Crazy Beats Big, Every Time//How to Really Start a Crypto Hedge Fund

The quote is from Malcom in the Middle. Describing a scrawny and crazy child demolishing a large bully.

(Image looted from the internet.)

The story of David & Goliath applies to and reaches most minds despite its religious undertones. However, if you need a refresher:

  1. Never underestimate your opponent.

  2. The bigger they are, the harder they fall.

  3. Think smarter, not harder.

  4. Never doubt yourself, despite a perceived disadvantage.

  5. Think outside the box, and master your focus (aim).

After the 'COVID Crash' in March, some of the most significant hedge funds in the crypto space have shuttered their doors after substantial losses. I won't name names, but last year nearly 70 crypto funds closed, more than had opened. Whereas this year, fewer have shut down, but the amount of capital managed by single entities that closed was much higher.

One such fund closed after reportedly losing 75% of its $33,000,000 fund. I highlight their downfall, not to mock them. The losses speak for themselves, and Gumbo is no stranger to sharp drawdown.

However, the reason we could keep going had more to do with the way we organized our fund rather than what we do.

The first mistake I've noticed is usually made on day #1 when determining how much capital the fund will raise.

The standard theory would indicate bigger is better in the hedge fund world. The opposite couldn't be more accurate in the crypto world.

Crypto markets are sitting at around $300 billion at the time of writing. We know that about half of (although it is likely more if a deep dive was done) the market has not, and likely will not, move. The reasons vary, but the critical thing to note is the market is at least half as large as people think. The majority of it is locked up in cold storage and has never moved since its purchase. Think hodlers.

Half as large, but 1/50th the liquidity.

Crypto markets are not only much smaller but also much less liquid than known by most. Top exchanges are likely to have a hard time filling orders of even just $100,000 before things start to move. And if an order of $1 million or more is made, it'll likely make the (crypto) news.

The solution lies in figuring out theory and strategy and then measuring the selected constituent's liquidity. The process will yield an idea of where to set the fund's raise. However, the market is volatile, and things may change rapidly, but setting a conservative fund size would adjust for this. Regardless, a $5 million fund with the same strategy as a $100 million fund will undoubtedly be the more agile of the two.

Improper benchmarks are another plague of the crypto fund world. Using the S&P as an index is pointless for crypto. The difference in volatility and daily swings are too significant to give this any perspective. One good year of crypto could equal ten good years for the S&P; likewise a bad year could be a 10-year retrace overnight.

A more appropriate measure is to use Bitcoin and crypto indexes. The visualization will give the investor an idea of whether to buy & hold or stay with a given fund. However, there may be a reason dubious they refuse these crypto benchmarks...

...Buying and holding crypto for investors. The crypto trust charges outstanding fees for near-zero effort and stores crypto for interested parties. They have their place in the market and aren't too bad comparatively, but worse is the hedge fund version.

Hedge funds that essentially buy & hold for investors do 0 work. They sit back and hope the market will 10x in a few years. Then they will collect their 2-and-20 fee, grossly underperforming the market and Bitcoin, but perhaps besting the S&P.

Recap, look for these red flags when considering:

  • Fund size too large

  • Strategy requires too much liquidity

  • Non-crypto based benchmarks

  • Buying and holding tactics

There are very few exceptions to these tips, but they do exist. Generally, these factors have been the most common amongst the failing funds, along with huge losses. If anything, I want new funds to temper expectations and take the time to learn the markets first, learning from the mistakes of others before making them on their own.


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