Summary from Arca's Chief Investment Officer: 9 Key Takeaways from Managing Crypto Funds Over the Past Five Years

Author: Jeff Dorman, Chief Investment Officer of Arca

Compiled by: Felix, PANews

Jeff Dorman, Chief Investment Officer of the crypto investment firm Arca, has been managing a cryptocurrency fund for 1825 days. Arca has just achieved a significant milestone, setting a record for external capital managed in a liquidity hedge fund over the past five years.

In any other industry, five years may not seem like a long time, but in the crypto space, five years is quite a stretch. Due to around-the-clock trading, one year in the crypto industry can be said to equate to five years in traditional industries. Over the past five years, witnessing many peers come and go, Jeff Dorman has left some survival insights in crypto asset management.

CoinDesk columnist Jeff Dorman is the Chief Investment Officer of Arca, leading the investment committee responsible for portfolio sizing and risk management. He has over 20 years of trading and asset management experience at firms such as Merrill Lynch and Citadel Securities.

As the Chief Investment Officer responsible for overseeing this fund and three other funds under Arca, Jeff Dorman has personally experienced the evolution of the industry, including its ups and downs and continuous innovations. Here are the most important lessons learned from managing a cryptocurrency portfolio over the past five years.

In short: the crypto investment market is highly challenging.

Adjusting Assumptions and Risk Models

For anyone who has invested in this market, adjusting assumptions and risk models is self-evident, but crypto assets are not an easy category to invest in. For newcomers, the frequent booms and busts can create a false sense of liquidity and an inaccurate portrayal of expected beta* (note: here refers to the price volatility of individual tokens relative to the overall market). All risk models, expected loss reserves, and scale parameters are based on historical data and correlations, which change at a rapid pace. For those managing liquid funds, it is a game of constantly adjusting assumptions and risk models.

Interpretation Over Speed

Contrary to the common perception in the market, the crypto market can trade globally 24/7 but does not require around-the-clock trading coverage. In any asset class, overtrading on every price movement is costly, and the 24/7 nature of cryptocurrency trading often tries to lure you into more trading activity. But the reality is that the decentralized global investment landscape actually gives you more time to react to news and information.

While there will always be bots and algorithms reacting to news immediately, these initial subconscious reactions are often wrong. Due to time zone differences, a third of the world's population is always asleep, so true market reactions often take days to manifest. Correctly interpreting information is far more important than reaction speed.

Detailed Documentation is Crucial

Around-the-clock trading does bring challenges that do not exist in traditional markets. In traditional financial markets, even the worst day/week eventually ends, giving you ample time to readjust and rethink decisions during market closures without being blinded or influenced by price fluctuations. But in the crypto space, these do not exist.

Take the Terra/Luna incident as an example, where a $30 billion ecosystem collapsed within three days. During these 72 hours, there was a continuous stream of trading and new information. Decisions made by traders during this time often lack much of a timeline in hindsight, and crypto professionals have gradually learned how to better implement risk management under such urgent timelines in the future.

In hospitals, errors often occur not because doctors are overworked or fatigued, but because information is incorrectly passed to the next doctor due to incomplete records from the previous doctor, leading to a lack of complete information for the next doctor. Crypto asset management also requires similar knowledge transfer and documentation.

Balancing Short and Long

In the debt and equity markets, calm periods (summer, holidays) typically lead to slow price increases. The cost of shorting is high, and dividends and coupons accumulate, adding more buying interest to the market. The situation for crypto assets is quite the opposite. Since most crypto projects accumulate value through network activity, during dull periods, the momentum for asset appreciation often slows down. With most assets lacking cash flow distribution, the cost of shorting is minimal. During market downturns, negative price trends are often more prevalent, making it difficult to make decisions regarding hedging and long positions.

Therefore, active management is superior to passive indexing. Rule-based passive index strategies simply cannot keep up with the innovations and changes in the crypto market. Similarly, passive indexes cannot capitalize on market volatility to generate significant alpha. Over time, this may change as the market matures, but the crypto space has not reached that point yet.

Hire Passionate People for the Industry

Building a great team is the foundation of success and is also highly challenging.

Over the past 25 years, Jeff Dorman has worked at seven different financial firms. He has seen thousands of resumes and interviewed hundreds of candidates. Jeff Dorman has personally worked in almost every financial sector (banking, trading, research, sales, business development). If a traditional Wall Street financial firm sought a candidate, Jeff Dorman could easily find the best fit for their needs.

What are the best attributes and qualifications for a cryptocurrency research analyst? What makes the best trading operators? Who is best suited to handle investor relations? These are still not easy questions to answer in the crypto space. In the early years of Arca's fund establishment, anyone who wanted a job was hired by Arca. Salaries were low, hours were long, and the future was uncertain. Those looking for jobs in the crypto industry in 2018 were genuinely passionate about the success of blockchain and willing to learn any knowledge and skills required for the job. Most of those who joined the industry before 2020 are still working in the industry, and their job responsibilities are changing in real-time. By 2021, Arca could personally select anyone from major banks, brokerages, and hedge funds who wanted to join, even if they had no crypto experience, as they saw the potential for significant wealth in the future, and resumes flooded in. But by 2023, only those who are truly passionate about the industry remain.

Everyone Wears Multiple Hats

This is a highly practical business where research analysts must test the functionality of applications, challenge existing financial models, and engage in real-time discussions with other industry veterans during meetings. Traders must switch back and forth between U.S. macro, Asian currency markets, and specific on-chain wallet trends based on current correlations. Back-office staff must test new service providers every three weeks to keep up with changing regulations, best practices, and LP requirements while dealing with constant bankruptcies, closures, and hacks.

What they have in common seems to be a genuine willingness to test new ideas. If you provide the same information to ten equity analysts, they will give you roughly the same answer and provide homogenized modeling to arrive at that answer. If you provide the same information to ten crypto analysts and traders, they are likely to use completely different analytical models to provide ten different answers. This is refreshing and often brings significant alpha, but it also presents challenges in creating repeatable success models.

Trading Operations is the Most Important Department

When Jeff Dorman worked at credit and equity fund companies, he found that back-office work was often overlooked. These employees were usually young and eager to quickly become "real" trading roles. Back-office work primarily ensures trade settlements, accurate broker reporting, and that fund administrators do their jobs.

But in the crypto space, one should consider themselves lucky.

Trading operations are the most critical jobs in the cryptocurrency field. You must interact with these assets daily, and one mistake can cost the company millions of dollars. Therefore, these individuals not only need to be the most trusted people in the company but may also be laid off, yet the company can still operate without them. Entering a trading operations position is more attractive than exiting because those working in this department will learn the most about blockchain.

Similarly, in the crypto space, compliance is not an afterthought. Unlike traditional financial markets, you cannot assume your employees understand the rules, as most employees come from backgrounds entirely different from Wall Street. Continuous education and oversight are essential. Moreover, compliance officers cannot merely read the rules and assume compliance, as there are almost no clear rules to follow (though Gary Gensler has stated otherwise). Being both a fiduciary and a compliant company is a daunting task.

The Situation for Sell-Side is Improving

In traditional finance, the sell-side plays a very important role. They underwrite new deals, create novel financing ideas, advise companies on how best to participate in capital markets, facilitate the trading of existing securities, and write research reports on new and existing securities. Full-service investment banks and broker-dealers exist, and whether you use a one-stop shop or provide services piecemeal to multiple firms, the service itself is included.

While the sell-side in the crypto space is improving, it remains highly fragmented, with many services still nonexistent. As a result, fund management companies often find themselves isolated, forced to seek trades on their own, build financing structures themselves, and conduct research from scratch. Although the number of research reports published by OTC platforms has significantly increased, and the quality has improved, trading itself still heavily relies on exchanges* (which can be likened to the black box of an airplane)*. There are currently no full-service investment banks available. In fact, the services providing underwriting and consulting for token issuances may represent the largest market gap in the future.

Jeff Dorman has been shocked by the minimal use of well-known capital market tools in the crypto space. Most token issuances are doomed to fail from the start. From low liquidity/high fully diluted valuation (FDV) token issuances to direct listings at crazy prices, to poorly written token economics, token issuers (often developers lacking financial knowledge) have to enter the market without third-party assistance. This subsequently leads to poorer investment returns for asset management companies.

Some service providers are becoming better, such as custody solutions, OTC trading, and options liquidity. Nevertheless, others are getting worse, like fund managers and auditors, who are withdrawing from these products following the collapse of FTX.

In terms of technology and research, Bloomberg's crypto services remain subpar. Coverage lists, indexes, and all functionalities are still from 2017, without considering the industry's development and maturity. Fortunately, the pace of innovation from new companies like Nansen, Messari, Glassnode, Dune Analytics, and Telegram is fast enough to capture this market, and thanks to these companies. By 2023, it is entirely possible to operate a cryptocurrency fund without logging into a Bloomberg terminal.

Overall, fund management still faces the challenge of a lack of sell-side tools. As the sell-side improves, the scale and breadth of funds will also improve.

Investor Base is Becoming Smarter

When Arca Fund was established five years ago, Arca believed that the educational journey for future investors would be long. Arca has continuously learned through investing and has made every effort to educate interested investors in real-time, but it is unrealistic to expect those who do not focus full-time on the industry to keep up.

Today, the script has completely flipped. Investors are becoming increasingly knowledgeable about asset classes and investment areas, leading to better questions. In some cases, investors now know more than the fund companies because the different areas they are exposed to may not be the focus of the fund companies' daily attention. That said, a significant amount of misinformation continues to spread to investors through "media" and "KOL" accounts, often leaving fund companies surprised by certain topics that they consider irrelevant but investors find hot.

As investors begin to understand crypto assets better, they seek more control over their investments, and personalization increases accordingly. Asset management companies in the field have launched highly specialized funds based on investor demand, including funds focused on DeFi, NFT funds, and more. Many asset management companies, including Arca, have begun creating "Funds of 1," allowing for more targeted approaches while providing professional teams to manage investments.

As information becomes more accessible and project UI/UX improves, there is a shift from needing professional fund managers to guide, to gradually encouraging retail investors to conduct their own research and invest. However, to generate alpha in the presence of information asymmetry, having professional fund managers who can leverage around-the-clock news, market volatility, and ambiguous regulatory environments remains highly valuable.

Conclusion

Overall, operating a fund in this new innovative space is highly rewarding, and the next five years are eagerly anticipated. Fund managers will continue to seek new investment blue oceans rather than being limited to opportunities exclusive to the crypto space, such as liquidity mining, airdrops, and testing new applications.

The most important factor for success in the crypto asset space is confidence in the future. It must be believed that the crypto industry is at the forefront of building a new financial system capable of transforming society. While there will be bumps along the road and resistance from some enterprises, as long as we keep moving forward, striving for necessary changes, and adjusting as needed, this industry will succeed.