The Risk-Return Trade-off in Cryptocurrency Funds

The value of active management has become a heavily studied question, especially given the increasing rise of passive management and the growing popularity of index funds and exchange-traded funds (ETFs). Using empirically validated models of risk, researchers can quickly and robustly evaluate the performance of many different investment products. Because of their structure and increasing popularity, and the rising prices and public awareness of cryptocurrency and Initial Coin Offering (ICO) investments, crypto funds have quickly become a focal point of this area of research.

Sharpe (1966) noted that the “traditional view” was that “the search for securities whose prices diverge from their intrinsic values is worth the expense required”, that is, active investment management should justify fees and expenses normally paid. The early findings of the literature, however, indicated that traditional active management, on average, did not beat the market net of fees and that few, if any, individual funds consistently outperformed. From these studies, over the last few years a new consensus has arisen that the value created by most managers is offset - or more than offset - by their fees. This conventional wisdom is perhaps best summarized by the conclusion of the seminal study of Carhart (1997): “The results do not support the existence of skilled or informed mutual fund portfolio managers” (p. 57).

Cryptocurrency funds provide a unique playground to understand the role of active asset management for three key reasons. First, crypto asset management tools are quickly emerging to assist retail investors with their exploration of a new and still underdeveloped market such as the one of cryptocurrencies. A more mature market means that less knowledgeable investors are likely to dip their toes in, therefore requiring platforms that deliver easier and more professional to access compared to the fragmentation that currently defines the cryptocurrency trading ecosystem. Second, cryptocurrency funds provide an element of transparency and liquidity which is rarely observable in traditional active asset management. For instance, Tokenized Funds (TF) often provide customers with the possibility to more freely trade shares on funds on the blockchain after a short period of time. Third, returns on cryptocurrencies are virtually uncorrelated with any other asset class (see, e.g., Yermack, 2013, Liu and Tsyvinski, 2018, and Bianchi, 2019). This is relevant as diversification is one of the fundamental building blocks of active investment management.

A recent research paper produced by Dr Daniele Bianchi (Queen Mary, University of London) and Mykola Babiak (Lancaster University Management School) contributes to a further understanding of the value of active management by looking at the risk-adjusted performance of a new category of investment funds - cryptocurrency funds, or “crypto funds” for short. The authors investigate whether crypto funds can generate risk-adjusted returns above and beyond fees and expenses, that is, they indeed generate value for investors, on average.

The empirical analysis is based on a sample of cryptocurrency funds which have been actively managed between May 2016 to November 2019. Two findings emerge; first, even in an unconditional sense, the returns on the cryptocurrency funds are not all positive on average. As a matter of fact, about 20% of funds have a negative Sharpe ratio (SR henceforth). This shows that despite the hype that surrounds this growing industry, a large fraction of these funds cannot outperform the returns on a risk-free bond over the same time period. This shows that the risk-return profile of the funds is highly heterogeneous in the cross-section.

Second, the authors show that a more granular analysis reveal a substantial heterogeneity in the risk-adjusted performance of individual funds. In particular, only a small fraction of funds – that is 12 out of 97 – are able to generate significant alphas (i.e., alphas with a t-stat greater than 3) after controlling for sources of systematic risk. On the one hand, these results make the performance of crypto funds more comparable to other more traditional investment funds. On the other hand, such heterogeneity makes the case for a careful selection of funds among those actually available. A variety of robustness tests confirm that net-of-fees risk-adjusted performance of crypto funds although not significant on average, show pockets of actual value.

As a whole, the authors argue this research should contribute to a better understanding of the economics of cryptocurrency markets through the lens of existing research designs normally applied to more traditional markets.

The complete paper can be found here.


The material provided in this article is being provided for general informational purposes. Aaro Capital Limited does not provide, and does not hold itself out as providing, investment advice and the information provided in this article should not be relied upon or form the basis of any investment decision nor for the potential suitability of any particular investment. The figures shown in this article refer to the past or are provided as examples only. Past performance is not reliable indicator of future results.

This article may contain information about cryptoassets. Cryptoassets are at a developmental stage and anyone thinking about investing into these types of assets should be cautious and take appropriate advice in relation to the risks associated with these assets including (without limitation) volatility, total capital loss, and lack of regulation over certain market participants. While the directors of Aaro Capital Limited have used their reasonable endeavours to ensure the accuracy of the information contained in this article, neither Aaro Capital Limited nor its directors give any warranty or guarantee as to the accuracy and completeness of such information.

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