What Is a Crypto Hedge Fund — and Is It Safe?

In late June 2022, one of the biggest crypto hedge fund managers, Three Arrows Capital (3AC), fell into the arms of liquidators. The firm, whose fund products had significant exposure to Bitcoin (BTC) and other cryptocurrencies, became one of the most prominent victims of the ongoing crypto market slump.

3AC’s failure has brought the concept of currency-based hedge funds to the fore of investment folk’s attention. The fund’s failure has highlighted the issues of risk and safety when using this type of investment vehicle. In this article, we’ll cover the topic of cryptocurrency hedge funds and discuss the risks, pros and cons, and regulations involved in using these products.

What Does “Hedge Fund” Mean?

A hedge fund is a financial vehicle in which money from multiple individual and institutional investors is pooled and invested in a variety of assets — stocks, bonds, commodities, foreign currencies, cryptocurrencies, derivatives and more – with the goal of maximizing returns. The pooled funds are managed by professional fund managers at the investment firm which offers the product.

Originally, hedge funds were focused on managing investments to hedge against market risks, hence the name. However, over the years, these funds have grown increasingly more aggressive, with high-risk/high-return strategies favored by fund managers. Today, hedge funds are characterized by a higher risk profile than the other popular types of funds — mutual funds and index funds.

What Is a Crypto Hedge Fund?

As you might have guessed, a crypto hedge fund is a type of hedge fund that invests in cryptocurrencies and crypto-based products. Some of these funds may invest exclusively in crypto and digital assets, while others combine cryptocurrency investments with traditional asset types — stocks, commodities, derivatives and more.

In 2021, there were approximately 300 crypto hedge funds, with the total assets under management (AuM) averaging $56.8 million, more than double the AuM in the past year, which reached around $23.4 million.

Source: Pwc.com

Compared to traditional hedge funds, crypto hedge funds might be subject to somewhat less regulation, depending upon the composition of the overall investment portfolio, as detailed in the regulations section further in this article.

How Do Crypto Hedge Funds Work?

Crypto hedge funds invest in a variety of cryptocurrencies, crypto-based derivative products, blockchain ventures, and other assets related to the crypto/blockchain industry to maximize investor returns. For example, one of the largest crypto hedge funds, Pantera Capital, balances its investment in its Blockchain Fund between:

1. promising new tokens with the potential to become rising stars like BIT

2. established tokens, such as BTC, ETH, SOL, UNI and more

3. venture equity in leading industry projects, such as Balancer, Alchemy, Blockfolio and others.

Source: PanteraCapital.com

Crypto hedge funds typically charge a management fee of between 1% and 3% of your investment. In addition to the management fee, there is nearly always a performance fee payable as a share of the positive return generated from your investment. This fee may vary from 10% to as high as 40% of the return on investment.

For example, let’s say your initial investment in the fund is $1 million and the performance fee was set at 20%. After a year, your investment has grown to $1.5 million, a return of $500,000. Under this scenario, the fund manager will charge 20% of that $500,000 (that is, $100,000) as the performance fee.

Participation in crypto hedge funds typically requires a substantial minimum investment. Pantera’s Blockchain Fund mentioned above, for instance, has a $1 million minimum investment requirement. This isn’t an unusual amount for a hedge fund. However, there are some funds for which the minimum investment could be as low as $100,000.

Crypto Hedge Fund Regulations

The Three Arrows Capital (3AC) debacle shone the spotlight on cryptocurrency regulation, including issues related to the operations of crypto hedge funds. Tighter regulation of crypto had already been an ongoing development in the U.S. and other jurisdictions before the 3AC failure. The firm’s high-profile collapse will likely expedite the introduction of additional regulatory measures, with crypto hedge funds being among the primary targets of this new government tough love.

At the moment, crypto hedge funds that invest exclusively in cryptocurrencies don’t have to register with the Securities and Exchange Commission (SEC). This is because the SEC has yet to officially recognize crypto as a security. This could change — and rather abruptly — given the SEC’s incessant stream of opinion pieces and announcements hinting at bringing crypto under the umbrella of security-related products.

However, if the crypto hedge fund has a diversified portfolio that includes stocks and other highly regulated assets in addition to crypto, then SEC registration of the fund might be required — unless the fund has less than $150 million under its management, in which case it would qualify for an exemption from SEC registration.

Additionally, if the fund plans to invest in complex derivative crypto products, such as leveraged assets or Bitcoin futures, it would have to register with the CFTC (Commodity Futures Trading Commission), the primary regulator of futures-based financial products in the U.S.

Pros and Cons of Crypto Hedge Funds

Crypto hedge funds offer several advantages for investors. Naturally, along with the benefits of investing in these funds, there are some drawbacks and/or risks to watch out for.

Pros

The key advantages of crypto hedge fund investing are:

• Asset management by highly skilled professional fund managers. This is particularly important in the world of crypto, where inexperienced investors may fall victim to scams and rug pulls the industry is awash with.
• Higher potential returns, thanks to the high risk/high return strategies typically employed by these funds.
• Diversification away from over-reliance on traditional hedge funds.

Cons

The key disadvantages of crypto hedge funds include:

• Potentially high performance fees. In some cases, the fees charged by the funds can be as high as half of the generated return.
• Limited access for individuals who aren’t high-net-worth.
• In general, the risky nature of both the crypto market and hedge fund investing.

Top Crypto Hedge Funds

Among the hundreds of funds that invest in crypto assets, some stand out as the main market movers and shakers. The most notable among these funds include Pantera Capital, Multicoin Capital and Andreessen Horowitz.

Pantera Capital is considered by some observers to be the largest crypto hedge fund manager. It launched the first-ever crypto fund in the U.S. back in 2013. The firm’s Blockchain Fund (described above) is the main vehicle used by Pantera Capital to invest in cryptocurrency and blockchain assets. The fund started in June 2021 with an investment target of $600 million, to be allocated to promising tokens and projects. By now, the fund has grown to $1.3 billion, a mammoth amount by the standards of the crypto hedge fund industry.

Texas-based Multicoin Capital is another high-profile hedge fund manager. The firm invests exclusively in crypto, blockchain, decentralized finance, and Web 3.0 projects and assets. The total amount of assets under management (AuM) of this industry giant is close to $9 billion.

One of the world’s largest technology investors, Andreessen Horowitz is among the most recognizable names in the hedge fund industry. The firm runs a number of crypto funds and venture capital investment vehicles. The company’s largest fund solely dedicated to crypto is estimated at a staggering $4.5 billion.

How to Start a Crypto Hedge Fund

Starting a crypto hedge fund in the U.S. requires following a number of steps to ensure that you don’t end up on the wrong side of the law. Fund managers who plan to invest only in crypto coins, and who won’t have more than $150 million under their management, don’t need to register with either the SEC or the CFTC.

Managing more than $150 million — or combining crypto investments with securities — triggers a requirement for registration with the SEC. Meanwhile, a CFTC registration is mandatory for investments in crypto futures, other derivatives and leveraged products.

Additionally, the fund manager will need to check with the relevant state-level authorities concerning any local registration, approval or permits.

Closing Thoughts

Crypto hedge funds might be a great way to invest because of their potential for astoundingly high returns. However, high returns inevitably come with high risks. In particular, the inherent risks involved in crypto hedge funds must always be kept in mind. Don’tt forget that these funds combine two highly risky investment forms — cryptocurrencies and hedge funds.

If you don’t mind this combustible mix, you may find crypto hedge fund investing to be a rewarding endeavor — at least when your assets are overseen by a skilled fund manager.