Why hedge funds are stocking up on cryptocurrencies

Hedge funds look set to significantly raise their allocations to cryptocurrencies in the next five years, according to a recent survey by global fund administrator Intertrust.

The report, first published in the Financial Times, surveyed 100 hedge funds and found that they plan to hold an average of 7.2% of their assets in cryptocurrencies by 2026 – with 17% of hedge funds planning to hold more than 10%.

North American hedge funds are the most adventurous: they plan an average exposure of 10.6%; UK-based and European funds say they will hold around 6.8%. But all hedge funds, irrespective of their location, expect to at least have 1% of their portfolios in crypto. That could add up to assets of around $312bn, estimates Intertrust, using data from alternative finance data provider Preqin.

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Assets under management (AUM) surged from $2trn to $3.8trn between 2019 and 2020, says the annual “Global Crypto Hedge Fund Report 2021” published earlier this year by PwC, the Alternative Investment Management and Elwood Asset Management. This trend is expected to accelerate as four out of five actively managed crypto hedge funds were launched between 2017 and 2020.

Why hedge funds are flocking to crypto

While hedge funds’ current allocations are not known, what’s clear is that even before these findings were published, they were increasingly flocking to cryptocurrencies to boost returns.

The most common motivation for hedge funds for investing in digital currencies was simply “general diversification”, according to PWc, with 57% of the funds polled citing diversification as a reason to buy crypto.

Another factor was that hedge funds say they see cryptocurrencies as a “safe haven” in times of inflation and low yields, themes which have rocked markets in recent months.

Hedge funds are also likely to have wanted to capitalise on the frenzy that has engulfed the crypto market in recent months. Indeed, bitcoin accounted for the biggest share of gains at SkyBridge Capital, a US hedge fund founded by Anthony Scaramucci, the former White House communications director.

While bitcoin and the wider crypto market have been somewhat topsy-turvy in recent weeks, the market was on a bull run for several months before, because of higher mainstream adoption by big Wall Street titans and bullish statements by Tesla’s Elon Musk.

However a series of regulatory upsets and U-turns by Musk has driven bitcoin down from above $64,000 to around $40,000 in just two months. But even with recent bearishness, bitcoin is up more than 400% in the last 12 months.

What does this mean for investors?

Hedge funds looking at cryptocurrencies isn’t exactly new, but what’s interesting is the amount by which their allocation to cryptos is expected to grow.

But greater interest from them doesn’t necessarily mean the outlook for cryptocurrencies is rosy. As PWC notes, hedge funds who want to invest in digital currencies still face many challenges. These include client/reputational risk; regulatory uncertainty; current service provider availability and lack of infrastructure.

Many countries are trialling central bank digital currencies (CBDCs) which promote the exact opposite of cryptocurrencies. They are unlikely to want competition, so any fresh setback by regulators can still send cryptocurrencies in freefall.

On Friday, the Basel Committee floated the idea that banks who hold cryptos would face the strictest capital requirements, which caused bitcoin prices to nosedive.

So, hedge fund participation in the crypto sector may offer some upside to the market, but until the market doesn’t mature and increase resilience against day-to-day shocks and surprises, it still remains a highly speculative asset.