Creating a more transparent, trusted and accessible investment universe
Fund managers play an important role in the global financial system. By allocating capital to a fund manager, you are effectively outsourcing investment decisions to a investment professional who, in theory, has the resources and knowledge to be able to manage your capital far better than you could. Fund managers usually have teams of highly educated analysts that have spent many years and often substantial fortunes studying highly quantitative subjects at some of the best universities in the world. This gives us some peace of mind knowing that our money is safe, being managed by intelligent, hard-achieving, ambitious people whose incentives are usually aligned with ours, thanks to the performance fee structure.
Hedge funds have often been among the more exciting firms in the investment world, being romanticised and played-up in Hollywood and the media for many years. Back when I was at university, working for a hedge fund was one of the most sought-after careers that only a few people were ever lucky enough to experience. The hedge funds were considered places where highly quantitative people worked, working on innovative complex leveraged strategies which could often result in impressive returns for the firm, their investors, and often good bonuses for the staff.
How are hedge funds different?
Hedge funds are considered far more risky than traditional asset managers due to the complexity of their strategies. They are able to short-sell, trade complex derivatives, use a high amount of leverage and take positions in some esoteric alternative asset classes. This allows them a great degree of flexibility in creating innovative strategies in order to provide the best returns possible to their investors.
Some of the most notable hedge funds in the world include Renaissance Technologies and Bridgewater Associates. Renaissance’s Medallion Fund returned an average annual return of 66% since 1988, 39% after fees. An impressive annual return for anyone.
This all sounds great, however there are several issues associated with the hedge fund industry which have been around for some time:
1. Lack of Transparency
Hedge funds keep details of their strategy mostly hidden away from the public and even their investors. However, after scandals such as Amaranth Advisors where investors lost over 60% of their capital, the need for transparency in this industry is greater now than ever. The lack of transparency means that investors cannot actually see what the manager is doing with their money, giving the manager free reign. This presents some issues for a potential investor:
Unable to assess if the manager is diverging away from the stated strategy
Unable to assess if the manager has a large position in any indivdual asset which the investor might want to hedge against.
Unable to assess if the manager is inappropriately using derivatives or leverage
Unable to make fully informed decision making by being unable to monitor performance and assess risks.
2. Inaccessible
Hedge funds are exclusively accessible to High-Net Worth Individuals (HNVI) or large investment institutions. Retail investors are not able to invest in hedge funds due to regulatory restrictions, they are assumed not to be ‘financially sophisticated’ enough to understand the complex strategies they undertake. Obviously this is not a fair assumption and prevents many financially sophisticated individuals from participating in some of the impressive returns the hedge fund industry has to offer.
3. Security of Funds
As we saw with the Bernie Madoff scandal, security of client funds can also be a concern. When you hand over your funds to a hedge fund you have little visibility on what the manager does with your funds. Securities fraud is a real risk as history has shown.
How can ethereum (DeFi) help?
The hedge fund industry is long overdue for change. We have seen technological progress remove market inefficiencies across all industries, yet the hedge fund structure has mostly resisted change. The natural evolution of the hedge fund industry is to create a more transparent, trusted and accessible investible universe for all. With the growth of DeFi (decentralised finance) on the ethereum network, this has presented many opportunities for progressive and innovative managers looking to lead the change in the industry.
By migrating fund management onto the ethereum blockchain we can overcome many of the problems that have been associated with the archaic hedge fund industry.
1. Transparency
a) Assets Under Management (AUM). By putting assets on-chain, the AUM of funds can be seen transparently on the blockchain. This makes it very difficult to misrepresent AUM to new potential investors and misreport AUM on documentation. All assets of the fund can be visible on-chain for all investors to see.
b) Current Exposure and Risks. Positions that the fund takes can be seen on-chain too. This enables investors to assess the risks the fund is currently taking, and hold them to account if they are deemed to divert away from the agreed strategy with which they raised capital. While some hedge funds would worry about competitors trying to mimic their strategies by watching their trades on-chain, the positives from openness and transparency should win far more confidence from investors when considering a new manager to manage their capital.
c) Verifiable Track Record — This transparency allows investors greater insight into the activities of the fund manager to help them make an informed decision to invest. As trades are made on-chain, there is a verificable and immutable track record that develops overtime which cannot be forged.
2. Security
One of the greatest benefits of fund management on-chain is that the funds can be ‘self-custodied’. This means that the managers do not have access to the funds and do not custody them on behalf of the investor, nor does any other entity. The investors hold the value of their investment stake in their own ethereum wallets via minted ERC20 tokens. The investors are the only people who can get access their orginal investment via the wallet with which they invested.
How does this work?
When an investor allocates capital to a new fund manager on-chain, the assets are sent to a secure smart contract vault which then issues the investors ERC20 tokens that are linked to the Net-Asset-Value (NAV) of that specific fund. The investor receives the relevant number of ERC20 tokens that are of equivalent value to the amount invested. These ERC20 tokens can be freely traded on any decentralised venue or directly with other investors and/or traders. The investor holds these tokens in their own wallets, the value of which changes based on the value of their investment in the fund over time. What’s more, the fund manager has no access to these underlying assets in the smart contract vault.
The added security by investing in funds on-chain means:
There is very little risk of the manager being able to hide any mis-managment of your invested funds.
There is very little risk from him/her from being able to run away with all the funds assets as they have no access to the invested funds.
The investor always holds onto the tradable assets which represents their stake in the fund in liquid form. Again, less trust is needed with manager of the fund.
3. Liquidity
As the ERC20 tokens are freely tradable on any crypto venue which supports ERC20 tokens, investors stake in a fund can easily be sold to another investor/trader or instantly redeemed with the fund manager at anytime. This is a stark contrast to the traditional fund management industry, where in the US the average redemption period is quarterly (every 3 months)
What are some of the challenges?
1. Available Assets
The biggest challenge currently is the lack of investible assets on-chain. While the world of DeFi is growing at a rapid rate, we are yet to see some of the traditional assets in ERC20 form that would enable some traditional asset managers to migrate over on-chain. Assets such as commodities, currencies, equities, derivatives etc. That being said, there is lots of work going on in the community and it will not be long before we see start to see these assets on-chain. The guys over a Synthetix Exchange are working on just this as are a couple of others.
2. Security of Code
As many of these business being built on the ethereum blockchain are new, some of their smart contract code has not had suffucient time to be thoroughly tested or audited. This may result in issues arising for those businesses that have unknowingly left vulnerabilities open for others to abuse. Insurance products from firms such as Nexus Mutual help to limit this risk. As the market matures hopefully these vulnerabilities should be less common.
Conclusion
The hedge fund industry has been married to its inefficienices for many years now, servicing only the wealthiest while maintaining opaque operations requiring an unreasonable level of trust with the manager of your capital. Issues such as lack of transparency, inaccessibility and security of funds have led to huge global scandals which have often made it to mainstream media.
As we’ve seen across all industries technological innovation paves the way for greater efficiency improvements and better terms for customers/investors. Managing investment funds on ethereum brings about improvements including:
Transparency of size of AUM
Transparency of risks and exposures
Verifiable and immutable track record on-chain
Vastly improved security of funds
Investors have more control over their capital
Much greater liquidity terms for investors
Challenges remain moving all types of asset management on-chain due to the lack of assets represented on-chain via ERC20 tokens and the imature nature of some of the smart contract code.
The time for change in the investment management industry is here thanks to Ethereum. A more open, accessible and secure investible universe for investors is now possible. As the space grows we will begin to see more synthetic assets on-chain allowing more different types of strategies to be deployed, including shorting and leveraged strategies.
On-Chain Fund Management in Action
Eager to be among the first to lead the change in this industry, my fund Alphachain Capital has developed two systematic cryptocurrency strategies on-chain in partnership with Token Sets. The ETH Trending Alpha ST set and the ETH Trending Alpha LT set are trading live now, already developing their immutable track records for the world to see and are accessible to everyone.
Find out more about Alphachain Capital and our DeFi strategies.
Join the Alphachain Capital DeFi strategies group here: https://t.me/alphachaindefi