Digital assets, equally a new asset class, showroom interesting characteristics that could do good a diversified portfolio of traditional assets. There are, notwithstanding, many ways to go exposed to digital assets — passive investment, actively managed, short or long term investing, etc. — and with over 800 funds of all sizes, ranging from passive index to active trading funds to venture capital letter funds and fund of funds, it can be hard to sort the wheat from the chaff.

Just similar hedge funds, crypto funds come up in all shapes and sizes, and investors tend to await at them through their usual hedge-fund assay prism. However, equally crypto funds deal with a new asset class that has unique characteristics — digital assets — investors tin be led to misleading conclusions when traditional nugget metrics are used.

The purpose of this commodity is to provide a quantitative analysis framework to get a first sense of a crypto fund. This is a simple set of tools that helps to understand the potential risk and possible upside of a crypto fund, but no investment decision should exist only made on them. One may use these tools to screen a list of crypto funds from a database and excerpt a short-list to be reviewed in-depth or to assess more precisely a selected crypto fund.

Curt-listed funds should then be assessed for their noninvestment strategy aspects — i.east., their operations, their team, their service providers, etc. — which are out of the telescopic of this commodity. Besides, please note that this is not the de facto method to analyze funds, simply only i that has proven its robustness over time.

Different kinds of funds

Passive index funds. These funds provide passive exposure to a unmarried or a basket of digital assets in an easily investible format — fund or document — where the value is linked to the underlying minus fees. Virtually of such funds volition hold the concrete assets (such equally Grayscale Investments), just others provide the exposure — essentially, to Bitcoin (BTC) — through futures contracts, which are derivative instruments linked to the value of the physical digital assets. They evangelize the performance of the underlying asset held, and typically accept college daily-to-weekly liquidity and lower fees.

Initial coin offering/venture capital funds. These funds invest substantially in early on-stage companies via the detention of company-emitted tokens instead of traditional shares of the company but without disinterestedness ownership and correct to future dividends. These funds are not unlike from traditional venture capital funds: They invest in a handbasket of promising projects and await to resell their ownership when the projects have matured, splitting their investment take a chance on various projects instead of merely an "all-or-nothing" strategy. Their liquidity terms for investors tend to be better than traditional VC funds/private disinterestedness firms, just they are nonetheless highly dependent on the liquidity of the underlyings.

Active trading funds. This category can be dissever into 2 sub-categories: (1) market-making/marketplace-neutral funds that provide exchanges liquidity; and (2) directional-trading funds. Funds from the outset sub-category tend to deliver a steady performance by sharing the profits they make by acting as the counterparty to traders on exchanges charging a small fee for their service; whereas funds from the second sub-category tend to deliver a more volatile operation than the market place-neutral funds simply in exchange of a generally much higher performance over the mid-to-long term.

Market-making/market place-neutral funds tend to exist fully automatic due to the very big corporeality of trades taken in a short period of time, only directional trading funds can be either discretionary — i.e., investment decisions are human-based — or systematic where investment decisions result of a homo-designed model but executed by a computer for the best efficiency.

An overview of the main types of crypto funds

Selecting a crypto fund

Passive index funds

For an investor just looking to get exposure to a hard-to-shop asset such as digital assets, a fund providing passive exposure is the best option as long as the fund custodies the physical digital assets and could provide "in-kind" redemptions — i.e., the fund could render the investors' money in the course of concrete digital assets, every bit well as in equivalent fiat currency.

Funds that provide passive exposure to digital assets through futures are the worst option. Because futures have to exist "rolled" on a regular footing, extra costs are incurred, including trading costs, execution slippage and "curlicue" costs, which can exist seen as actress direction fees, eating the investors' investment value over fourth dimension independently of the underlying returns.

Moreover, since such funds don't concord any physical nugget, they cannot deliver them "in-kind" directly; if they provide the option, that would come at an extra price to the investor, every bit the fund would have to purchase the concrete digital assets on the market in order to evangelize them to the investor — for a value less than their market place value when all purchasing costs are accounted for.

ICO/VC funds

Investing in such funds is very difficult, as no one has a crystal brawl to predict what early-stage projects are going to exist the next unicorn. Investors can merely rely on the feel of the fund direction squad in selecting projects and their means to strengthen and develop them. Picking upwards the next unicorn could lead to an astronomic return on investment, but it will take fourth dimension.

Investing in such funds can provide uncorrelated returns versus the wide market, just during global bear markets, the valuation of these projects tends to fall as well, and and so does the value of the funds.

Active trading funds

Funds that are neither passive alphabetize nor VC funds can be considered active trading funds. It is mandatory, first of all, to accept a key understanding of the management investment strategy: Will it exist more market-making/market-neutral or directional? Long/cash or long/curt? Systematic or discretionary? What universe of instruments are traded? And then on. This sheds light on the general framework of the fund.

Market-neutral funds tend to exhibit a steady functioning — i.e., low volatility and low drawdowns — just tin can appear very remote from the digital assets returns, whereas directional funds tend to exhibit a higher return only at the price of higher volatility and deeper drawdowns.

Two types of active trading funds

Marketplace-neutral funds

Market-neutral funds are more often than not easier to assess than directional funds, as their performance is expected to be every bit steady as possible: the steadier, the improve.

However, before investing in a market-neutral fund that exhibits the highest expected functioning among its peers, given an adequate level of returns steadiness, the investor has to understand what could possibly go wrong with the fund strategy. For a market-making high-frequency trading fund, it could exist an Information technology issue or some dislocation in the broad market place, leading to very large spreads impacting the market-making algorithm (encounter the notorious 2022 flash crash).

Since their operation is generally much lower than directional funds but are much steadier, an investor tin exist tempted to leverage investments in such vehicles. Still, the investor has to keep in heed that there is no guarantee of steady returns, and leveraging several times such funds could atomic number 82 to an unexpected, desperate loss should something get wrong.

Indeed, even if market-neutral funds exhibit a very low net exposure, information technology doesn't mean that they have a very low gross exposure; they can be levered on the long and the curt side many times, which may lead to a very sudden, huge loss (see 2007 Quant Quake for a more academic analysis).

Directional funds

Directional funds, contrary to their market-neutral cousins, endeavor to capture marketplace moves being either long (during market up-moves) or short (during market down-moves) for funds having the power to play both sides of the market (long/short funds), whereas the long/greenbacks funds will try to only capture market upwards-moves while remaining in cash during downward market moves.

Directional funds are much more than volatile than marketplace-neutral funds, and their drawdowns could be pregnant, specially with cryptocurrencies.

Discretionary vs. systematic directional funds

Assessing a discretionary, man-managed fund is harder than assessing a systematically reckoner-driven fund.

Past rails record. The by live runway record of a discretionary fund may not reflect its time to come performance, equally the fund director took some trading decisions forth the way according to the marketplace surround back so and may not take similar decisions going forrad. Yet, a systematic fund implements a set of trading rules applied by a estimator, guaranteeing that the output will e'er follow the same investment procedure every bit far as the fund manager doesn't modify the model nor override the model decisions.

Backtest. The backtest of a fund is a simulation of the trading rules as if they had been applied in the past. For obvious reasons, a backtest is inherent to systematic funds every bit the investment process has to always be the same. Despite all of the caveats of a backtest (like whatsoever simulation), if information technology has been established under reasonable hypotheses, information technology can requite some insights most the expected operation of the manager going forwards. Detailing all of the potential caveats and how to estimate the value of a backtest is beyond the scope of this article, only one quick check that can be done is to compare the backtested results vs. the realized results over the same flow. The more in-synch the two runway records are, the more robust and insightful the backtest. However, if the two track records diverge, some questioning of the managing director prevails.

24/7 markets. Crypto markets are open 24 hours a twenty-four hours, vii days a week, in contrast to traditional asset markets, which are open only a few hours a day and not on weekends. Therefore, a crypto fund manager must always be on the sentinel, as swift moves tin occur without much notice at any time during the day — much like how Bitcoin lost 50% of its value in less than two hours on March 12, 2022. So, only the well-nigh reactive investment strategies volition be able to trade.

Therefore, a discretionary directional trading crypto fund has to exist managed by a squad of at least 3 portfolio managers relying on each other every eight hours to monitor the markets and trading accordingly, equally well as a couple of extra portfolio managers as substitutions for the chief ones, but nothing guarantees that the different portfolio managers would react the same in a given situation.

On the other hand, a systematic computer-driven fund, if properly designed with strong oversight and risk-management processes, can run 24/7 and be but monitored past a small squad. This is why most of the directional trading crypto funds are systematic and computer-driven.

This is part one of a two-role serial on how to sort crypto funds — read part two on how to analyze actively trading crypto funds with some useful metrics to assess their true risk here.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, you should conduct your own research when making a decision.

The views, thoughts and opinions expressed here are the author's alone and do not necessarily reverberate or represent the views and opinions of Cointelegraph.

David Lifchitz is the main investment officeholder and managing partner at ExoAlpha — an expert in quantitative trading, portfolio construction and risk management. With over 20 years of experience in these fields and viii+ years in it with fiscal firms, he has notably been the former head of risk management at the U.S. subsidiary of Ashmore Grouping, which had $74 billion in assets under management in 2022. ExoAlpha has developed proprietary, institutional-class trading strategies and infrastructure to operate seamlessly in the digital asset markets applying potent risk management principles.