Why hedge funds are warming up to crypto

Wall Street is getting more comfortable with crypto as regulation looms and investment-grade infrastructure shapes up for the emerging asset class, with more traditional hedge funds reporting plans to boost their exposures and get in on the digital asset boom.

Nearly one-third of hedge fund managers plan to add crypto to their portfolios in the near future, according to firms surveyed by EY for a recent report on the global alternative fund industry. The report, which deemed digital assets an “area of focus” among these investment managers in 2021, marks the latest research to show that crypto is gaining momentum among big money managers.

The “institutionalization of the cryptocurrency ecosystem,” which includes more established exchanges and the emergence of custody solutions, or specialized storage and security systems that help safeguard an investors’ assets like with traditional financial products, are driving hedge funds and other alternative managers to become more active participants in the space, according to EY. Regulatory clarity, which the industry expects to see next year, may also be a “major milestone” in moving the market forward.

“The regulatory framework is one of the major hurdles to wider scale adoption for a lot of investment managers,” Joe McCarney, the global blockchain assurance leader at EY told Yahoo Finance. “But I think when you look at what happened up to this point from a regulatory perspective, you’re starting to see some movement.”

“You’re not going to see full-scale adoption, but most asset managers are having conversations at least to determine if they want to play in this space and what they want to do, because the market is rife with opportunities for people that want to be early movers in certain digital assets,” McCarney added.

Several high-profile hedge funds have outlined plans to foray into cryptocurrencies, including hedge fund Brevan Howard Asset Management, which said in September that it was expanding its crypto business with the launch of a new unit focused on managing crypto and digital assets.

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Last year, Tudor Investment Corp. founder and Chief Investment Officer Paul Tudor Jones gained the attention of crypto enthusiasts after arguing in an investor memo that bitcoin can serve as an inflation hedge.

Other hedge fund leaders who have publicized their support for bitcoin and other digital currencies include billionaire investors Steven Cohen, who runs Point 72 Asset Management, and Ray Dalio, founder of the world’s largest hedge fund, Bridgewater Associates.

At a conference earlier this year, Dalio said he had more crypto than gold, while Cohen said he hoped not to miss out on opportunities presented by digital currencies, shortly after his firm made its first investment in a crypto company in August.

The availability of more digital custody solutions, an umbrella term for various methods of storing and protecting financial assets, has been a driver of manager interest in crypto, according to EY. Internal control reports from these custodians, assessments that have been evaluated by independent parties, have helped firms better weigh regulatory, business, and other risks associated with crypto assets.

EY’s report indicated 31% of hedge funds plan to add crypto to their portfolios in the next one to two years: 26% said they plan to increase their exposures, while 5% said they would maintain them. Among other alternative industry respondents, 13% of private equity firms and 24% of investors in alternative funds expressed interest in allocating to crypto over the same time period.

EY told Yahoo Finance that the response rate could be even higher today compared to earlier this year when the survey was conducted in terms of the number of firms interested in exploring investment opportunities in crypto assets.

“Anecdotally, it feels as though all of our managers are kicking the tires in some way to understand what’s happening with digital assets and whether they fit their investment framework,” said Ryan Munson, a report author and partner in EY’s financial services office.

A separate study released in May by Intertrust Group, a fund administrator based in the Netherlands, also found that hedge funds are looking to significantly expand their crypto exposure. Its survey of 100 hedge fund chief financial officers worldwide showed the execs predicted 7.2% of their assets will be held in cryptocurrencies in the next five years.

Intertrust’s report also listed custodianship of digital assets, how they are stored and protected, as a primary focus of hedge funds as they think about moving forward with crypto allocations.

“From an investor perspective, CFOs are going to have to really ensure they have those controls in place for investors to be comfortable. If one in six expect to invest more than 10% in crypto, then one in six will need to be prepared for that investment,” said Jonathan White, global head of fund sales at Intertrust and an author of the report.

EY’s Munson told Yahoo Finance the return profile of digital assets, which is less correlated to more traditional asset classes and has significant opportunity for upside, was also a factor in garnering the attention of a number of mainstream alternative managers who see alpha-generating opportunities in crypto as the industry and regulators begin to better understand the asset class.

“The clients within the industry who typically tend to be more adverse to regulations in this area may actually react positively to crypto regulation, whereas relative to other areas, increased regulations might be frowned upon,” Munson said. “The right regulatory framework would allow for even more investment opportunities.

Larger asset managers were most likely to boost their exposures, with 36% of hedge fund managers with over $10 billion in assets under management and 32% of hedge funds managing $2 billion-$10 billion outlining plans to do so.

Still, despite rising interest, current participation in the space remains low overall. Only 10% of hedge fund managers reported being allocated to crypto, and just 4% of private equity firms have exposure to the space. Dedicated crypto investments as a percentage of total assets under management are also small relative to other investment strategies, with only 1%-2% for hedge funds.

Among management firms detailing plans to participate in crypto, nearly half said they would invest directly into cryptocurrencies, and 43% expect to allocate to crypto derivatives. More than one-third of managers intend to invest in private companies involved in the crypto industry, and more than one-fourth are considering investments in crypto ETFs. About the same number of managers who completed the survey plan to invest in publicly-traded crypto companies.

“For managers looking to get into the space, the amount of operational lift it takes is not insignificant,” Munson told Yahoo Finance, adding that although institutional solutions have become more robust, much work remains for managers in navigating considerations such as valuation policies, compliance, risk management, and fitting crypto into their investment strategies.

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Alexandra Semenova is a reporter for Yahoo Finance. Follow her on Twitter @alexandraandnyc

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