Cryptocurrency concerns keeping investors at bay

Institutional investors are like kids in a candy store, looking with longing at the stratospheric returns of bitcoin and other cryptocurrencies without the means to invest, at least for now.

As attractive as 1,200%-plus returns might be, concern about the speculative nature of cryptocurrency investment and the lack of institutional-quality infrastructure and reporting will deter near-term investment by asset owners, sources stressed.

In fact, industry observers — including investment consultants, hedge fund-of-funds managers, asset servicing executives and cryptocurrency hedge fund managers — said they could not name a single institutional investor that has taken the plunge.

Two cryptocurrency funds targeted at institutional investors — hedge fund 3iQ Global Cryptoasset Fund and hedge fund of funds The BitBull Fund — launched in November and manage about $20 million for family offices and high-net-worth individuals.

"It is not at all surprising that institutional investors are presently refraining from investing in the cryptocurrency space. The nature of the investment mandates for these institutions is geared toward steady growth coupled with capital preservation, and to date, the crypto space has been very volatile," said Steven B. Nadel, a partner in the hedge fund practice of Seward & Kissel LLP, New York.

"Cryptocurrency is not yet an institutional asset class. There might perhaps be an investment through a growth equity fund or something, but I haven't heard of any and I think it unlikely," said the chief investment officer of a large U.S. public pension plan who asked not to be identified.

In addition to questions about the suitability of cryptocurrency as an institutional asset class, sources noted the necessary infrastructure and due diligence procedures for investment in cryptocurrency funds aren't up to institutional standards.

"Our operations team looked at cryptocurrency investment in response to questions from our clients and they found that being able to custody bitcoin assets really isn't possible yet. Even if you could figure out how to do it, it wouldn't meet normal custody standards," said Stephen L. Nesbitt, CEO of alternative investment consultant Cliffwater LLC, Marina del Rey, Calif.

"Just getting an audited financial statement of bitcoin assets is not easy," Mr. Nesbitt said, adding that cryptocurrency "is not an investment reality now for institutional investors."

Mr. Nadel said once cryptocurrency hedge fund managers begin using hedges such as futures — which are under consideration by U.S. regulators now (Pensions & Investments, Nov. 14 and Dec. 1) — to reduce volatility, and "guidelines around valuation and custody are established … I anticipate that institutional investors will find some comfort and begin to take a closer look at the area."

Reluctance to invest in digital currency hedge funds doesn't mean institutional investors aren't asking questions and investigating the investment opportunity.

A recent teach-in for clients and prospects about cryptocurrency investments held by hedge fund specialist investment consultant Aksia LLC attracted strong attendance, said Kenneth Chen, senior analyst, macro and quantitative strategies.

"There's definitely a lot of interest, but I'm skeptical that funds directly holding physical cryptocurrencies will be an institutional investment option in the near-term," Mr. Chen said, noting that a looming trust issue hangs over the nascent cryptocurrency investment industry.

"For institutionalization to happen, there has to be trust in people and processes in the industry. Anyone could walk away with a USB drive and your money would be gone," Mr. Chen said.

Cryptocurrency skeptics abound among institutional investment consultants. "I may be a Luddite, but I struggle with the legitimacy aspect and accountability of the cryptocurrency industry," said James McKee, senior vice president and director of hedge fund research at investment consultant Callan LLC, San Francisco.

"The biggest question for me is: Who is driving bitcoin investment? Who is your bedfellow in a cryptocurrency fund? It seems that the industry is being driven by speculators, tax avoiders and money launderers," Mr. McKee said.

Callan Associates hasn't fielded "serious inquiries" from clients about cryptocurrency investment to date, Mr. McKee said.

Governance is another potentially limiting factor when it comes to investment in cryptocurrency strategies, said Andrea McGee, managing director on the alternative investment research team of investment consultant Rocaton Investment Advisors LLC, Norwalk, Conn.

"Cryptocurrency investment seems too speculative for institutions at this point," Ms. McGee said. "It's often hard to get board of trustee approval for co-investments much less bitcoin."

An alternative to cryptocurrency hedge funds available now is hybrid private equity or venture capital funds that invest in initial coin offerings for startup companies, Ms. McGee suggested.

CEOs of BitBull Capital Management LP and 3iQ Corp. are confident that institutional investment in their funds will come.

"My prediction is that the first institutional investor will make an investment in cryptocurrency hedge funds in the first quarter of 2018," said Joseph DiPasquale, CEO of BitBull Capital. "The first institutional investors in bitcoin and other digital currency funds will gain the most alpha, which is pretty typical of investment in new strategies."

Mr. DiPasquale said the BitBull fund is the industry's first cryptocurrency hedge fund of funds. BitBull's San Franciso-based team evaluated 135 hedge funds and selected seven underlying funds with buy-and-hold, ICO investment, quantitative, shorting and arbitrage strategies among others.

Mr. DiPasquale said the lure for asset owners is not just the "stunning return streams" — two funds in the BitBull portfolio have year-to-date returns of 2,000% and 2,500%, respectively — but also the lack of correlation to other asset classes providing risk-reducing diversification to institutional portfolios.

The 3iQ Global Cryptoasset Fund, on the other hand, is a single-strategy hedge fund that uses a buy-and-hold approach with 50% allocated to bitcoin, 35% to ethereum and 15% to litecoin, providing investors with a core, diversified approach, said Frederick Pye, CEO, president and founder of Toronto-based 3iQ Corp.

Optimistic arguments for investment notwithstanding, Boston-based investment consultant Cambridge Associates LLC recently advised clients to avoid investment in cryptocurrencies or such funds.

"In our opinion, much of the interest in cryptocurrencies is simply speculation, with new entrants drawn in by the allure of rapidly rising prices," wrote Aaron Costello, a Beijing-based managing director on Cambridge's global investment research team, in a client brief.

Mr. Costello recommended asset owners instead focus on investing in companies that will profit from the development and adoption of blockchain technology that will facilitate trading of digital currencies.

"The potential application of blockchain technology across a wide range of industries … suggests it may generate economic returns for firms that successfully adopt the technology or facilitate its spread (and) development. As the old adage goes: In a gold rush, money is made by selling picks and shovels," Mr. Costello wrote.