The Economics of Crypto Funds
Crypto funds are a new financial intermediary that trade in cryptographically protected digital assets, known as coins or tokens. Both the number of crypto funds and investments in crypto funds are soaring. As of the second quarter of 2021, more than 800 crypto funds are active, and their aggregate assets under management exceed USD 60 billion. The trend is likely to continue, as crypto funds returned an average of 98 percent (before fees) to their investors in the first quarter of 2021.
Crypto funds differ from more traditionally-managed funds in significant ways. For example, CryptoFundResearch reports that 43 percent of all crypto funds do not have physical offices and instead rely on globally distributed teams.
Crypto funds largely operate in a legal gray area because they mostly trade in coins that are classified as non-securities. This feature largely exempts them from many regulations, such as the Investment Company Act and the Advisers Act. As a consequence, they face fewer regulatory restrictions, which helps set them apart from more traditionally-managed funds. For example, crypto funds are not required to restrict their fundraising to qualified or accredited investors, which enables them to raise funds from relatively small investors as well (the crypto fund industry has set the median minimum investment requirement at around USD 100,000). Similarly, there is no applicable regulation that prescribes the management and performance fees crypto funds may charge their investors.
The flip side of a lack of regulation is that crypto funds disclose little information, and hence there is no systematic empirical evidence on the performance of this important new intermediary.
To fill this void, we compiled a unique dataset from various sources that track crypto fund activity and performance over the last four years. Our paper is the first to examine the economics of crypto funds.
Two important empirical patterns emerge from the analyses:
- Crypto funds underperform the market.
The most striking finding is that crypto funds underperform the market, no matter the benchmark (equally-, value-, and liquidity-weighted crypto market benchmarks). For example, relative to the equally-weighted market benchmark, crypto funds underperform by 21 percent per year. This means that investors are on average better off if they invest in either Bitcoin, Ether, or both.
The result is striking because crypto funds underperform the market even before fees. Considering that most of the funds charge investors substantial fees (most funds charge a performance fee of 20 percent on the profits and a management fee of 2 percent on the assets under management), the underperformance is even more pronounced.
It is true, however, that crypto funds manage market risk for their investors. In periods in which the overall crypto market experiences significant downturns, crypto funds temporarily outperform the market.
- Crypto fund-backed tokenized firms benefit from the investment.
Although crypto funds underperform the market, crypto fund-backed tokenized firms benefit from the investment in two ways.
First, if crypto funds back token offerings, the post-offering performance of the backed token is significantly better than that of comparable non-backed tokens.
Second, cryptocurrencies in which crypto funds invest in the after-market experience a sharp token price increase over the 10 days after the investment. In fact, the token price starts to increase around five days prior to the crypto fund investment, suggesting that there is some informed trading occurring.
Despite crypto funds’ average underperformance, they may add value for investors. For example, crypto funds return gains to investors with in-kind redistributions, meaning that investors can time their personal tax liability. Gains from crypto funds become taxable only at recognition events; that is, if the token returns are exchanged for fiat currency. This individual timing may thus reduce investors’ aggregate tax liability over time.
Crypto funds might have macroeconomic benefits as well. They bring sophisticated trading strategies to otherwise illiquid entrepreneurial finance markets, which increases efficiency in the market for startup projects, thereby potentially improving the allocation of growth capital to the best projects.
To harvest these potential benefits, the crypto fund industry is urgently in need of a sound regulatory framework. As a recent survey among crypto fund managers shows, legal uncertainty in the U.S. and Europe is a key reason why many crypto funds move to the British Virgin Islands or the Cayman Islands.