypto currencies. Additionally, higher interest rates can also increase the opportunity cost of investing in riskier assets like crypto currencies, as investors may be more inclined to opt for safer investments that offer a more predictable return.
High potential returns is a key reason for hedge funds to pursue crypto currency allocations. Cryptocurrencies are known for their high volatility and potential for large gains, making them an attractive investment opportunity for hedge fund managers. For example, in 2017, the Crypto Fund, a hedge fund focused on investing in crypto currencies, generated a return of over 2,700%, driven by the surge in the price of Bitcoin and other digital assets. Similarly, the Pantera Bitcoin Fund, which launched in 2013, has reported an average annual return of over 100% since its inception. More recently, Paul Tudor Jones, a well-known hedge fund manager, has been vocal about his investment in Bitcoin as a hedge against inflation.
Cryptocurrencies play an important role in diversification. Cryptocurrencies offer hedge funds a new asset class to diversify their portfolios beyond traditional investments such as stocks, bonds, and real estate. Cryptocurrencies can also provide exposure to new and emerging technologies, such as blockchain, which have the potential to transform industries and create new investment opportunities. This can be particularly valuable for hedge funds looking to stay ahead of the curve and identify new sources of alpha.
While those are some of the oft-cited reasons for investors, it is important to weigh those with some of the pronounced issues in crypto currency allocations.
The volatility of crypto currencies can lead to significant losses if investments are not properly managed, as we saw with the steep drops in Bitcoin prices in 2018 and 2021. Despite the risks and regulatory uncertainty, the crypto market has continued to show resilience and resurgence in recent months, driven in part by the increasing interest rates and market volatility. As traditional investments like stocks and bonds have become more volatile and uncertain, investors have looked to alternative assets like crypto currencies as a way to diversify their portfolios and potentially generate higher returns.
Crypto currencies still have an element of regulatory risks. The regulatory environment surrounding crypto currencies is still evolving, and regulatory changes could significantly impact the value of these assets. Regulation of crypto currencies is also evolving rapidly, with many countries around the world exploring new rules and regulations to govern the use and trading of digital assets. While regulatory changes can be disruptive to the market in the short term, they may ultimately provide more stability and legitimacy to the industry, which could benefit investors over the long term.
Cybersecurity and fraud risks still abound. The digital nature of crypto currencies makes them vulnerable to cyber attacks, which could lead to losses for hedge funds and their investors. The recent bankruptcy of the FTX exchange highlights these risks through a combination of exchange hacks, fraud, and operational risks. However, it’s worth noting that the bankruptcy was caused by a specific set of circumstances related to leveraged trading and the liquidation of positions, and does not necessarily reflect on the broader health of the crypto market or the potential for investment opportunities.
Overall, hedge fund managers need to carefully consider the risks and potential rewards of investing in crypto currencies, and be prepared to manage these investments actively to mitigate risk and maximize returns.
