LONDON (Reuters) - Bitcoin is booming, digital currency hedge funds are sprouting at the rate of two a week and the value of all cryptocurrencies has surged tenfold this year to more than $170 billion.
Yet for all the hype, mainstream institutional investors are steering clear of the nascent market, taking the view that it is too lightly regulated, too volatile and too illiquid to risk investing other people’s money in.
Bitcoin, the biggest and most well-known cryptocurrency, has outperformed all the world’s traditional currencies each year since 2011, except for 2014. But many investors still view it as an opaque, esoteric instrument used by gun-runners and drug-dealers on the Dark Web that should be avoided.
This year, though, a flood of new hedge funds focused on cryptocurrencies has offered institutional investors who might be unfamiliar with the market a potential route into the world of digital currencies.
According to Autonomous NEXT, a financial technology research house, 84 so-called crypto hedge funds have been launched this year, taking the total to 110 with about $2.2 billion in assets altogether.
But the fact most of the funds are relatively small with a limited track record - and that cryptocurrency price swings have been so pronounced - means the world’s pension funds, insurance companies and large mutual funds are staying away.
“While cryptocurrencies are probably here to stay, they are difficult to analyze, wildly volatile and some may be prone to fraud,” said Trevor Greetham at Royal London Asset Management (RLAM), part of the Royal London life insurance company.
“Diversification is a good thing but that doesn’t mean investing in everything just because it’s there. We favor assets with a long track record in producing returns or reducing risks,” said Greetham, who heads RLAM’s multi asset team.
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Autonomous NEXT partner Lex Sokolin said there were probably only a couple of funds worth several hundred million dollars with most in the $5 million to $20 million range - well below the threshold most institutional investors would consider.
“For many institutional, discretionary fund managers, those funds wouldn’t get cleared because the big question would be around liquidity,” said James Butterfill, head of investment strategy at ETF Securities in London.
One way mainstream money managers could get exposure is by investing in a basket of hedge funds that includes a crypto fund. But the head of hedge funds at a major European bank that invests in more than 100 hedge funds said there were no crypto funds in his portfolio.
“It’s a very controversial proposition,” said the banker, who declined to be named. “It’s unlikely that the most established hedge funds will make big bets on this because you could put your core business at risk.”
Determining the value of bitcoin and other cryptocurrencies is tricky. There are almost 17 million bitcoins in existence now but the total supply is limited to 21 million, and that won’t be reached until the next century.
Bitcoin’s total value, or market capitalization, is close to $100 billion, bigger than U.S. investment bank Morgan Stanley. At the start of the year it was just $15 billion. Ethereum, the second-biggest cryptocurrency, is now worth almost $30 billion.
“If the supply is truly fixed then the price of these securities are determined purely by demand which, in turn, is determined largely by sentiment,” said Ken Dickson, investment director, money markets and FX at Aberdeen Standard Investments.
“This means huge price swings with bubbles, booms and busts. Unless the supply processes of these instruments are reformed then it is unlikely that they will play any part of an investment portfolio,” he said.
Bitcoin has been on a rollercoaster ride this year. After hitting what was then a record high just below $5,000 in early September it lost about a third of its value in less than two weeks. It has since almost doubled in price again, to new highs near $6,000.
Ethereum has been even more erratic. Its price surged almost 50 times from the start of the year to June, before falling back by about a fifth, according to industry website CoinDesk.
That kind of volatility means committees at institutional investment firms looking at the relative risks of asset classes are likely to rule out cryptocurrencies, asset managers said.
“Your risk-budgeting committee will say: you can’t hold a lot of that because of the amount it increases risk in your portfolio,” said Butterfill. “I do expect volatility to decrease over time but risk budget teams tend to look historically.”
For now, those investing in crypto funds are high-net worth individuals, companies managing money for wealthy families, private wealth managers and some venture capital investors.
“It’s clear there’s money piling into these funds,” said Emad Mostaque, co-chief investment officer at the London office of South African hedge fund firm Capricorn Fund Managers. “There’s just not that institutional investor comfort yet.”
Alistair Milne, co-founder of the Mayfair-based Altana Digital Currency Fund, likens investment in crypto funds to the start of the hedge fund boom in the early 1990s, when wealthy individuals were the first to invest in a raft of new funds making high returns.
“It always starts with the high-net worth individuals,” he said. “It wasn’t until 2004-2005 that institutional investors started getting involved in those.”
The new crypto hedge funds take a variety of approaches, betting on new coins issued to raise funds via so-called initial coin offerings (ICOs), price direction or differentials between rates on the many cryptocurrency exchanges.
One new fund, the London-based BitSpread, says its $25 million market-neutral fund - which trades on price differentials alone - gives major investors a way into the market without exposing them to violent price swings.
The fund is up 32 percent so far this year, having managed to exploit the kind of arbitrage possible in a young market where large price gaps exist.
“(Institutional investors) haven’t invested in this ecosystem yet because they haven’t yet found the right vehicle,” said Cedric Jeanson, BitSpread’s founder.
Reporting by Jemima Kelly and Maiya Keidan; additional reporting by Claire Milhench; editing by David Clarke