Decentralized Hedge Funds: What Are They and How Do They Work?

Josiah Makori
By Josiah Makori
Marcel Deer
Edited by Marcel Deer

Published May 22, 2022.

Man sitting at a desk using his laptop

A decentralized hedge fund is a community-based investment pool, where the members/community select allocation funds instead of a hedge fund manager. It uses smart contracts that run on blockchain technology. This technology guarantees trust in a trustless environment and ensures all members participate in decision-making.

Traditional hedge funds rely on a fund manager's view of the market. They mitigate market risks by appropriately diversifying investor funds. Therefore, when a traditional hedge fund attracts investors to invest their money based on market prospects and the fund manager's expertise, the manager's sole mission is to maximize profits while mitigating risks.

Importantly, traditional hedge funds are centralized, and most apply the 2/20 principle. The rule assigns 2% of the earnings to expenses and 20% to the founders and fund managers. The lack of obligation for public disclosure is the root cause of such huge payouts.

Besides, there is minimal supervision by the limited partners (investors) in traditional hedge funds' financial activities since their operations and profits are opaque. In other words, the law doesn't compel funds to disclose their investment operations to investors.

In a decentralized hedge fund:

  • Members/investors vote to determine market possibilities, review the result of the investment strategies and compensate themselves evenly based on their contributions
  • Smart contracts allocate investor funds – there are no human fund managers
  • Blockchain-based secondary markets facilitate 24/7 trading – investors can withdraw their funds anytime

How Do Decentralized Hedge Funds Work?

The original vision of Satoshi Nakamoto, the pseudonymous creator of Bitcoin, was to establish decentralized finance. Thus, the financial models of the crypto market should be fully decentralized. Luckily, blockchain technology – the technology behind crypto – facilitates decentralization.

Here is where a decentralized hedge fund comes in. A decentralized hedge fund is an investment vehicle of funds managed by smart contracts running on a blockchain network like traditional hedge funds. The smart contracts automatically allocate funds based on the consensus arrived from investor votes.

Since decentralized hedge funds are built on blockchains, their activities are completely transparent, and the investors can view all transactions. Anyone from any part of the world can participate in these funds by connecting their digital wallets to their chosen decentralized hedge funds. Besides, decentralized funds don't have a minimum deposit apart from the one-time activation fee, further lowering the barriers to entry.

Let's consider the DeFi hedge fund created by Alpha Protocol. The fund consists of cryptocurrency investors, who hold digital currencies, and quantitative strategists who leverage math and other cutting-edge techniques to generate profits from investor funds.

The Alpha Protocol investors apply decentralized governance to vote for the strategists using the Alpha Protocol Token (ALP). The protocol allocates a certain amount of funds from the Alpha pool to every strategist based on voting outcomes. Eventually, the earnings are split between the strategists and the Alpha pool and sent to investors.

Risks of Decentralized Hedge Funds

Decentralized Autonomous Organizations (DAOs) provide many pro-competitive benefits to owners and investors, including lowering entry barriers, increased efficiencies, and minimal operational expenses. However, they also come with their fair share of risks.

Regulatory Risk

Decentralized hedge funds are still in their infancy stages, and most governments have not created proper laws to regulate and tax them. Legal uncertainty is a major problem for founders since they lack total control over the organization's treasury at some point in the governance adoption stage. Before joining a DAO, check how the local regulations may affect you.

Unilateral Decision-Making via a Dominance of Governance Tokens

The primary reason for starting a DAO is to tap into the diverse and rich experience of the community. Suppose a decentralized hedge fund issues ERC20 governance tokens, but a few individuals hold more than 50% of the tokens. In that case, these individuals may collude in what is known as a Sybil Attack.

Poor Engagement from the Community

The moderators won't get the much-needed feedback to forge ahead without active community participation from a DAO's main communication channels, like Twitter, Telegram, Discord, and Facebook.

Decentralizing too Early

Decentralized hedge funds that seek community ownership early (starting with token issuance) risk creating a speculator community instead of real users. Minus a working product, a DAO ownership is valueless, and the members will disengage.

Are Decentralized Hedge Funds Profitable?

Yes, decentralized hedge funds are profitable. Profits normally vary from 9-12% per month. Some hedge funds like DHF hold investor funds in stablecoins, meaning the funds are not affected by volatility that plagues the crypto market. Here are more benefits of decentralized hedge funds:

  • 24/7 automated trading on secondary markets
  • Low barriers to entry as there is no minimum deposit apart from the one-time activation fee
  • Earnings are compounded automatically if they are not withdrawn
  • Trading fees of less than 1%
  • Live trades displaying profits and losses are available

If you want to invest in decentralized hedge funds, you should consider a few things:

First, ensure that the fund you invest in is legit. Unfortunately, because of decentralization, there are multiple scams and Ponzi schemes impersonating DAOs. Therefore, Do Your Own Research (DYOR) before investing!

Secondly, evaluate a fund's track record before joining. While DAOs are still new, some, like MakerDAO have been in existence for years and have track records to consider. Lastly, read the whitepaper of the hedge fund you want to invest in to ensure it aligns well with your investment goals. Some DAOs are dedicated to making short-term profits, while others have long-term visions.

How to Withdraw Decentralized Hedge Fund Tokens

As mentioned earlier, investors can cash out their decentralized hedge fund tokens anytime. There are two options for withdrawing DAO tokens:

Transferring the DAO tokens to a secondary exchange and selling them.

Splitting into an individual DAO and claiming the amount of crypto relative to your DAO holdings

Bottom Line

As the DeFi landscape grows, a bridge is being created between traditional financial models and the cryptocurrency world. Cryptocurrency investors require a platform to exploit the volatility of cryptocurrencies. Decentralized hedge funds act as an avenue for linking digital asset investors to community-driven hedge funds. As blockchain technology continues to gain traction, traditional hedge funds may mutate into smart contract-based commonwealths exhibiting DAO features.