Institutional investors’ initial forays into crypto were most often via Venture Capital funds. It was an easy entry as these funds are generally institutional quality and they do not have the high volatility of liquid crypto funds primarily because they do not mark to market their holdings on a monthly basis. Institutional quality VC funds dedicated to crypto and blockchain include A16Z, Brevan Howard and Pantera Capital among others, which are all relatively large household names. There is low career risk for investors if one of these funds has negative performance or worse. Furthermore, since these early-stage investments are illiquid, the funds do not value their investments on a regular basis, so investors never experience wide swings in valuation on a monthly or even quarterly basis.
Having experienced high returns from crypto VC investing since 2018, institutional investors are now moving into the liquid crypto hedge fund space. One of the most popular strategies is “market neutral” trading in crypto. This type of absolute return trading seeks to take advantage of the inefficiencies in the nascent and growing crypto space. Managers (including Pythagoras) in this category focus entirely on alpha with no beta to the crypto markets. Managers must be highly skilled and nimble as the crypto market is fraught with high volatility and other risks, such as counterparty risks. Market-neutral strategies include:
- Cross exchange arbitrage
- Basis trading
- Funding-rate trading
- Defi staking
- Providing liquidity in defi
- Volatility arbitrage
- Hard-Fork harvesting
- Regulatory arbitrage
- ETH merge trading in the forward curve
- Market making
- High-Frequency Trading
- Market making in NFTs and gaming assets
- Statistical arbitrage
- LS token trading
- Relative value token trading
Market-neutral crypto strategies are attractive to investors because of their potential for steady returns with low volatility, low drawdowns, and higher Sharpe ratios. Institutional investors often seek exposure to crypto given its low correlation to traditional equity and commodity markets, but without the directional risk or high volatility. While institutional investors look for those extremely high returns from their crypto VC investors, they don’t need to get that from their crypto HFs investments, rather they seek uncorrelated, consistent returns with very low drawdowns.
The recent crisis and bear market in crypto has separated the wheat from the chaff among supposedly market-neutral crypto funds. To quote Warren Buffet, “when the tide goes out, you can see who is swimming naked”. During the Terra Luna crisis in May, several crypto funds and companies blew up or had significant drawdowns. On the other hand, a few, including our own Pythatgoras funds did extremely well in navigating treacherous markets through skill and discipline.
The Pythagoras crypto trading funds ranked #1 and # 3 in May 2022 during the crisis and bitcoin crash according to the Galaxy Vision Hill databases of 50 crypto hedge funds. The Pythagoras momentum / trend following strategy gained 15% during May by catching short trends during that month. Our Pythagoras market neutral fund gained 3.3% during May 2022 by buying cheap puts on Luna and delta hedging those puts with perpetual swaps on FTX.
Harvesting alpha is perfect in the crypto markets because the market is new, highly inefficient, and growing. To paraphrase ETH lead developer, Ben Edgington “every day in crypto there is drama. Every week is an adventure. That is what is fun about crypto”. Trading crypto for a skilled trader is like being a kid in a candy shop. It’s similar in many ways to trading FX in the 1970s when FX trading went global. It’s like CTAs during their heyday 1990s. It’s like HF investing in the 1990s. Arbitrage has not yet been “arbbed out” in crypto because of the large regulatory barriers to entry for large financial institutions and the complexity of the market. It’s still the wild wild west where pioneers end up with arrows in their chests that is unless you are skilled at risk management, at navigating the unknown, and have a dedicated experienced team knowledgeable in the intricacies of cryptocurrencies.
We strongly believe that arbitrage in the crypto space will continually evolve but that opportunities for gain will persist for some time to come.