In the last few years, traditional hedge funds have begun dipping their toes into the cryptocurrency waters. However, they are mostly taking a conservative approach by making small-scale investments. The cryptocurrency market became increasingly popular when coins like Bitcoin shot significantly in value, turning some of the earlier investors into overnight millionaires.
In the first half of 2021, Bitcoin prices shot to an all-time high of over $64,000. Although this did not last past summer ’21, many traditional investment firms such as hedge funds had to reconsider their position on digital currency because it was clear that they were here to stay. The potential was also apparent.
Last year, PWC partnered with Elwood Asset Management and Alternative Investment Management Association to survey what traditional hedge funds intend to do about cryptos. They estimated that in 2021, cryptocurrency hedge funds worldwide had approximately $3.8 billion in assets under their management. This was an increase from $2 billion in 2019.
The decline of cryptocurrency
According to the survey by Price Waterhouse Cooper and its partners, the most traded cryptos by hedge funds were Bitcoin, Ethereum, Litecoin, Chainlink, and Polkadot. The percentages being 92%, 67%, 34%, 30% and 28% respectively. Short-selling in cryptos has dropped significantly from 48% to 28% in 2021. Currently, about half of all cryptocurrency hedge funds are trading in derivatives.
Although the price of major virtual assets had surged significantly in the first half of 2021, it was followed by a massive plummet. In November, prices stabilized slightly, but the market lost about $1 trillion in value in January 2022. Part of the loss was recovered in March when the prices rose again, but unfortunately, this was not long-lasting either.
The market crashed again, and this time, Bitcoin lost 60% of its value from the $64,000 all-time high in 2021. The other cryptos were hit harder, with the small-cap coins experiencing devastating losses. It is clear to every skilled trader that the crypto market is currently bearish, and these accelerating declines are not about to take a complete turn overnight.
Endorsements from tech moguls like Elon Musk don’t seem to improve the fortunes of crypto. Although there have been worse resets, like in 2018 when Bitcoin lost 80% of its value, the situation is different this time. Back then, plummeting prices did not have a vast effect as they do now that more institutions and people hold virtual currencies.
Many people flooded into this market during the pandemic, including hedge funds, some utilizing debts to increase their crypto stakes further. Early investors are mainly in a more comfortable position despite the steady and rapid decline in the past few months. However, hedge funds that bought into virtual currency when the values surged last year are increasingly vulnerable.
Is the decline in the crypto market equal to the stock market?
The crypto crash is part of a more significant pullback from risky assets experienced throughout the financial markets. It has been triggered by inflation, increasing interest rates, and economic uncertainty resulting from Russia’s invasion of Ukraine. All these factors feed into a sort of pandemic hangover since they began just as life started to go back to normal.
Companies like Netflix and Zoom, whose stocks thrived during the pandemic, have been negatively impacted. Still, although the stock market is also experiencing these plunges, the decline of the crypto market is more severe. So far, by May 2022, there has been a 16% decline in the S&P 500. During this same period, the crypto market plunged by about 50%.
The crypto hedge funds have devised strategies to gain excellent returns from the market. However, end-of-year 2021 data by HFR indicated that virtual asset managers bypassed all the other hedge fund strategies. It is essential to acknowledge that it is tough to have a profitable strategy for a market as volatile as cryptos.
Unless the hedge fund has a team of people that really know how to work with the derivatives, it is difficult for the firm to have a working strategy. Correlations in the market are significantly complex compared to the bond or equities markets. So, you need advanced knowledge of hedging and correlation to run your crypto hedge fund successfully.
The hedge fund has to look into inexplicable underperforming sections of the crypto market constantly. They also have to crunch massive amounts of data, which can be labor and capital-intensive.
Because the cryptocurrency market is a 24/7 market, it presents many opportunities for systematic funds. However, this model can be challenging for the investment funds since they are typically accustomed to trading with traditional hedge fund strategies such as macro, short/long equity, and CTAs. Crypto hedge funds need to adopt a different mindset since this market has no open or close. Additionally, they must acknowledge that the market is very different and very hard to trade for most.