Identifying meaningful investment opportunities in the crypto space is getting more challenging. With over 200 hedge funds dedicated to crypto investment, how do you know who will be a trustworthy steward, and who is just looking to make a quick buck on the hype?
At BitBull Capital, we have developed the following diligence and vetting process for singling out the true top-tier crypto hedge funds, and their managers.
The first challenge lies in compiling a list of funds you may be interested in. You can’t pick an MVP if you don’t even know who’s in the game, right?
While there are a handful of databases out there offering to provide names and contact details for crypto hedge funds, they often charge a significant fee for this information, and there is no guarantee their information is up to date, or accurate.
A quick Google search will reveal some well-known funds, but being well-known doesn’t necessarily ensure excellent performance. Additionally, some of the top, more exclusive funds in the industry are prohibited from advertising, due to the private nature of their offerings.
As in many industries, the best way to learn of stand-out opportunities is still word of mouth. Having a network of informed, connected professionals that you can comb for leads is more valuable than any single source available. In a pool of 200 funds, it’s not difficult to find out who is making waves; provided your network is strong. Limiting your list to funds that come highly recommended from reputable experts in the space will also simplify the vetting process.
With your network thoroughly scraped, and your list of funds in hand, it’s time to start scratching names off. If you are looking for a single investment, start by narrowing your search to strategies that appeal to your risk appetite. Gone are the days of an index fund being your only option as today’s market offers a wide variety of strategies, from early-stage and venture capital style investment, to pure quantitative and arbitrage.
There are pros and cons to each strategy, and some funds offer a mixed-strategy that incorporates several different approaches. Identifying the approach that aligns with your investing ethos can help thin the list of eligible funds and allow you to compare apples to apples.
Roll up your sleeves – it’s time to get down to the nitty gritty details. When you initiate contact with a new fund, always ask for a slide deck. Many funds rely on this type of document for the bulk of their marketing efforts, and it is usually a comprehensive overview of who they are and what they do. A thorough review of this document could potentially save you a lot of time enduring sales pitches for funds that don’t suit you.
Provided everything checks out in the slide deck, it’s time to move on to the interview. Below is a list of factors you want to keep in mind, and questions you’ll want answered:
Question: “Have you done this before? If so, how well?”
In addition to obvious traits such as integrity and a strong reputation, look for managers that have a proven track record of success in whatever strategy you’ve selected. If it’s fundamental, long-only investing, then look for a manager who has proven they can pick winners. If it’s quantitative, statistics-driven trading, then a history of successful algorithm development and model building is crucial.
Many of the top managers in the industry come from traditional finance backgrounds. Do your research on their past ventures, and don’t hesitate to ask questions if their track-record shows any misgivings.
Question: “What steps have you taken to mitigate the risk of loss or theft?”
With exchange hacks and code vulnerabilities being exploited with increasing frequency, you want to make sure the team handling your investment is implementing security best practices. Look for measures like cold storage, air-gapping, multi-signature authentication, geographic redundancy, and so on.
Some strategies – such as arbitrage – require a greater amount of counterparty risk since funds must be held on an exchange to execute trades efficiently. In such cases, a common practice is to limit the total amount held on any one exchange to 10% of holdings. If a significant portion of holdings are being housed in one place – and that one place isn’t well protected, and strictly within the manager’s control – that should be a massive red flag.
Question: “What edge do you bring to your strategy that your competitors lack?”
Having the best strategy in the industry doesn’t mean much if you fail to execute. When comparing like-funds, make sure you are taking note of the variations that differentiate each fund.
For example, if one arbitrage fund is relying on a single trader who is manually identifying opportunities and executing trades during his waking hours, while the competition has built out fully automated models that identify opportunities and execute trades via exchange API’s, which fund do you think will be able to exploit market inefficiencies more often?
If one fundamental, long-only fund is relying on the “intuition” of its found in selecting investments, while the next fund employs a team of dedicated researchers and analysts to pour over whitepapers and explore use cases, who do you think will be able to identify the game-changing projects with greater accuracy?
Performance and AUM
Questions: “What is your current AUM? How many LP’s are currently invested?”
Scale can both help and hinder hedge funds; it’s good to get a sense of the size of the fund you’re evaluating. With the increasing number of venture capital firms and funds of funds in the space, we’ve found some crypto hedge funds have institutional backing before they ever reach the public eye.
Question: “What percentage of your AUM is external capital?”
Unless you are interested in being a seed investor, look for funds with multi-million dollars in assets under management. If the manager has only been playing with their own portfolio up until now, there should be significant evidence that the strategy can be scaled before you consider allocating.
Question: “What have been your best and worst months so far, and what led to each?”
Performance should be contrasted against funds using a similar strategy under the same market conditions. Again, don’t be afraid to ask questions; sometimes the circumstances surrounding an outstanding month of performance can be just as telling as those underlying a bad month. Use the performance information to add color to the manager’s decision-making process.
Terms and Conditions
Alright, so the manager is solid, they’re implementing top grade security practices, and they’re absolutely crushing their strategy execution. Performance has been off the charts, with household name venture capital firms clamoring to get in. Just tell you where to sign, right?
Not so fast. The terms of the offering can often make or break the deal. The following list of questions – and why they’re important – will help you navigate the intricacies of the offering and could potentially save you significant loss.
Question: “What is your fee structure and schedule?”
While the 2%/20% traditional investment fee structure is also common in the world of crypto hedge funds, there are a variety of other structures being implemented as well. Graduating performance fees above a certain threshold or fees based on the outperformance of Bitcoin aren’t unheard of. Also, do not assume that the performance fee is annual. Quarterly – or even monthly – fees have been known to crop up, which can significantly impact your net returns.
Question: “At what allocation threshold do the fees become negotiable?”
If you can bring value to the fund as an investor or offer a strategic partnership (remember that network we talked about earlier?), the fee structure is often negotiable. It never hurts to ask.
Question: “Is there a lock-up period?”
Lock-up periods can range from non-existent to greater than 3 years. Make sure the terms match your liquidity requirements.
Question: “What is your redemption frequency, and how much notice is required? Is there a fund-level or investor-level gate?”
After any applicable lock-up period, monthly or quarterly liquidity is common; though outliers of daily, weekly and annual liquidity do exist. You may also be limited in how much you can withdraw at one time.
The goal is to have a firm grasp on how often you have access to your investment, how much you can withdraw at once and how far in advance you need to provide written notice.
Question: “What is your minimum investment?”
This is the $10,000 to multi-million dollar question. Common entry points are the $100,000 and $250,000 marks, but elite funds often charge $1 million or more. A strategic partnership, or the promise of ongoing allocations, tend make this figure more pliable.
If the fund has survived your scrutiny up to this point, the final step of the process is to request the PPM and subscription documents. You’ll want to go through them thoroughly, comparing the terms and conditions to what has already been presented to you. Always seek clarification if there is anything you don’t fully understand.
While page after page of legal lingo can make for rather tedious reading, it's worth the time investment to be sure there are no hidden loopholes or unexpected expenses that will eat away at your investment and returns.
While there are many subtleties and indicators that only experience can clue you into, this basic outline covers the majority of the issues and concerns facing an investor in the crypto hedge fund space today. Follow this process and you’ll be well on your way to picking a winner.