As soon as the crypto markets change from a bear to a bull market, there is a skyrocketing hype from non-crypto investors and newcomers that suddenly want to jump on the crypto bandwagon. Rightfully so, because who does not want to realize 10x on a quick crypto investment? They would do it at any cost and time is suddenly of the essence. The opposite is true when the crypto prices take a dive. A lot of people make one big mistake though: they rush into buying digital assets without understanding what exactly they are buying into.
For one, having gone through two bear/bull cycles, if it sounds too good to be true, it normally is.
If you are not passionate about watching the market 24/7 and reading the latest crypto news as it breaks, there are a couple of good options that will enable you to dip your toe into the crypto investment pool while being a passive investor. One option for a passive investor would be to invest in a digital asset fund. In the Cayman Islands we have registered Mutual Funds governed by the Mutual Funds Law (2020 Revision) which, if you struggle with Insomnia, I suggest you read page 30 – 32 tonight in bed.
A Mutual Fund is any company, trust or partnership either incorporated or established in the Cayman Islands or, if outside the Cayman Islands, managed from the Cayman Islands, which issues equity interest redeemable at the option of the investor. The purpose of a Mutual Fund is the pooling of investors’ funds with the aim of spreading investment risk and enabling investors to receive profits or gains from investments. A Mutual Fund is geared towards more sophisticated investors that have quite a chunk of money and are willing to take a risk to invest in alternative investments.
If you are considering investing in a Mutual Fund that will be holding digital asset investments, here are a couple of things to take into consideration:
1. Minimum Buy In
The Mutual Funds Law requires a minimum initial investment of CI$ 80,000 which is more or less $US 100,000. The reason for the high buy-in amount is because a mutual fund inherently has a higher risk due to its investment in alternative investments, by asking for a high minimum investment, the regulator (CIMA) ensures that the investors are sophisticated and understand the risks of the fund.
An alternative is to invest in an Administrated Fund, as they do not have the CI$ 80,000 minimum initial investment restriction. However, there are only a few hundred of these funds in existence.
2. The risk-return tradeoff
It is an economic principal that states that the higher the risk the higher the reward could be.
The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.
This depends on a variety of factors including an investor’s risk tolerance, the investor’s years to retirement and the potential to replace lost funds.
Each Digital Asset Mutual Fund will have an Offering Memorandum that discloses all the risks that investors should be aware of prior to investing into the fund. Make sure that you read the crypto/blockchain specific risk disclosures to ensure you understand all the risks involved.
The risk would vary depending on what type to digital assets/tokens and protocols the fund invests in. Some of the specific risks that you will be confronted with when investing into blockchain technology could be:
- Digital Assets represent a speculative investment and involve a high degree of risk.
- Risk due to the price volatility of Digital Assets.
- Legal status and risk if restricting the right to acquire, own, hold, sell or use Digital Assets.
- Industry risks such as security issues, bugs, and software errors.
- 51% attack risk.
- Digital Asset exchange specific risks.
- Counterparty risk due to blockchains decentralized nature.
- Specific Digital Asset custody risks.
- Risk relating to forks.
- Risk of loss of private keys.
- Stolen or incorrectly transferred Digital Assets may be irretrievable.
- Specific Digital Asset liquidity risks.
- ICO, Decentralized Exchange, NFT or DeFi Lending risks.
- Risk of rug pull scam.
Stay tuned for our article “17 Risks to consider when investing in crypto currencies” which will discuss these risks in more detail.
3. Investment Strategy
All Cayman funds are required to disclose their investment objective, strategy and restrictions to potential investors in their Offering Memorandum. This will tell you what type of instruments the fund is planning on investing in, what strategies they will be following and what the Investment Manager or Advisor is not allowed to invest in.
Another section worth looking at is the “borrowing and leverage” paragraphs. This would indicate what the powers of the Investment Manager or Advisor is with regards to borrowing funds and using leverage in the portfolio.
Certain investments are riskier than others and involve more judgement and volatility. Some of the most common strategies we see in the market are:
- Early-stage investments: The fund will invest in SAFT (‘Simple Agreement for Future Tokens’) contracts or ICOs. These investments are generally tokens that an investor would receive in a new company or protocol at a certain point in time. This is a high-risk investment as the investor is investing in an agreement where a team is planning on developing a protocol/company but there is not much substance behind the project yet.
- Long-term capital appreciation strategy: The goal is that the fund would take a position and buy into digital assets with the aim of holding it for a long period of time to accumulate value. If you believe in the building blocks of blockchain technology, then you will likely be enticed to follow a long strategy when thinking about investing.
- Top 10 / 20 coins: This strategy will invest in the top 10/20 coins traded in the market. They will rarely invest in a less popular coin unless they believe that they could realize a substantial profit. This is a lower risk strategy, and the basket of assets would be less volatile than most other strategies.
- Arbitrage strategy: Due to the difference in supply and demand in the crypto markets between different exchanges and the fact that there are so many exchanges that create independent markets for crypto currencies, it creates price inconsistencies between exchanges. The Investment Manager simultaneously purchases and sells the same asset in different markets to profit from tiny differences in the asset’s listed price.
- Yield investment strategies: The fund will realize a profit from staking, yield farming and liquidity pool participation opportunities. This is a high-risk high-reward strategy.
- Decentralized Finance (DeFi) strategy: The fund will participate in DeFi protocols. DeFi strategies are popular for new funds registered at the end of 2021 and beginning of 2022 but comes with its unique set of risks.
4. NAV Frequency
Due to the volatility of the crypto markets this is a very important consideration. Mutual Funds have redemption periods which can be quarterly, monthly, weekly or even daily. If the fund is investing in higher risk coins and protocols you would want to pair that with a daily redemption option as an investor, in that case you can redeem your investment with a days’ notice at that day’s price. But when the fund only has a monthly redemption cycle, you will get the price of the fund at the end of the month. Which could be significantly less than what the price was mid-month.
5. Service provider reputation and fees
As with any industry, there are services providers that are more reputable than others. Ensuring that your money is in safe hands is increasingly important in the crypto market. I would suggest reading “Lessons independent directors learned from the FTX collapse” Part 1 and Part 2 for some guidance on the hard lessons learned. Compared to the stock and futures markets, the crypto market is extremely new, fast evolving and high risk.
Inspect the PPM for the following:
- Disclosure of the names and addresses of the legal advisors, fund administrator and auditor of the fund, to ensure that the service providers have a good reputation in the industry and that they have sufficient experience in the Digital Asset market.
- The bios of the directors to ensure that they have sufficient experience and relevant knowledge in the Digital Asset industry.
- The description of the Investment Manager describing the name and address, their directors / managers / principals / senior officers of the Investment Manager with their names, experience and addresses of their registered or principal business office.
The classic performance structure for a fund would be 2 and 20, which means that the investment manager will earn 2% in the assets under management as a management fee and 20% as a performance fee for profits made. We have seen the management fee percentages being dragged down the last couple of years to lower than 2% in order to be more competitive in the market and become an attractive investment vehicle against other similar funds. What we see in terms of Crypto Mutual Funds are even more alternative than the traditional 2 and 20 structure. Some Investment Managers will ask for a lower 1.5% management fee and then only have performance fees on certain types of profit such as staking rewards. This benefits both the investor and motivates the manager to improve performance as staking of coins can escalate the returns over and above the returns of just storing a coin in cold storage. It is important to understand how the fee structure works before subscribing into a fund.
It is worth noting any other fees that could be imposed on an investor such as subscription, redemption fees or Investment Advisor fees.
This is only the tip of the iceberg when it comes to looking into investing into a Crypto Mutual Fund. At Hash Directorships we pride ourselves on solving the mysteries and answering the hard questions.