Percentage of HFs Secretly Investing in Cryptos?

Esuric's picture
Esuric - Certified Professional
Rank: Almost Human | banana points 8,096

It's no secret that the HF industry has been under a lot of pressure lately. The industry bled more than $100 billion in 2016 as fund flows moved into ETFs an other passive investment vehicles. It's also no secret that net returns have lagged behind the general market, though HF risk characteristics differ dramatically from publicly traded, blue chip stocks. Recently Warren Buffet made some news by winning a $1 million bet with major HF managers. The article is linked below but here's an excerpt:

Specifically, Buffett offered to bet that over a ten-year period from January 1, 2008, to December 31, 2017, the S&P 500 index would outperform a portfolio of hedge funds when performance is measured on a basis net of fees, costs, and all expenses. Hedge fund manager Ted Seides of Protege Partners accepted Buffett's bet and he identified five hedge funds that the predicted would out-perform the S&P 500 index over ten years.

As I reported last September on CD, Buffett's now-famous bet was actually settled early and ahead of schedule, because the outcome was so one-sided in favor of the S&P 500 index over hedge funds:

The Oracle of Omaha once again has proven that Wall Street's pricey investments are often a lousy deal. Warren Buffett made a $1 million bet at end of 2007 with hedge fund manager Ted Seides of Protege Partners. Buffett wagered that a low-cost S&P 500 index fund would perform better than a group of Protege's hedge funds. Buffett's index investment bet is so far ahead that Seides concedes the match, although it doesn't officially end until Dec. 31.

Given the poor risk/return performance of the industry, and the dramatic returns promised in ICOs and in cryptos in general, one would expect a greater proportion of managers to invest in this controversial space. I mean Ethereum is up 130% this month alone. Peter Thiel made some news recently (also linked below) by making millions in bitcoin. I've also received some messages/spoke to a number of individuals who told me that their funds are secretly trading in cryptos to bump returns.

So my question is how prevalent do you think this is and would you feel comfortable if your HF manager was throwing your money around in this space?

https://fee.org/articles/warren-buffett-won-a-deca...
http://www.foxbusiness.com/markets/2018/01/02/pete...

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Comments (61)

Jan 7, 2018
Esuric:

Peter Thiel made some news recently (also linked below) by making millions in bitcoin.

What a clown.

But seriously, you would be an idiot not to put some trivial amount in to boost your P&L.

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Jan 7, 2018

Yeah I agree, but it's hard to call yourself a value investor if you're throwing money around in crypto. Also, what's your benchmark? How do you assess the risk-adjusted return? I think many, if not most funds will do it but few will acknowledge it.

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Jan 13, 2018

"Risk adjusted return" is a bunch of bullshit.

Jan 13, 2018

So true. I couldn't count the number of times some cool-aid drinker bragged about their superior "risk-adjusted returns" when they were really only talking about returns. And on top of that they probably ended up with more risk anyway.

I would say I wish there was a way to nail down a definition of "risk" (a real one, not std dev) but I also would like to prolong the inevitability of yielding my job to a computer as long as I can.

Jan 13, 2018

Can you elaborate?

Jan 14, 2018

Anything that uses a measure of volatility as a way to judge risk.

Jan 14, 2018

lol okay so all of finance. What's the alternative? How do you measure risk? What drives return, in your view?

Jan 14, 2018

Much of academic finance, yes.

I prefer to watch what the titans of industry - the Druckenmillers, the Icahns, the Buffetts, etc. - do, rather than listen to what a bunch of academic nerds say.

Jan 14, 2018

Okay, but what drives return, in your view? How would you define risk?

Jan 14, 2018

You drive returns by purchasing at a discount to value. Risk is the chance of permanent loss of capital.

Seth Klarman ftw:

"Beta also assumes that the upside potential and downside risk of any investment are essentially equal, being simply a function of that investment's volatility compared with that of the market as a whole. This too is inconsistent with the world as we know it. The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk."

Jan 14, 2018
surferdude867:

You drive returns by purchasing at a discount to value. Risk is the chance of permanent loss of capital.

Okay, but how do you know when something's at a "discount to value?" Again, how do you measure value, in your view?

surferdude867:

Seth Klarman ftw:

"Beta also assumes that the upside potential and downside risk of any investment are essentially equal, being simply a function of that investment's volatility compared with that of the market as a whole. This too is inconsistent with the world as we know it. The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk."

Yeah, maybe in your undergrad intro to finance course. No one forces you to assume a symmetric distribution. CAPM doesn't depend on it.

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Jan 14, 2018

Present value of future cash flows.

Yeah because Seth Klarman doesn't know what he's talking about.... Nerds make finance needlessly complex, CAPM sucks.

Jan 14, 2018
surferdude867:

Present value of future cash flows.

Well yeah, but how do you estimate the present value factor? How do you account for the uncertainty contained in those cash flows, or does that uncertainty not matter in your view?

Let me try this another way. Suppose I offer you two options: Option A is a guaranteed $50 return; Option B is a risky return with a 50% probability for a $0 return and a 50% probability for a $100 return. Which option do you choose, and why?

surferdude867:

Yeah because Seth Klarman doesn't know what he's talking about.... Nerds make finance needlessly complex, CAPM sucks.

You're the one that brought up CAPM. You just didn't do so correctly..

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Jan 14, 2018
Esuric:

Let me try this another way. Suppose I offer you two options: Option A is a guaranteed $50 return; Option B is a risky return with a 50% probability for a $0 return and a 50% probability for a $100 return. Which option do you choose, and why?

But that's not how academic finance measures risk.

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Jan 14, 2018

And while we're at it, let's throw the strong form of the efficient markets hypothesis out the window as well.

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Jan 8, 2018

Firms have agreements with their investors regarding what they can and can't invest in and the strategies they can and can't pursue. They can't just decide to start trading Bitcoin on a random day.

That isn't how things work.

Now, they could go to their investors and ask to change those agreements. However I would guess the majority of those discussions would go poorly.

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Jan 8, 2018
JV123:

Firms have agreements with their investors regarding what they can and can't invest in and the strategies they can and can't pursue. They can't just decide to start trading Bitcoin on a random day.

That isn't how things work.

Now, they could go to their investors and ask to change those agreements. However I would guess the majority of those discussions would go poorly.

How is someone with 1 point already a gold star certified WSO user? Incredible.

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Jan 8, 2018

I don't know how WSO works behind the scenes. It may be because I've held significant positions in the industry. So rather than make up plausible sounding answers answers/responses....I have actual experience.

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Jan 8, 2018

As someone with a few thousand WSO points and a few thousand hours spent drafting the agreements that @JV123 is talking about, I can absolutely assure you that he's right. If your manager is making a unilateral decision to throw money into cryptos without consulting the IC or the LPs, your'e dealing with a shady manager.

Jan 8, 2018

Yeah, well that's my point. How many fund managers will go the "shady" route in order to bump returns? I know it's not ethical, but it certainly is profitable.

Jan 8, 2018

I'm no more an expert on that than anyone else. Do I think there will be some effect like what you're talking about? Sure - an increase in fraud and the height of an asset bubble often go hand in hand.

Then again, I think the established players have too much reputation to lose if they were to be caught with their hands in the crypto-cookie jar. Let alone the fact that any legit manager would face very punitive covenants and potentially regulatory action if he did something like that to his limited partners.

Jan 9, 2018

Institutional investors pretty closely track their holdings. At least at my firm they do. We regularly update them on reasoning behind drawdowns, trades, etc. It would be difficult to hide any sizable holding in crypto.

Perhaps funds that have a larger allocation from UHNW investors would have an easier time. But institutional investors no way.

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Jan 9, 2018
Esuric:

Yeah, well that's my point. How many fund managers will go the "shady" route in order to bump returns? I know it's not ethical, but it certainly is profitable.

Maybe your mate John who took money from you and a couple of his friends and created a "fund" did this. You can't just invest against your mandate and go the "shady" route in any fund that is able to raise money from outside investors (ie: outside of family and friends and marketing) - that's misrepresentation etc... And you can probably go to jail for this.
There are pockets of discretionary cash in a fund, maybe 5% that the investor can invest outside of his mandate, but again he can't just go ahead and "invest" it at the casino or in alt-coins...

That said, while writing this post I was going to write something about unregulated exchange and how fund managers can't just go and invest on Kraken. But a lot of houses are now offering futures on bitcoins, so if it's bitcoin you are talking about, there might be a way to invest this within their mandate. I partially retract some of the things I said earlier in this message.

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Jan 8, 2018

All you have to do to get certified is have a legitimate email handle from your employer.

Jan 13, 2018

You also need a 2-1 banana to MS ratio

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Jan 8, 2018
JV123:

Firms have agreements with their investors regarding what they can and can't invest in and the strategies they can and can't pursue. They can't just decide to start trading Bitcoin on a random day.

That isn't how things work.

Now, they could go to their investors and ask to change those agreements. However I would guess the majority of those discussions would go poorly.

How is someone with 1 point already a gold star certified WSO user? Incredible.

A guy I know from college left a "regular" finance job to launch his own crypto hedge fund in NYC. He has been on CNBC multiple times already. From what he told me, family offices, VC firms, and hedge funds, are "all-in" on crypto. Not sure what that means, but it sounds like there are a lot of institutional players piling on.

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Jan 8, 2018

My primary point is not inconsistent with your random anecdote ("A guy I know....."). My point is a firm cannot just start secretly trading a random security that isn't already in the IMA.

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Jan 8, 2018

Seconded, again. The covenants which bind the trading activities of any fund worth investing in would never allow for that sort of opaque behavior on the manager's part.

Sounds like your friend is either working at a toy fund or a family office where there are no LPs to consider.

Jan 8, 2018
JV123:

My primary point is not inconsistent with your random anecdote ("A guy I know....."). My point is a firm cannot just start secretly trading a random security that isn't already in the IMA.

I'm not disputing your point at all. I'm merely saying that a lot of institutional investors are pouring into the space.

Jan 8, 2018

I think that's a stretch. I cannot think of one investor that I would describe as "institutional" getting into cryptos. Nor can I think of one manager that I would describe as "institutional" doing the same.

In fact the latest news would suggest such attempts have been met with a pretty lukewarm response from the LPs of the world:

https://dealbreaker.com/2018/01/blocktower-crypto-...

Jan 8, 2018

I'm hearing some stories as well, which prompted the thread. I think it'll be hard for any struggling manager to turn away from 130% monthly returns if he/she thinks they can get away with it..

Jan 13, 2018

Right, but isn't that contingent on the LPs then? I'm sure some more flexible LPs -- HNW and smaller family offices would be okay with a small allocation to crpyto capped a reasonable level?

Jan 8, 2018

I probably have better visibility than most on this forum regarding the answer to your question. While I think there is a lot of interest in crypto from managers, much of it is casual, and is curtailed by the fact that most legitimate managers still view crypto as a bubble/the stuff of criminals and tin-foil hat wearers. The few funds that I know of that are actually wading into crypto have no exposure to LPs - i.e. they are family offices or prop shops.

No serious fund manager soliciting state pension plans and blue chips is going to continue being taken seriously if they make a pitch for allocating some of the portfolio to cryptos. It's just far too hazardous and controversial right now.

I also want to point out that regardless of one's views on the validity of cryptos as an asset class, the infrastructure which currently supports trading cryptos is going through serious growing pains in order to keep up with demand. It does not take knowledge from inside the industry to know that some of the largest exchanges are running into real operational challenges when it comes to setting people up on their platforms and ensuring that the tremendous inflows (relative to the size of the exchanges' staffs) are being vetted properly vis a vis KYC etc. Suffice to say that if I were a manager that was used to having fiber optic pipes straight to the exchange floor, I (and my LPs) would not at all be jazzed about the speed and manner in which transactions are currently settled in the crypto world.

Jan 8, 2018

I don't doubt any of this, but we're talking about, in some instances, 200%+ monthly returns and north of 1,500% annual returns. There's a lot of temptation there. What happens if they get caught? What's the risk/reward for the manager?

Jan 8, 2018

I can't opine on the risk reward profile. What you're describing sounds like fraud to me at worst, or at best, a clearviolation of the restrictive covenants surrounding the investments in the fund.

Generally speaking, I would imagine that managers engaging in this sort of behavior are risking going to jail/being barred from the industry, or at the very least, facing crippling redemptions from jilted LPs.

I honestly don't think this is something worth worrying about. Sure, some small-time managers with unscrupulous practices might try this as a way to save their flagging returns. But for most established managers - between the legal risks, the reputational risks, and the intense scrutiny that they're already receiving as a result of the poor performance you cited - I don't think this sort of behavior is in the realm of consideration.

Jan 10, 2018
Esuric:

I don't doubt any of this, but we're talking about, in some instances, 200%+ monthly returns and north of 1,500% annual returns. There's a lot of temptation there. What happens if they get caught? What's the risk/reward for the manager?

There definitely isn't enough liquidity in the crypto market for too many funds to make sizable allocations into crypto. Your question seems analogous to asking why hedge funds don't focus more on penny stocks since the returns there are often wild.

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Jan 10, 2018

Not an accurate analogy. The return on penny stocks in aggregate don't come close to the return on cryptos.

Jan 10, 2018

I meant in terms of volatility and return of certain individual penny stocks. There are tons of alt coins out there. How do you know what/which ones are gunna blow up?

Jan 10, 2018

https://coinmarketcap.com/all/views/all/
Sort by weekly returns. They're almost all blowing up. Talking about 4,000%+ weekly returns.

Jan 10, 2018

more than half of the market caps don't seem to be listed and the ones that are are 50m or less for the highest return coins the past week. Again, no liquidity here.

Jan 10, 2018

You can sort by market cap as well. XRP has multi billion dollar market cap with annualized return of 35,000%+. That said, I don't really dispute the liquidity point, just the comparison to penny stocks in terms of risk/return. There really isn't an industry ever, with the possible exception of 16th century diseased tulips in the Netherlands, that offers this sort of upside potential.

Jan 10, 2018

Ok returns are higher for crypto than penny stocks. That said there are still ridiculous returns in penny stocks to be found.

http://quotes.freerealtime.com/dl/frt/M?SA=Percent...

Jan 10, 2018

In aggregate Cyrpto's have a much higher return relative to penny stocks.

Best Response
Jan 8, 2018

Somewhat unrelated, but only somewhat:

You cannot make this up. "Dogecoins" are now at a market cap of $2+bn. According to this article, they were created as a parody of BTC back in the infancy of crypto - the inventor of dogecoin himself is alarmed that most of the media coverage of his creation contemplates its validity as an investment, rather than its origins in parody.

Look, I get that blockchain is an interesting technology, and that a currency that isn't backed by fiat is also interesting. But the emergence of crypto is potentially the most ridiculous thing I've seen in my whole (admittedly brief) life as an investor.

We are now at a point where "coins" that make no pretense about being a nerdy joke between memeing internet trolls have a multibillion dollar market cap. To be clear:

  1. Pathologically anti-establishment nerds who in any other context would be described as losers are inventing coins for the lols
  2. Morons who don't understand the technology they're being hyped on are buying into this garbage because their buddy made a few hundred gambling on it.
  3. Now the institutions of the world, apparently smelling blood in the water, are wading in to take advantage of the greater fool theory. And sorry, but I don't buy the argument that any of these institutions have a genuine belief in the value of cryptos. That's why they're maintaining 100% margins on the futures contracts that they just barely managed to launch recently.

I turn on the news and read about all the absolute fucking morons that are out there like Icarus, throwing money at various "investments" and daring the sun to melt their wings. And after years of pumping the price up within their close knit outcast-community, they're finally being joined by the pigs and the vampire squids of the world who are finally, sarcastically, jumping on board to cash in on the coming peak while proselytizing about how it "might" be legitimate.

As a society, we keep wishing away all the obviously fraudulent ICOs and the horrendous server crashes at the exchanges, and the fact that there's no actual use case where these coins make more sense than just using fiats. The list of logical quandaries one must ignore to be gung-ho about crypto goes on and on and on. And yet all the forces of the world seem to be scrounging up weak rationales to justify the existence of these meaningless zeroes and ones invented by shady nerds. But anyone with a shred of skepticism should be able to see that this is a dangerous configuration. The ignorant are drunk on their recent success, and the sarcastic have willed themselves into the belief that they can time their exit on this ticking bomb. I am staying out of this shit, and I don't care how many 200% return months I have to miss if it means I still have a chair when the music stops.

Sorry for hijacking your thread @Esuric

Jan 9, 2018

Hearing about Dogecoins and all the other coins reminds me of the digital pets of the 90's, tamagotchi.

Not saying anything about the legitimacy of cryptocurrencies. But just think, at one-time people paid for digital pets.

Jan 9, 2018

Have you every heard of Cryptokitties?

Jan 9, 2018

You couldn't be more right. Upvoted you! I have made quite a bit of money and have taken out all of my initial investments plus profits. At this point, even if it collapses, I am up more than 100%

Jan 10, 2018

Fantastic post

Jan 8, 2018

zero percent chance. gotta realize that these large funds are still bringing in $$ in the form of management fees. if you're a GP running an event driven fund, and your LP's find out that you're trading crypto (Which they will, because any LP with a brain reads attribution reports), you're done. style drift like that can end you. it's not worth the risk for an established fund.

sure if there's a $50m pop up shop that doesn't care about blowing up their investors or reputation.

gotta remember that a lot of this money is pension funds, endowments,etc. if you're the CIO of a public pension and it comes out that you allocated to someone who drifted and blew himself up in crypto, you are also out.

rep risk isn't worth it.

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Jan 9, 2018

Bingo

Jan 8, 2018

I hope this is true so we can get a great Michael Lewis book about it when it all goes wrong.

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Jan 9, 2018

& movie adaptations.... but with more Margot Robbie

    • 1
Jan 9, 2018

There's something called a PPM, look it up.

    • 1
Jan 9, 2018

I can save a lot of the discussion and say no. If any are then they are smaller funds or smaller positions. There is a huge misconception about how much FIAT has flowed into crypto. I have made many discussions and posts on this across the web, but there is no where near the liquidity for a real fund. If a mere 1% of the market pulled their funds out (that's about 7BN) the entire crypto market would crash 90%+. In addition to that almost every exchange or crypto to FIAT service provider has limits on how much can be withdrawn in a day/week/month. Finally because of the contracts and agreements in place, most funds are not able to participate. There probably are some small scale positions held by funds in crypto, but those gigantic returns are recent, and outside of shit coins (very very little liquidity) they are rare.

    • 1
Jan 9, 2018

...but those gigantic returns are recent, and outside of shit coins (very very little liquidity) they are rare.

By "shit coin" I assume you're referring to bitcoin? That said, this comment is simply wrong:

LTM Returns:

  • BTC: +1,533.71%
  • BCH: +448.00%
  • ETH: +11,603.03%
  • LTC: +5,821.31%
  • SYS: +10,284.03%
  • XRP: +35,410.67%

There are more, but I'm too lazy to list them out.

    • 1
Jan 9, 2018

There are over nearly 1400 crypto currencies in total right now. Out of those maybe 100 or so would be considered non-junk grade. You essentially took the top 5 coins, with the exception of SYS and provided return information. Just becaus FANG stocks returned 80% this year doesn't mean it's reoresentative of the market as a whole. A majority of the coins that return insane amounts start out with average volumes in the five figures. Hedge funds aren't interested in investing $10K and watching it grow to $100k. SYS coin less than 12 months ago had a pathetic 10k daily average volume, not whag hedge funds would notice. For years LTC sat around $15 and didn't move, for almost 5 years straight BTC sat around $200-$400 not moving. You said my comment was wrong about the returns being recent then went in to give last twelve months return. What is the preceding 12 month return for those coins? Don't get me wrong. I've made tons of money in crypto, I've recommended multiole coins in WSO that went 5x to 10x and have been invested for a while. But I've also held coins so thinly traded that my buy made them 2x in value alone. A hedge fund jumping in with $1M would buy their first coin and last coin at 500% different prices on some of the coins. Lastly, no one was looking at crypto on an institutional level 12 months ago, it only recently became popular because of the outrageous returns. A better view of how hedge funds may have performed since joining if at all would be last three months. In which you gave 2-3x on ETH, XRP and 4-5x on LTC. Even then it's unlikely due to all of the exchange problems, withdrawal issues, deposit issues, verification problems, lack of user friendly GUIs, and intense price manipulation.

Sorry for any typos or weird stuff, on my phone in a hotel on the other side of the world right now.

    • 7
Jan 13, 2018

It's a bit strange that you didn't actually respond to my comment here. I had no idea you posted this so I couldn't respond, though I will now.

Praesto:

There are over nearly 1400 crypto currencies in total right now. Out of those maybe 100 or so would be considered non-junk grade.

By what definition? How did you come up with this "junk grade" classification? Can you elaborate?

Praesto:

You essentially took the top 5 coins, with the exception of SYS and provided return information.

False. The one's I posted don't even represent the top 5. Here are the top 10 coins by last week's return:

  1. Cyder: 9,310.25%
  2. SHND: 1,154.38%
  3. EGOLD: 1,050.77%
  4. ABJ: 768.43%
  5. FC: 732.69%
  6. HAL: 695.39%
  7. FAP: 663.71%
  8. 10MT: 620.01%
  9. DFS: 609.92%
  10. JET: 607.92%
Praesto:

Just becaus FANG stocks returned 80% this year doesn't mean it's reoresentative of the market as a whole.

lol 80%. A coin with an 80% annual return would be considered a low performer in this space.

Here, let me help you out so that you can stop blatantly spreading misinformation on public forums:

https://coinmarketcap.com/all/views/all/
Sort by market cap and calculate annual returns for yourself.

Praesto:

For years LTC sat around $15 and didn't move, for almost 5 years straight BTC sat around $200-$400 not moving. You said my comment was wrong about the returns being recent then went in to give last twelve months return. What is the preceding 12 month return for those coins? Don't get me wrong. I've made tons of money in crypto, I've recommended multiole coins in WSO that went 5x to 10x and have been invested for a while. But I've also held coins so thinly traded that my buy made them 2x in value alone. A hedge fund jumping in with $1M would buy their first coin and last coin at 500% different prices on some of the coins. Lastly, no one was looking at crypto on an institutional level 12 months ago, it only recently became popular because of the outrageous returns. A better view of how hedge funds may have performed since joining if at all would be last three months. In which you gave 2-3x on ETH, XRP and 4-5x on LTC. Even then it's unlikely due to all of the exchange problems, withdrawal issues, deposit issues, verification problems, lack of user friendly GUIs, and intense price manipulation.

Well yeah, they weren't great a year ago but now they are, hence the temptation and the point of this thread. If they were great a year ago, I would have made this post then.

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