The rise in the price of Bitcoin and other cryptocurrencies since the beginning of the year is generating headlines and interest around the world.

While some investors continue to struggle to understand how the market works (and this includes some bankers in the City of London, financial professionals, I met with last week), others are desperate to get a piece of the action.

One trend we at The Armchair Trader have been noticing in the last few months is the sudden proliferation of Bitcoin funds, namely investment funds that are cropping up, seemingly on every street corner, with the single objective of providing investors with exposure to the Bitcoin market.

Particularly in the United States, but also in Europe, these funds are beginning to solicit investment from wealthy individuals interested in the Bitcoin story, but who may not understand the market, or indeed the funds they are dealing with.

The funds concerned encompass a range of strategies, including those which engage in initial coin offerings, or ICOs, and those which hold several differing cryptocurrencies, including Ethereum and Litecoin.

Yet a recent Bank of America survey of 200 fund managers revealed that many experienced portfolio managers think the Bitcoin trade is currently the world’s most crowded trade, and such funds are heavily exposed to a sudden reverse in the market.

Assets which gain value so quickly will always attract those who see the opportunity to make money from a market which essentially travels in just one direction.

The only difficulty here is that no market does this forever.

There will be reverses, sometime catastrophic ones.

The issue with many of the new cryptocurrency funds is that they are being managed by people who might understand Bitcoin, but may not necessarily understand markets, or hedging risk.

If Bitcoin turns sour, or there is a more general rush for the door, and out of cryptocurrencies, will they be able to survive?

And what will happen to their investors?

We have been here before with dotcom stocks in 2000-01; in 2007 the hedge funds universe was over-stuffed with managers who claimed to be hedge funds, but who failed abjectly to cope with the financial crisis in 2008 and were driven out of business.

Hundreds of funds which professed to be long /short equity funds (i.e. capable of making money even during a bear market) went to the wall. They were long only funds charging hedge fund fees, and had to shutter once the market turned against them.

Bitcoin has its sceptics, and they are big ones.

China has already begun to crack down on Bitcoin exchanges, although we would argue that this is partly to close it down as a channel for exporting wealth out of the country.

Vitor Constancio, vice president with the European Central Bank, said last week: “Bitcoin is a sort of tulip. It is an instrument of speculation…but certainly not a currency and we certainly don’t see it as a threat to central bank policy.”

Buyers of hedge funds, regardless of what they invest in, should approach those with a single trade proposition with extreme caution.

Part of this boils down to survivability.

What is the fund manager going to do if his market turns against him, and the price of Bitcoin drops suddenly overnight?

What is a major financial regulator suddenly outlaws Bitcoin?

In short, what does his/her risk management policy look like?

Before writing a cheque to such a fund, investors need to ask themselves whether it is a one trick pony or a genuine effort to build a diverse business. As one seasoned hedge fund manager told me recently:

“More investors need to look at hedge funds as businesses, not just as investments.”

Next time you are solicited by a Bitcoin fund, ask yourself whether you are looking at a viable business.

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27th September 2017
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