Dear Crypto Fund Manager

The Special Considerations, which can be found here, are an integral part of this blog post, are incorporated into this blog post by reference and must be read in conjunction with this blog post. This blog post is considered “Site Content” for purposes of such Special Considerations.

Introduction

Building a successful hedge fund is astronomically difficult. Even with blue-chip pedigrees and the relative safety of trading established asset classes, the typical hedge fund story is one of failure.

This lack of success is not necessarily due to irresponsible business or portfolio management — though that of course happens from time-to-time — but is more often driven by some combination of an unattractive return profile, inability to raise capital, or suboptimal business dynamics (e.g., poorly structured incentives, inadequate resources, etc.).

As with many things in life, the hedge fund universe follows a Yule distribution where a small minority of funds manage the vast majority of assets. While multi-billion dollar fund managers make for juicy headlines, the typical hedge fund manages far less. In fact, roughly 25% of hedge funds manage less than $50 million and over half of them manage less than $250 million. And once in business, their survivorship is on average limited to under five years.

There is a certain Darwinism at work here since the vast majority of hedge funds simply fail to justify their fees. But also on display is the reality that starting, building, and managing a successful hedge fund is just plain hard.

Similar to the opportunities they seek to exploit, crypto hedge funds are in their nascency. It is estimated that there are several hundred such funds in the world today, the vast majority of which manage less than $10 million and have limited track records.

In addition to navigating a volatile asset class and uncertain regulatory backdrop, these fund managers are attempting to build businesses in the cutthroat world of high finance.

Compounding these challenges is the fact that many crypto funds are helmed by individuals with no prior investment management experience. Given the newness of the asset class and its cypherpunk origins, it is not surprising that crypto has yet to attract waves of top talent from Wall Street.

The resultant amateurism — and lack of early success — is therefore to be expected. Instead of the old hedge fund adage of “two guys and a Bloomberg” we now have “two hoodies and a Macbook…working from bean bags…in a serviced office”.

Many of these fund managers are true crypto believers and early adopters. Having in some cases made a killing on the back of stratospheric price action in 2017, a few now fancy themselves professional money managers.

These individuals are not the first to fall victim to a narrative fallacy that ascribes skill to luck. But it takes a certain chutzpah to extrapolate one phenomenally good punt into qualification to manage fiduciary risk.¹

But so long as they are attempted in good faith, most crypto hedge fund efforts are to be respected, with Roosevelt’s quote about the man in the arena coming to mind. The majority of practitioners we encounter have a genuine desire to build something special, and they are certainly on to something by attempting to exploit an asset class that is highly inefficient.

While most fall short of the traditional hedge fund standard, it has taken decades for their more established counterparts to become the well-oiled machines they are today. Indeed, many of the best known hedge fund managers had relatively humble beginnings.

Ken Griffin famously launched a $265,000 convertible bond fund from his Harvard dorm room before founding Citadel. Paul Singer was a real estate attorney before he too hit upon a successful convertible arbitrage strategy that allowed him to raise $1.3 million to start Elliott. Renaissance’s Jim Simons was an academic before launching the most successful hedge fund of all time.

This gives us hope that the crypto fund stars of tomorrow are clumsily but earnestly plying their trade today. A little guidance can go a long way in setting these firms on the path to future success.

A Guide for Best Practice

Having spent the better part of the past three years surveying the crypto hedge fund landscape, we have identified a handful of areas where we believe guidance is warranted.

With wishful intent we aim to provide insight on what we believe constitutes best practice for these fledgling fund managers. Someone once said that the only thing to do with good advice is to pass it on. This represents our attempt to do just that.

To quickly establish our own bona fides before we get started:

• We have spent the majority of our careers in alternative investments;
• We have helped deploy, manage, and raise billions of dollars in traditional hedge funds, private equity, and venture capital;
• We have built operational due diligence programs for multi-billion dollar alternative investment platforms;
• We have decades of legal and compliance expertise focused on alternative investment vehicles;
• We have launched hedge funds from scratch — traditional as well as crypto;
• We have traded across the asset class spectrum with a particular focus on emerging market debt and FX;
• We have experience with investors of all types — ranging from family offices to sovereign wealth funds — from all corners of the globe; and
• We have traded crypto since 2016.

The counsel provided herein is designed to serve as a starter kit for managers as they seek to engage investors. It is our hope that this feedback helps to elevate the overall discussion and improve managers’ odds of success.

Expectation Management

Bill Gates once described expectations as a form of first-class truth. Whether done explicitly or subconsciously, we apply some form of expectation management to all manner of decision-making. This self-regulating mechanism is crucial for price discovery in myriad aspects of life and plays an especially important role in asset management.

We have observed a pervasive inability among crypto fund managers to explain what it is that they are seeking to achieve for their investors.

Clear articulation of what is being targeted by way of risk/return should be table stakes for any asset management business. Otherwise, why are we even here? How do we know what constitutes success or failure? How do investors account for additive exposures in the context of a broadly diversified portfolio? When should managers be applauded or redeemed on the basis of their performance?

Playing on another business adage: If it can’t be measured, it shouldn’t be underwritten.

Nobody is seeking or expecting performance guarantees. Guidance is all that is needed. Whether the objective is to relatively outperform or to maximize absolute returns, some direction is required in order for investors to make fully-informed allocation decisions.

Even more important is letting investors know what sort of drawdowns should be expected. Whether measured over months, quarters, or peak-to-trough, investors need to understand what pain threshold is required for this journey.

Something important to note here is that most investors are not allocating to a crypto hedge fund for the diversification benefits alone. We are nowhere near the point where asset allocation programs suggest that investors have some percentage of their portfolios allocated to digital assets. This means the primary appeal must lie on the risk/return spectrum.

Competition for capital is intense and battles are being fought across strategies and asset classes. Any allocation to crypto is likely coming from either absolute return (i.e., hedge fund) or venture capital portfolios. It is therefore important to articulate a value proposition that is attractive relative to those strategies.

Investor alternatives are more likely to be a laggard multi-strategy fund or direct bitcoin (“BTC”) than it is to be another crypto hedge fund or cash. Narratives need to be adjusted accordingly as a consequence.

For example, those managers employing more directional strategies will likely need to demonstrate return potential exceeding that which is typically found with successful venture capital funds. Such a fund seeking to generate just 15–20% net annualized returns may struggle to compete against the venture standard of 25%.

Similarly, those managers focused on risk-adjusted returns will need to demonstrate both an ability to generate relatively attractive absolute returns as well as Sharpe ratios well in excess of 1.0. Convincing an investor to allocate to a crypto strategy that annualizes at 7% with a Sharpe of 1.1 will be a tall task when that investor has thousands of similar risk/return profiles to choose from in the traditional hedge fund space.

Expectation management is not just important for prospective investors but also for the fund managers themselves. Considering one’s raison d’etre is mission critical when the idea of a fund begins to germinate and should precipitate any fund formation process.

Absence of self-reflection suggests arrogance, incuriosity or naivete, none of which is flattering or likely to result in success.

A manager’s genesis story is important and contemplation of risk/return objectives can help crystallize the why of it all for everyone involved.

Unfortunately, many crypto funds appear as a random assemblage of friends with a shared interest in digital assets rather than a thoughtfully constructed team combining complementary skills to execute on a clear strategy.

Having a considered and structured approach to defining outcomes will go a long way in signaling one’s seriousness of intent.

Liquidity Terms

Like many things in asset management, setting fund terms (i.e., fees and liquidity) is more art than science. It is difficult to be precise when passing judgment here as the only right answer is the one that works for investors. However, there are a few high-level issues we encourage managers to consider.

There are two forces at play when considering what liquidity terms to offer: 1) Ensuring that a manager’s ability to satisfy redemption requests aligns with its ability to fund those requests with limited price impact; and 2) Encouraging investors to adopt a longer-term mindset both in an effort to provide business stability and to give the fund sufficient time to meet its risk/return objectives.

As a basic rule of thumb, the liquidity offered by a fund should match that of its underlying investments. It should go without saying that investors simply should not be offered generous liquidity terms if the underlying portfolio itself is illiquid. That unfortunately has not been the experience for some crypto fund investors given the asset-liability mismatches experienced by several early vintage funds. This could have been avoided had the issue received proper consideration at the outset.

The standard lockup provision with digital asset hedge funds appears to be one year (i.e., investors may not seek to redeem any of their investment for a period of one year following the initial allocation date). This is uncontroversial since any investor engaging with this space in fund form should do so with at least a one-year time horizon.

Ideally, lockups would extend beyond just one year to encourage longer-term thinking among investors and allow managers a full market cycle to deliver on their risk/return objectives. Fee discounts are typically required as a trade-off for duration, which we often see in traditional hedge fund fee structures.

It is also not uncommon to see traditional hedge funds limit the amount of capital that investors can redeem following expiration of any applicable lockups. The use of a 25% gate appears to be most common (e.g., simplistically, if an investor sought to redeem $100 from a fund that offers quarterly liquidity, then a maximum of $25 would be received at each subsequent redemption date; it would therefore take a full calendar year for that investor to fully redeem its holdings).

Allocators often begrudge the use of gates and usually limit their acceptance in exchange for only the highest quality exposures. Crypto managers should therefore consider their own use of gates very carefully.

Gates are fine in concept so long as they are properly considered and implemented. If it can be demonstrated that a gate helps funds responsibly fulfill redemption requests in light of their own portfolio liquidity, then a good faith argument for its use can be made. But to the extent a gate is being applied to otherwise liquid portfolios, then managers should perhaps reconsider.

Liquidity is an important consideration for prospective investors who are already being asked to invest in an entirely new asset class with managers who — in many cases — lack much of a track record to evaluate. We would therefore encourage managers to avoid the use of gates to the extent possible and only implement them if their strategies truly require it.

Something else to consider with gates is the issue of bucketing, where investors need to categorize a fund on the basis of its liquidity profile rather than its actual strategy. Coupling lockups with gates may see a fund pushed into an investor’s illiquid bucket, which in addition to being strategically incongruous can limit a fund’s potential audience.

On the implementation side, some fund managers opt for a fund-level gate rather than an investor level one. We believe this is suboptimal.

With a fund-level gate, investors are free to redeem any amount of their own capital balance on a given redemption date so long as total fund redemptions do not exceed a certain threshold. For example, if a fund has instituted a 50% fund-level gate, investors are free to redeem as much of their individual capital balances as they want so long as those requests do not combine with others to collectively exceed 50% of total fund assets.

With an investor-level gate, all investors are limited to the amount they can redeem on a given redemption date regardless of what total fund redemption requests may exist.

To illustrate, in the case of a 25% investor-level gate, each investor would be limited to redeeming that percentage of its capital balance even if aggregate fund redemption requests on that date fell short of 25% of total fund assets.

If each investor is subject to a specified limit in terms of how much it can redeem during a fund’s transaction window, then there exists little doubt about what sort of liquidity would be made available over a given period.

But with fund-level gates, no such assurance can be given. Investors are instead forced to contemplate the potential actions of other investors and how they may affect their own situations.

Having witnessed the redemption challenges encountered by many traditional hedge funds during the Global Financial Crisis, we can attest to the deficiencies associated with fund-level gates. In normal times, fund-level gates are theoretically good for investors since redemption requests go uncapped when the fund is not under significant redemption pressure.

However, during periods of uncertainty — either at the market or fund level — investors suddenly find themselves conducting game theoretic exercises. Even if an investor is not particularly concerned, it may nonetheless be inclined to submit a redemption notice earlier than it otherwise would for fear that other investors may soon be doing the same and therefore trigger the gate. By submitting earlier, there is a chance this investor may be able to “escape” free and clear before the rush for the exits ensues on the following redemption date.

The existence of a fund-level gate invites a type of gamesmanship among investors whereby their actions may be influenced by the potential actions of other investors rather than by their own conviction. Moreover, a fund level gate can see some percentage of early movers get fully redeemed before the triggering of a gate, leaving all remaining investors at a disadvantage.

With an investor-level gate, the implementation is clean and fair. All investors are subject to the same limit on the amount they can redeem on a given date, thereby removing the need for gamesmanship and limiting any non-investment motivations to redeem. This allows all investors to be treated equally without the pretense that full liquidity may exist for anyone on a given date regardless of the market backdrop or behavior of other investors.

Investor-level gates have their drawbacks as well. In addition to guaranteeing a restricted redemption schedule for investors — thereby making that investment less liquid — they can invite shorter-term thinking and sometimes force premature redemptions.

For example, knowing that it may take a full year to redeem, an investor may be quicker to initiate a redemption cycle than it otherwise would. Without a gate, an investor has a greater inclination to give a struggling fund another quarter or two to see how things go. But with a gate, it may be better to initiate the redemption process sooner just in case.

Fees

Traditional hedge fund fees have been locked in a race to the bottom since 2008. With rare exceptions, managers have been steadily lowering fees in an effort to compensate for their relative decline in value-add. Historically known for their rich 2/20 pricing (2% management fee and 20% incentive fee), hedge funds today charge average fees of just 1.3/15.

Informed by that prior experience, investors may flinch when confronted with the relatively healthy fee structures found amongst crypto fund managers. Unlike their traditional counterparts, 2/20 is standard fare for crypto funds, with many charging fees well in excess of that already lofty amount.

These higher fees may seem strange given the unproven and emergent nature of both the asset class as well as its fund practitioners. However, we believe such pricing is justified for several reasons.

First, the return objectives for crypto funds are substantially higher relative to their traditional counterparts. There was a time when traditional hedge fund fees were 2/20, which the market could bear because their net return outcomes made the costs worth it.

In fact, there are a handful of traditional hedge fund managers that can still charge that (and more) because their net returns justify the expense. Since the net result is all that should matter, it stands to reason that crypto funds aiming to generate outcomes far superior to their traditional counterparts would come with relatively higher price points.

Second, most strategies being employed by crypto funds are capacity constrained. Though impressive in its breadth with nearly 6000 coins, the digital asset market is not particularly deep; in fact, nearly two-thirds of its approximately $350 billion market capitalization is comprised of BTC and Ethereum.²

While certain fundamental strategies are relatively scalable, many trading and arbitrage strategies are limited in the amount of capital they can productively deploy. The implications for this are twofold: 1) Unlike with many traditional hedge funds, the crypto fundraising game is not an asset gathering exercise where management fees often overtake incentive fees in priority; and 2) Given those capacity constraints, the management fee consequently needs to be higher in order for managers to achieve reasonable levels of business breakeven.

Lastly, crypto funds form an active management vanguard helping investors access differentiated sources of risk/return by navigating an entirely new asset class. Rather than deploying plain vanilla investment strategies in mostly efficient markets, crypto funds are combining investment expertise with technical proficiency to break new ground in a highly inefficient marketplace. There is surely more value to be added in this context.

But fees are not one size fits all and in fact involve plenty of nuance. Going back to the discussion around expectation management, a crypto fund manager should start by considering what it is seeking to achieve for investors. A discussion around true value-add and quality of return is very much warranted when fee structures are being considered.

For example, investors should be wary of paying 2/20 for a long-only approach that is essentially beta masquerading as alpha. Why pay such fees when a better net result could be achieved by simply purchasing BTC outright or gaining exposure through some other lower cost, more liquid beta alternative?

The cleanest fee arrangement in our view is one that adheres to the original promise of traditional hedge funds, which is to maximize absolute as well as risk-adjusted returns in relatively uncorrelated fashion. This often equates to targeted net annualized returns in excess of 20% with a Sharpe ratio of at least 1.0 and beta to relevant benchmarks of less than 0.3. Since we believe the most attractive strategies in crypto are capable of generating these types of outcomes, then a fee structure in the range of 2/20 makes sense.

If a fund’s approach is to simply outperform on a relative basis, then any incentive should come with an appropriate hurdle (i.e., no incentive fee should apply unless and until the fund exceeds the performance of a relevant benchmark). It strikes us as disingenuous to target relative returns but be able to eat all of the absolute ones. Particularly in a space that has demonstrated such explosive upside potential, despite its many risks.

Interestingly, we have seen some crypto fund managers charge no management fee and very high incentive fees. We view this as a cheeky move ostensibly designed to assuage one level of generic concern regarding fees while maximizing a fund manager’s near-term payout potential.

Since the management fee tends to be the focus for many investors complaining about pricing with traditional hedge funds, a crypto fund manager may look awfully smart when short-circuiting any such discussion by taking that fee to zero.

But what does this signal really? While some may claim pure alignment of interests (“we only get paid when you get paid”), we believe it represents the opposite in most cases.

Let’s use a realistic example to illustrate the drawbacks of this approach. Assume a $1 million investor in a fund that charges 0/50 saw gross returns of 500% during the crypto bull run of 2017. This means that $5 million in profits were generated, of which the manager in this instance gets to keep $2.5 million (or 50%). The investor is left with a capital balance of $3.5 million, which is still pretty darn good even after the hefty incentive allocation.

But as we all know, digital asset prices fell off a cliff the following year, so let’s say this fund incurred a 70% loss during 2018, thus leaving the investor with $1.05 million remaining in its capital account. So the manager would have pocketed $2.5 million over a two-year period while the investor effectively received nothing in return.

Moreover, the manager now needs to generate a 250% return before it retakes its highwater mark and can begin earning incentive fees again, increasing the odds that it may choose to shut down before the investor is able to recapture those prior gains.

It is our view that managers using the above pricing framework are signaling to investors their desire to get rich quick rather than build sustainable businesses. At 0/50, the manager is likely operating on a shoestring budget with hope that a bull run is quickly caught so fees can be expeditiously extracted.

This provides a perverse incentive for the manager to take unreasonable risks in order to maximize its own potential outcomes. It also encourages investors to redeem their capital following any bull run in order to protect themselves against the scenario highlighted above.

Inviting such short-term thinking is clearly suboptimal for everyone involved.

We can think of several instances where this type of pricing structure might make sense for a mature alternative investment business (e.g., co-investments, a recommitment to investors that performance is a focus).

But the only way such an aggressive pricing structure could be justifiable in crypto is where the management company is sufficiently well capitalized, appropriate hurdles are in place, and clawback provisions apply. We are otherwise hard-pressed to understand the wisdom of such an approach.

One final comment on fees relates to the frequency of incentive fee crystallizations. Traditionally, this typically occurs on an annual basis and most often at the end of a calendar year. However, since many crypto fund managers are small and eager to earn fees, they often seek to crystallize their incentive allocations more frequently. In fact, it is not uncommon to see managers do so on a quarterly or semi-annual basis. We have even seen some try to do so weekly(!).

In addition to being nonstandard, more frequent incentive crystallization can present conflicts for funds seeking to manage to interim pay periods. It can also have adverse consequences for investors given the volatility associated with the asset class. While individual investors may be less sensitive to such fee considerations, there is little chance an institutional allocator would ever sign off on such an arrangement.

Risk Management

Volatility remains a major roadblock for institutional engagement in crypto. In fact, Fidelity’s latest Institutional Digital Asset Survey Report found it to be the most common obstacle to adoption. This is yet another variable to be solved for in a way that can provide a discernible advantage.

Having a thoughtful approach to portfolio risk management and a robust operational framework is of paramount importance in a space defined by its volatility and immaturity. These are issues that for the most part only receive lip service amongst managers today but again represent a true edge for anyone who takes them seriously.

Approaches to risk management span the complexity spectrum. It is admittedly difficult for crypto fund managers to implement such programs with the same level of sophistication achieved by their traditional counterparts.

But efforts must be made to mitigate those risks deemed most relevant to their respective strategies. At a minimum, this often involves some combination of limiting the use of leverage, instituting stop-loss measures, and monitoring position sizes in order to avoid liquidity problems.

On the topic of leverage, we question the wisdom of its usage given the volatility already present within the asset class. Even in cases where leverage is implied (e.g., through use of options), one should tread carefully.

Liquidity risk is another issue we often see neglected by crypto fund managers. As alluded to earlier, some of the earliest crypto funds turned out to be venture capital funds that tried to shoehorn themselves into liquid hedge fund constructs. That is, they were offering hedge fund liquidity while pursuing venture type strategies.

This was fine during the 2017 bull run that made liquidity seem plentiful. But the 2018 crash saw liquidity dry up and exposed these funds to significant portfolio imbalances. It was not uncommon to see these funds operating with side pockets in excess of 50%. In some cases, the resultant redemption challenges even resulted in investor lawsuits.

A common way to measure liquidity in the traditional hedge fund world is to take a security’s 90-day average daily trading volume (“ADTV”), assume a fraction of that amount for stress testing purposes, then measure that against the fund’s position.

For example, if a security trades $1 million per day and a fund holds $2 million of that security, then its position could be liquidated over the course of two days assuming normal trading conditions. But a portfolio’s liquidity should be measured over periods of stress in order to account for the possibility that liquidity might not be there when you want it most.

So if we assume 25% of the 90-day ADTV, then the estimated time to liquidate this position increases from two days to eight days. By conducting this same exercise for all portfolio positions, a manager can aggregate these statistics at the fund level and take a more conservative approach to estimating what percentage of the fund could realistically be liquidated over different time frames (e.g., one day, three days, ten days, one month, etc.).

Further complicating the risk management process are the risks unique to the digital asset class. For example, counterparty risk is something legacy investors can manage rather easily, but it is an even more important consideration within the digital asset space and harder to manage.

While managers are typically well aware of these risks, their risk management policies often do not adequately account for potential loss of capital for non-investment reasons. We appreciate that many of these counterparty risks are a function of nascent and developing infrastructure, but a lack of adequate care through simple processes such as diversification across counterparties is poor form.

Addressing these structural risks, even with imperfect solutions in the near term, is of critical importance.

Communication

There is a curious lack of proactive outreach in the crypto hedge fund community. Meetings and calls routinely lack any form of preemptive material dissemination. Most interactions fail to result in any follow-through and are instead met with radio silence. No immediate follow-up on the back of a meeting, no newsletters to digest, no monthly performance updates to consider. It is perplexing that many due diligence discussions require managers to be chased for even the most basic of preparatory materials.

A partnership mentality needs to be fully embraced by any manager seeking long-term success. And it must be signaled early in the relationship with a prospective investor.

Demonstrating organization and a willingness to communicate will automatically place a manager within the top decile amongst its peers. This is the low-hanging fruit of the fundraising game.

So what exactly constitutes good communication?

Procedurely, proper due diligence requires extensive review of protocols and processes that involve both front- and back-office functions. Managers should therefore have in place and ready for distribution a range of documents for review.

On the investment side, the bare minimum includes an updated presentation along with historical newsletters. An addendum that includes a comprehensive track record with relevant risk metrics summarized in clear view would be even better.³ Idea memos and any other thought pieces are also fair game.

On the non-investment side, a crucial piece of the puzzle is a comprehensive due diligence questionnaire to facilitate early discussions (the folks at Vision Hill have put together a good starter template).

As things progress, one should of course have at the ready all subscription documentation and other relevant policies (e.g., compliance, trade allocation, risk management, etc.). Moreover, biographical information for key personnel should be prepared to facilitate background investigations, and contact lists should be compiled well in advance for reference checks. Referees should include some combination of former colleagues, current investors, personal contacts, and perhaps even select counterparties or service providers. If the CIO/PM’s former bosses are not on that list, be ready for questions as to why. And be warned that more thorough investors will find their way to those former bosses anyway.

Beyond procedural elements, managers should be proactive in their outreach to existing as well as prospective investors when interesting things occur in crypto markets.

For example, the ~50% cliff dive that BTC experienced over the span of 36 hours in March presented a great opportunity for managers to go on the offensive.

If they got carried out with the drop, then explain the structural backdrop, why and how it happened, and what lessons were learned in the process. If they were profitable, provide the same sort of color with the added benefit of lauding the merits of their approach.

Managers in this space should view it as their duty to provide investors educational as well as economic value. This makes everyone better.

Transparency

Also like the early days of traditional hedge funds, opacity can serve as a gating mechanism for potential crypto allocators. Like most businesses, ours is one that ultimately trades on two things: trust and competence. The latter is easier to decipher in objective terms while the former requires subjective nuance.

An easy win here is to be fully transparent with investors, prospective and existing alike. Most investors approach crypto somewhere on the spectrum between skepticism and trepidation. Transparency that welcomes questions will help educate prospective investors, solidify relationships with current investors, and put those involved more at ease with what constitutes an exploratory foray for many.

Some managers may worry about sharing proprietary information. But those allocating to crypto funds are often professional investors who understand what confidentiality means. Managers of course need to be sensitive to any arrangements they may have with existing investors, but being proactively transparent will work wonders.

An element of transparency that often goes neglected with crypto funds relates to investor reporting. Specifically, many managers either fail to provide their investors with any information at all or the reporting they do provide often lacks sufficient detail.

One area of obvious improvement is in risk reporting metrics. For example, virtually all traditional hedge funds provide investors with some sort of exposure breakdown to give them a sense for how a fund’s risk is allocated — long and short — across strategies, geographies, asset classes, market caps, and/or sectors at a given point in time (typically month-end).

Coupled with other risk metrics like VaR and DV01 as well as scenario and/or liquidity analyses, this information gives a good sense for how one should think about risk at the underlying fund level. This in turn helps investors aggregate risk factors at their own portfolio level.

Having surveyed hundreds of crypto funds, we estimate fewer than 5% provide risk reporting of the sort described above. This is a massive failing and only serves to limit growth potential within the space.

Part of the challenge in assembling useful summary information is poor data quality as well as the lack of standard strategy definitions. Managers can nonetheless make much better efforts in this respect, however incomplete they may be for now.

Edge

One of the hardest questions for any asset manager to answer is how it defines its edge. That is, what is a manager really good at that justifies an investor entrusting capital to it?

This again requires some reflection but is critical in knowing oneself. It also helps investors understand what makes a manager potentially special. It is always better to shape one’s own narrative rather than have others do it for them. This presents an opportunity to do precisely that.

An edge is unlikely to be something that nobody else is good at, but it does need to be something at which a manager believes it is truly exceptional. This also helps a manager sharpen its focus on what it should be pursuing by way of strategy and approach.

It is up to the investor to determine whether that perceived edge appears real enough to warrant an investment. But at the very least this thought exercise will help a manager realize what muscles it has and what it can lift with those muscles.⁴

Governance

Ensuring that a manager is setting itself up for success through proper governance and structuring is another variable to consider. This often involves building a strong advisory board, installing independent fund directors, and appointing top-tier service providers.

The typical fund structure is a Cayman or BVI master-feeder whereby feeder funds (typically one for U.S. taxable investors and an offshore version for non-U.S. and U.S. tax exempt investors) invest directly into a master fund.

This setup requires director oversight and it is best practice to see that those directors are majority independent. When appointing those independent directors, managers should look to secure complementary expertise to ensure that the fund’s board is able to act on behalf of investors in an informed manner.

A strong advisory board is an added advantage. Beyond demonstrating legitimacy with the appointment of well-respected professionals, carefully selected advisors can provide significant value by way of insight.

For example, many crypto funds were founded by technologists with no prior asset management experience. It would therefore behoove them to surround themselves with that type of expertise to assist with their progression up the investment learning curve.

The same applies to asset management veterans who may lack the technical chops their tech-savvy advisors can offer.

Another option is to augment some of the capabilities a manager already has in-house for the sake of completeness, which is what we have done with our advisory board at Dalpha.

In terms of service providers, it of course makes sense to work with the highest quality firms a manager can access and afford. This is especially true when it comes to attracting institutional capital. Seeing familiar, blue-chip law firms, auditors, and fund administrators will go a long way in establishing credibility and earning trust.

While historically limited, the universe of service providers willing to work with crypto fund managers is steadily growing in both quality and quantity.

Conclusion

The advice provided herein is not meant to be exhaustive. Nor are our suggestions necessarily the right ones for every situation.

We are nonetheless hopeful that this piece provides a foundation upon which crypto fund managers can build. In their quest to build successful businesses, knowing how to properly engage and serve sophisticated investors is critical.

Dressing for the job one wants feels like the right adage here, appreciating its irony given the sartorial choices of this intrepid bunch!

Yours in struggle,

Dalpha Capital Management, LLC

Footnotes

1. As an aside, crypto provides fertile ground for observation of myriad psychological and sociological phenomena. For example, the Matthew Principle is pervasive as “influencers” offer platitudes and/or commentary that are amplified purely on the basis of status rather than quality. The Dunning Kruger effect is also prevalent as crypto aficionados often overestimate their understanding of macroeconomics, entrepreneurial instincts, and/or ability to trade.
2. Per CoinGecko as of October 1, 2020.
3. We recommend that managers avoid showing track records with gross returns. This is a real pet peeve for many investors and was even mentioned as such during a recent Capital Allocators episode featuring a $10 billion endowment CIO. Quoting gross returns will only lead to questions about how a track record was constructed, differences between share classes, etc. Any nuance can be addressed in footnotes and during more thorough due diligence. What is desired by most is a clean snapshot that mirrors the return stream in which one would be investing. Investors will be running a fund’s performance against various benchmarks in order to optimize their own decision-making and all of the other returns they’ll be using will be reported in net terms. Making this analysis an apples-to-apples comparison is very welcome indeed. If multiple share classes are involved, simply take a blended number. Better yet, show the fund’s performance using the highest fee share class. If all numbers are gross to-date (e.g., partner capital that is live and auditable), simply apply the headline fees pro forma.
4. Work ethic is not an edge. Similar to those who tout their integrity, anyone who cites hard work as an advantage is either compensating for something or demonstrating naivete. Everyone is supposed to work hard. Everyone is supposed to have integrity. Everyone knows their names better than anyone else. And a focus on absolute return is great but will do little to differentiate, not to mention it fails to constitute an edge per se.