Alpha, Beta, and Crypto Funds


HFR just debuted new indices aimed at blockchain and cryptocurrencies. HFR stands for Hedge Fund Research and the new indices measure the performance of twenty hedge funds investing in blockchain and trading cryptocurrencies.  So far this year, the HFR Cryptocurrency Index alone has risen 1,635%. But one must wonder if that performance is skill or just luck?

In the hedge fund world there is either alpha or beta returns. Beta returns are earned from just going with the market and don’t require great expertise. Whereas alpha returns required something extra, something more. If the S & P 500 Index is up 20% in one year, then you would want your hedge fund manager to earn more than that, but most do not. For in most professions there are the Jordans, Kanyes, and then everyone else.

Alpha returns in crypto may eventually come from some type of edge: a social network, a technology insight, or a trading acumen.

For example, former Fortress employee and macro  trader, Mike Novogratz, who made his $250 million crypto fortune from a “small” bet on ether back in 2016, will open his first fund next year, called Galaxy Investment Partners. Olaf Carson-Wee co-founded Polychain Capital with money from Andreesen-Horowitz  and USV. Carson-Wee’s edge comes from his social and intellectual capital developed as one of the first employees of Coinbase.

Recently Techcrunch founder, Michael Arrington, announced in late November his own fund focused on blockchain and crypto. As a former venture capitalist, Michael Arrington will be leverage his own social network and tech expertise. Out the gate, Arrington did score a first by establishing the first fund denominated in XRP, the cryptocurrency of Ripple Labs.  The XRP Capital Fund will only use XRP as investment from and redemptions to limited partners.

Since crypto funds are relative new, investors won’t really know for a while whether they’re paying for alpha returns from fund managers. It’s worth noting that most of the run up in the HFR Cryptocurrency Index came in 2017 when lots of new money flowed into the crypto-space.

So right now there might only be beta returns in the new crypto funds.


The Big Short, Again?


Just in time to burst a bubble, there comes this Sunday bitcoin futures come the Chicago Board of Trade (CBOE) and more later from the CME. Now there is way to bet against the tremendous rise in bitcoin. It’s almost similar to the housing bubble a decade ago when credit default swaps were applied to mortgage backed securities to short the real estate market. But in this Big Short, who will be on either side of the trade?

Unlike the stock exchange, in the futures market there is only one winner.  For every short position, there needs to be a long one since futures are a zero sum game. In effect, the short trader is betting prices will go down while the long trader hopes prices will go up. In order for a futures market to survive, there needs to be enough shorts and longs; or said another way, there needs to be enough hedgers and speculators.

Who would do the bitcoin short trade? Companies, firms, and individuals who are holding lots of bitcoin and who may not like the price of bitcoin going down. For them, the short trade is a side bet: if bitcoin goes down in value, the losses are offset by gains from the futures contract. Given the volatility of bitcoin, anyone doing business in bitcoin can not necessarily afford loses after receiving payment in bitcoin.

Online retailer, Overstock, who receives bitcoin and other cryptocurrencies as payment could be a short seller, a hedger. Overstock may use futures to lock in the value of their bitcoin holdings. Circle Financial may be another hedger given the volume of cryptocurrency transactions used its cross-border payment business. Circle no longer deals directly in bitcoin, after pivoting to doing payments. Its product is free and Circle makes money by trading bitcoin and other cryptocurrencies.

While it’s hard to predict the success of bitcoin futures, it’s helpful to remember that the CME lists futures contracts on real estate, based upon the Case/Shiller Home Prices Index. Despite being listed since 2006, the real estate futures never took off due to a lack of hedgers, speculators, and market liquidity.

Other than hedge funds and some business, who is willing to bet against the rapid rise of bitcoin?


Wall St. Comes to Bitcoin, For Good.



As announced by the CFTC, new bitcoin derivatives were self-certified by the CME, the Chicago Board of Trade (CBOE), and the Cantor Exchange this week. That news means that bitcoin futures and binary options will soon be listed and provide another way to trade bitcoin. While the CFTC did not actually approve the new contracts, its involvement may benefit traders of bitcoin futures.

Trading bitcoin futures has advantages over trading real bitcoin. Besides leverage and shorting, bitcoin futures receive a preferential or lower tax rate on gains. Trading actual bitcoin could mean any gains are taxed as ordinary income. For example, if one trades bitcoin and is in the 35% tax bracket, then a gain of $10,000 would mean taxes of $3,500 due to the government. But with bitcoin futures, the amount due is only $2,600.

For tax purposes, it appears that bitcoin futures will qualify as Section 1256 contracts. That designation means that sixty percent of the gains are taxed as long-term capital gains and the remainder as short-term capital gains. It also results in the favorable tax rate.  Section 1256 contracts are futures contracts that are subjected to marking for market for margin purposes  and trade on a qualified board or exchange (QBE).  

A QBE is a domestic exchange that operates under the oversight of the CFTC such as the CME or Chicago Board of Exchange.  The CFTC regulates futures on commodities  and two years ago it stake a claim on regulating bitcoin futures. In a case against Coinflip Inc, the CFTC said among other things that bitcoin was a commodity; that meant futures on bitcoin would be regulated by the CFTC.

In 2014, the IRS classified bitcoin for tax purposes as property rather than as a commodity. As property, gains from trading bitcoin can be subjected to ordinary income tax rates, which can be large for people in high tax brackets. But those same people could have lower tax bills when trading bitcoin futures rather than real bitcoin.

Disclaimer: This post is intended only for educational purposes. It should not be relied upon for investment or tax advice. Interested parties should instead consult with their investment and tax advisers.