Back on the sidelines
This article first appeared in the February 2023 Digital Assets Insights Report
Institutional allocations to digital asset funds – a genuine prospect this time last year – have been delayed again after the events of last year. But other investor types see opportunities.
In early 2022, Hedgeweek’s last digital assets Insights report found an industry excited by the prospect of long-awaited institutional inflows. After years spent addressing credibility issues and building the foundations of an institutional-grade ecosystem, managers believed that larger investors were ready – finally – to make meaningful commitments.
Twelve months and several crises later, 80% of the hedge fund managers surveyed by Hedgeweek in January and early February 2023 said that institutional investors’ appetite for digital asset funds has since weakened, including nearly half who said it had weakened significantly.
Respondents from non-digital hedge funds were more likely to say institutional interest had weakened significantly (54%) than digital asset hedge funds (38%), but the high scores for both groups suggest a general uphill struggle (see figure 2.1). Among larger hedge fund firms (AuM $1bn+), the proportion of ‘weakened significantly’ was higher still, at more than 70%.
As Galaxy Digital CEO Mike Novogratz explains, many investors last year “bought at bad levels” and “trust was damaged”. He points to those institutions that entered the space late and suffered losses, such as some Canadian pensions, forcing them onto the side lines.
“Conversations with institutional investors have somehow slowed down,” admits Arianna Luna, head of investor relations and COO of digital asset hedge fund firm Campsor Capital.
“Despite the collapses in the spring and summer, there was still significant interest from institutional investors and a desire to allocate to the asset class heading into the fourth quarter. But the FTX event was different – that undermined confidence in the asset class even if the issue lies with certain counterparties’ governance structures and unethical behaviour rather than with the asset class itself.”
Says Emil van Essen of Katonah EvE: “Investors are still interested but likely won’t flock to cryptos until a new bull market happens.”
A solid start to 2023
Data from CoinShares had net investor flows into digital assets funds last year at $430m, the lowest annual total since $220m in 2018 (see figure 2.2). In 2021, net flows were over $9bn.
At the time of writing – on an industry that moves faster than most – the cryptocurrency market has made a solid start to the year, with strong net inflows and an uptick in retail volumes. “That’s on the back of a lot of selling last year and the clearing out of excessive leverage,” notes Novogratz.
In fact, bitcoin has just had its best-ever January, its price rising 35% last month, from under $17k to over $23k. “A few more months like that and those investors – who are looking for the bottom of the bear – are going to realise they have already missed it.” says Michael Silberberg, head of investor relations at US-based Alt-Tab Capital, an emerging digital assets hedge fund manager.
Silberberg distinguishes institutions entering crypto for the first time and those who have ridden through the previous market cycle. Allocators who have had exposure through the bear market of 2022 are waiting for more confirming signals to further allocate into the market, even as their pro-crypto thesis stays intact. However, many allocators who are looking to get in for the first time are excited by the price action in play and are moving quickly to gain smart exposure before the market’s early recovery movement concludes.
By comparison, the ‘crypto believer’ institutions that were already in the market when it crashed will be slower to reinvest. They were burned badly last year, and their investments are going to need to recover, to some extent, before reinvesting. In short, those institutions that believe in digital assets but hadn’t invested in 2022 are more likely to enter the market faster than those that had invested.
Institutional investors may be back on the side lines, but many others are making active enquires. According to Hedgeweek’s recent survey, 46% of respondents said they had fielded a request from an allocator for a digital assets vehicle in the past 12 months, up from 39% this time last year (see figure 2.3). Among respondents at digital assets hedge fund firms, the 2023 figure was 69%.
Galaxy Digital is among the firms seeing opportunistic buying. “Investors who have small positions feel now is a good time to start adding, while others who have long eyed the space feel they’re closer to getting in,” says Novogratz.
Back in November 2022, a Hedgeweek survey of alternative investment allocators found modest interest in digital asset hedge fund strategies in the aftermath of the FTX collapse (see figure 2.4). None of the institutions surveyed had an allocation to digital asset hedge funds nor planned to, while at the other end of the spectrum, nearly one quarter of private wealth investors intended to increase an allocation to the strategy, reporting similar levels of interest to hedge funds generally.
As might be expected, smaller investors were the dominant source of enquiries last year for digital asset hedge fund managers – nearly 70% of those managers surveyed by Hedgeweek in January and February 2023 reported interest from smaller investors in the past 12 months.
Fund of hedge fund (FoHF) managers, meanwhile, occupy a middle ground in terms of appetite for digital assets, according to Hedgeweek survey data. But for some, the asset class represents more than just an investment – it is an opportunity to provide added value, or even for reinvention, when the FoHF industry’s very relevance remains a talking point.
Richard Byworth, the new head of liquid alternatives at Geneva-based Syz Capital, a provider of FoHF products, acknowledges that, with many traditional hedge funds now institutions in their own right, the need for investors to mitigate risk through FoHFs has become less salient.
“However, as crypto emerges as a new asset class, it brings with it many more challenges around wallet management, smart contract risk, insufficient hedging tools, and younger managers who have had typically little experience in traditional finance,” he adds.
“A FoHF that can bring traditional operational due diligence to this new industry, spotting red flags but also adapting to the new risks in those diligence assessments, provides valuable protection to investors looking to benefit from the extreme alpha available in crypto.”
Education remains an important part of a digital assets fund manager’s pitch. The crypto market moves quickly, and it can be difficult for those on the edges to stay informed. Even so, Campsor’s Luna echoes the sentiment witnessed in several interviews saying investors – institutions especially – have become savvier on cryptocurrencies, with a notable improvement to one year ago.
“The education element is still there, but we’re not starting from the basics any longer,” she says. “We spend less time explaining the building blocks of the ecosystem and more time on the latest industry developments.”