What are cryptocurrency funds and how do they work?
Cryptocurrencies have come a long way since the launch of bitcoin back in 2009. Digital currencies have started to receive a much higher level of widespread recognition and acceptance, particularly in the past few years. As evidence of this shift in public perception, look no further than the emergence of cryptocurrency funds designed to help investors gain exposure to this new class of digital assets.
What are crypto funds, how do they work, and what benefits and risks should you consider before handing over any of your hard-earned cash? Keep reading to find out.
What exactly is a cryptocurrency fund?
A cryptocurrency fund is an investment fund that allows its customers to gain exposure to the cryptocurrency asset class. Crypto funds allow investors to pool their capital together so that it can be invested on their behalf by a fund manager. It’s the manager’s job to make investment decisions based on the fund’s underlying strategy and goals for risk and return.
There are a few different types of cryptocurrency funds, including hedge funds and publicly-traded funds, and the exact strategy for buying and selling digital currency can vary from one fund to the next.
For example, some funds offer exposure to just one digital currency, such as bitcoin, while others spread their capital across a diverse range of crypto assets. Some will take a long-term “buy and hold” approach; Others look to trade actively to take advantage of short-term market movements.
In return, crypto funds take a percentage of the profit made from buying and selling cryptos as management and performance fees.
The growth of cryptocurrency funds
From shares and property to commodities and bonds, investment funds have been providing exposure to other, better established asset classes for years. They’re much more of a recent phenomenon in the world of cryptocurrency, however, with more than 100 new funds launching in 2017.
With the increased liquidity of global crypto markets and an easing of some of the regulatory uncertainty surrounding digital assets, the time is clearly right for investment funds to move into this growing market sector. According to Crypto Fund Research, the total number of funds in existence now exceeds 400.
What are the benefits of dealing with cryptocurrency funds?
There are several reasons why you may consider buying digital currency through a crypto fund, including:
- Expert management. The biggest advantage of crypto funds is that you can hand control of your portfolio to a professional. Rather than dedicating the time and effort needed to research different currencies and monitor market movements, you let an experienced fund manager make all the tough decisions.
- Avoid crypto confusion. If you’re new to the world of cryptocurrency, wrapping your head around how digital currencies work and how to safely buy and store them can be overwhelming. Using a crypto fund means you can avoid the hassle of transacting on cryptocurrency exchanges, dealing with the risk of hacking and theft and setting up secure crypto wallets.
- Diversify your portfolio. Using a managed fund also allows you to spread your capital across a more diverse range of crypto assets. This helps manage your level of risk in case one particular market segment experiences a downturn.
- Buying power. Investment funds also offer the benefits that come with increased buying power. For example, because of the higher amount of capital it has to invest, a crypto fund may be able to access digital currency projects that are out of financial reach for individual investors. It’s also much more cost-effective for a crypto fund than an individual buyer to purchase and maintain a diverse portfolio of crypto assets.
Cryptocurrency funds vs venture capital funds
Cryptocurrency funds should not be confused with venture capital funds, which offer a slightly different way to buy into tech-related projects. Venture capital funds allow investors to pool their money together to be invested in early-stage companies, with the capital under the control of a fund manager.
However, these types of funds take private equity stakes in the business in which they invest, adopting a high risk/reward strategy to support companies with a strong potential for growth. Venture capital funds often also take more of a hands-on role in the companies in which they invest, such as providing guidance and advice to the business owners and maybe even taking a seat on the board.
Different types of cryptocurrency funds
Cryptocurrency funds can be split into three main categories:
- Publicly-traded funds. These funds are listed on public exchanges and tend to adopt a strategy of buying and holding cryptos for the long term. Some concentrate on just one major crypto, such as bitcoin or Ethereum, while others offer exposure to multiple currencies, for example, the top 10 or 20 cryptos by market cap. Management fees of around 1 to 2.5% usually apply.
- Private buy-and-hold funds. Private funds aren’t listed on any exchanges and therefore don’t have the same regulatory requirements as public funds. They also usually have eligibility criteria – for example, only those with $50,000 capital or more can join. However, similarly to public funds, they typically adopt a buy-and-hold approach and charge an annual management fee.
- Hedge funds. Cryptocurrency hedge funds adopt complicated alternative investment strategies with the aim of providing returns to members in both rising and falling markets. For example, they might take advantage of cryptocurrency arbitrage opportunities, trade on leverage or use complicated trading algorithms. Hedge funds usually try to outperform a specific benchmark, such as a market index, and if they exceed the benchmark, they charge performance fees of 15%, 25% or even higher.
How do funds determine what cryptocurrencies to invest in?
There are several factors a fund manager will consider when choosing what cryptocurrencies to invest in, but the most important consideration is the fund’s stated goal for risk and return. For example, some funds are focused on stable long-term growth and would be more likely to consider major cryptos in the top 10 by market capitalization. Other funds adopt a high risk/high reward strategy designed to achieve maximum profit in a short space of time and may focus more on low-cap cryptos and ICOs.
Most funds also target a particular area of the market. For example, while one might focus on the top 30 cryptocurrencies, another might look to invest in ICOs and a third might specifically focus on projects attempting to solve blockchain scalability problems.
The currencies and projects to invest in are chosen on the basis of in-depth analysis. Technical analysis (predicting the market by looking for patterns in price and volume charts) and fundamental analysis (determining the intrinsic value of a currency by considering economic and financial factors) can both be applied to cryptocurrencies to assess whether prices will go up or down. The exact process followed in each type of analysis is beyond the scope of this article, so do your own research to find out exactly what’s involved.
What to consider when comparing funds
When comparing cryptocurrency funds, make sure to consider the following factors:
- Strategy. What is the investment objective for the fund? What level of risk will you need to accept to potentially achieve those returns? What types of cryptocurrencies will the fund invest in? How do all these specifics relate to your own investment goals and timeframe?
- How cryptocurrencies are chosen. Does the fund use technical analysis, fundamental analysis or some other investment approach? What process is followed when determining which cryptos to buy?
- Type of trading. Does the fund use manual trading or algorithmic trading when buying and selling cryptos? While manual trading is more focused on carefully selecting cryptos for long-term growth, algorithmic trading is designed to ensure that trades are placed at the optimum time and that you can quickly react to market moves.
- Fees. How much is the annual management fee? Do entry and exit fees also apply? Is there a performance fee if the fund outperforms a specific benchmark?
- Team. How much information is available about the team behind the fund? Who will be managing your capital? How much experience do they have?
- Past performance. While past performance is not a reliable indicator of future performance, it’s still a good idea to examine the fund’s track record for meeting its goals.
- Minimum investment. Is there a minimum investment required to join the fund? Will you need to meet any other eligibility criteria?
By considering these and other factors, you should be able to narrow down your choices to find a fund that aligns with your chosen risk/reward strategy.
What are some of the risks of investing in cryptocurrency funds?
Just like any other type of investment, cryptocurrency funds also come with a certain level of risk. Some of the factors you’ll need to take into account include:
- Loss of control. Handing control of your investments over to someone else – often a complete stranger – is a big stumbling block for many.
- Fees. Make sure you’re fully aware of all the fees a fund charges before you sign up as they can have a significant impact on your overall returns.
- Volatility. Cryptocurrencies are famously volatile and come with a high level of risk. If you’re looking for a stable investment with minimal risk, it’s probably a good idea to consider other options.
- Expecting history to repeat itself. Just because a fund has experienced solid returns in the past, that doesn’t mean it will do so in the future. It’s highly unlikely that any other crypto will enjoy the stratospheric price rises that bitcoin did, so don’t treat past performance as an indicator of future returns.
- Tax implications. Seek personalized advice from an accountant or tax expert about how investing in a crypto fund will affect your cryptocurrency tax obligations.
- Regulatory uncertainty. Crypto investment funds will continue to come under scrutiny from regulators for the foreseeable future, with authorities around the world (including the US Securities and Exchange Commission) cracking down on cryptocurrencies.
While the rise of crypto funds is good news for the legitimacy of digital currencies as an asset class, joining one of these funds comes with a certain level of risk. If you’re thinking of investing in a crypto fund, make sure to do your own research and compare a range of options before deciding whether it’s a sensible approach for you.
Disclosure: At the time of this writing the author holds ADA, ICX, IOTA and XLM.