Interval Funds

May 18. 16:50

Cryptocurrency Investors Find Great Potential in Interval Funds

The value of the world’s cryptocurrencies has than doubled since the beginning of 2021, and institutional investors are taking notice. Public companies are adding crypto to their balance sheets, and over 820 funds – mostly private equity, venture capital, and hedge funds – are investing directly in digital tokens.

Nine applications to form bitcoin ETFs are pending with the SEC, which has postponed its decision until later in the summer. Previous applications have been rejected due to concerns over crypto price volatility, difficulties in providing adequate liquidity, and potential for market manipulation.

But there’s still hope for over-the-counter investment in cryptocurrency funds. Retail and institutional investors looking for exposure to the growing market have turned to closed-end structures like interval funds as a convenient and value-preserving vehicle that doesn’t require individual ownership of digital tokens. Most of these operate as traditional closed-end funds, and they can suffer from secondary market discounting. But the unique structure of an interval fund makes it particularly well suited to handle the idiosyncrasies of the cryptocurrency market, and exciting opportunities are emerging in the space.

Cryptocurrency Investors Find Value in Interval Funds

Photo by Executium

FIRST: WHAT’S A CRYPTOCURRENCY?

To understand cryptocurrency, you need to first understand the “blockchain” – a term invoked far more often than it’s understood.

The concept of a blockchain was formalized in a now-famous 2008 white paper of dubious authorship, which ultimately led to the creation of the most popular and valuable cryptocurrency: bitcoin. Since then, the technology has grown to form the basis of an asset class worth more than $2 trillion.

In simplest terms, a blockchain is a digital method for storing information without the use of a central, master database. Through time, the blockchain is updated with discrete chunks of information, called “blocks,” which are timestamped and sent to a network of participating computers around the world. This “chain of blocks” method can be used to store many types of information, but its most famous and widely used application is to maintain a constantly updating, widely distributed ledger of ownership. When that ledger records individual balances of an entirely digital asset – a cryptocurrency is born.

The terms “blockchain,” “cryptocurrency,” and “bitcoin” are often used interchangeably. The three terms are related, but they’re distinct in important ways. Blockchain is the technology that cryptocurrencies use to transact in a secure, distributed way. Cryptocurrencies are digital tokens whose ownership is recorded on a blockchain. Bitcoin is a cryptocurrency – others include ether, cardano, and, yes, dogecoin.

Cryptocurrency Investors Find Value in Interval Funds

Photo by Executium

HOW ARE CRYPTOCURRENCIES TRADED?

Investors who want exposure to cryptocurrency have two options: directly purchase digital tokens or invest in one of the many options in the cryptocurrency derivatives market. The first option involves opening an account with a cryptocurrency brokerage like Coinbase or Kraken and purchasing the tokens using a government-backed currency. This is analogous to directly buying real estate, rather than buying shares in a real estate investment fund or an ETF that tracks a real estate index.

Some investors prefer to rely on a traditional fund structure to gain exposure to digital currencies. This approach eliminates the stress and learning curve inherent to purchasing tokens directly, and can be attractive to those wary of the technology’s somewhat shaky security record.

As noted earlier, there aren’t currently any operational cryptocurrency ETFs or mutual funds. On May 11th, the SEC released a statement justifying its wariness of greenlighting open-end crypto funds and casting doubt on whether any will be approved this year. Investors currently have the choice between traditional closed-end funds and interval funds – and for value, interval funds are the superior option.

TRADITIONAL CLOSED-END FUNDS FALL SHORT

Most listed cryptocurrency funds are traditional closed-end funds (CEFs). Unlike interval funds, CEFs sell their shares on a secondary market, allowing the forces of supply and demand to heavily influence their share prices. This can have a deflating effect on the value of shares: over the last year, the average CEF share traded at over 8% less than its net asset value.

Most crypto CEFs take the form of cryptocurrency trusts: pools of digital currency whose value is divided into purchasable shares. The largest of these, the Grayscale Bitcoin Trust (GBTC), holds over $32 billion worth of the coin. However, as of early May the fund was trading at over a 20% discount to the value of the bitcoin it holds – underlining one of the key disadvantages of traditional closed-end funds. At a 20% discount, shareholders are only exposed to 80% of the value of the underlying cryptocurrency, minus the fund’s fees.

Cryptocurrency Investors Find Value in Interval Funds

The value of most cryptocurrencies is fundamentally controlled by supply and demand. Because they aren’t backed by physical assets or governments, digital tokens are essentially worth what people are willing to pay for them at a given time. Therefore, when consumer sentiment about cryptocurrencies is negative, a cryptocurrency trust experiences downward pressure on both the price of a cryptocurrency trust’s underlying investments and the market price of its shares.

INTERVAL FUNDS PROVIDE UNIQUE OPPORTUNITIES FOR CRYPTO

Interval funds have neither the liquidity requirements of an open-end fund nor the secondary market volatility of a CEF. This makes them the best option among crypto funds for price stability.

Today’s operating or filed crypto-linked interval funds don’t directly invest in the currencies themselves, but in cryptocurrency futures. Because the U.S. classifies cryptocurrencies as commodities rather than currencies, marketplaces like the Chicago Mercantile Exchange offer crypto futures contracts. These agreements – which are settled in cash and rely on predictions about the upcoming price of a given cryptocurrency – are an alternative to holding tokens directly. Futures allow investors to speculate on the long-term movement of a cryptocurrency rather than endure the daily boom and bust cycles for which the asset is famous.

Furthermore, interval funds holding crypto futures don’t lose out on the upside growth of cryptocurrencies. The graph below shows the share price of the largest cryptocurrency interval fund, the Stone Ridge Trust VI (BTCNX), compared to the price of the Grayscale Bitcoin Trust (GBTC) and bitcoin itself. Both funds' growth is highly correlated to that of bitcoin -- but the value of a share of GBTC is currently 20% lower than that of the bitcoin underlying it.