To my dozen friends starting crypto funds right now: despite this post, I’m still pulling for you, and happy to direct interest your way. Godspeed.

***

We’re pretty clearly in a crypto bubble right now, and the pervasive greed is getting alarming.

There is no shortage of people who are explicitly bragging about flipping ICOs, getting rich quick, and of course, raising funds.

Things could get nuttier before the bubble pops, though, because everyone is convinced there is an institutional “wall of money” ready to enter the markets. The gating item preventing the influx seems to be a lack of rails to get the ole institutional gravy train into the frontier town.

So we need to build some railroad tracks.

You know, help the pensioners and endowments help themselves by providing access and insights. If you have “deep industry knowledge”, an “excellent network”, a “track record”, and “asymmetric information advantages,” you should be considering starting a fund right now.

(TBI Note: This means you “got into crypto before 2017”, “know some others who got in before 2016”, “held *any* basket of crypto-currencies for the past year”, and are at least occasionally “willing to trade on inside information”.)

I get it. I can make the fund pitch in my sleep. It goes something like this.

1) There’s a chance the crypto market ends up delivering 10–100x returns or better in the next 10+ years. There could be multiple trillion dollar networks created whose tokens power various distributed applications. Internet-level.

2) Given generally sky-high asset prices / low yields, what is a professional money manager to do to hit 8% returns for his clients? Even at these inflated price levels in crypto, the expected 10-year passive returns could still dramatically outperform the old staples on a risk-adjusted basis and are worth adding to a broader portfolio.

3) Asset custody, tax reporting, counterparty risk management, etc. is an absolute f*ing nightmare in crypto. There are few properly regulated exchanges in the ecosystem, and no liquid titled securities for the asset class. It’s simply cheaper (net of fees) to outsource those decisions and admin functions to people who know the industry better.

4) This all makes crypto funds look pretty attractive. Then there’s the fact that crypto is the first thematic investment where you can bet the trend with almost perfectly indexed exposure and/or rebalance depending on new information. That suggests there’s potential for smart managers to generate alpha by creating a perfect basket of blue chip investments in the theme, and rebalancing based on information asymmetries. (Legal since these aren’t securities. Unless they are, then…oops.)

5) I myself do not think an indexed bet of the top 100 cryptocurrencies will outperform most actively managed funds. I certainly pick my own cryptos, because in the long-tail of assets, there are some super interesting projects, and many really, really ugly babies. How is XRP still the third largest and fourth most liquid crypto? How is EOS a half billion dollar project? I’m not putting money in those. I’d rather beg, borrow and steal to get in the pre-sales of good ICOs, or even public sale prices.

I am making a pretty good pitch for actively managed crypto funds, right?

Big upside to the asset class, lots of misinformation, steep learning curve, few pros in the industry, etc. Seems like a perfect place to throw money behind an expert.

Why then do I think the everyone-start-a-fund movement is a joke?

Aside from the sheer number of new funds — many are confusing fortunate market timing for investing prowess — this trend will basically be an idiot tax on new passive investors.

In order to outperform a 70–30 bitcoin and ether portfolio over the next 10 years (roughly their proportional market cap today), you need to make some ballsy assumptions. A combination of these, perhaps:

1) There will be a “flippening.” BOTH bitcoin and ether — the only two cryptos with any real transactional demand and network effects today — are surpassed in value by other tokens. Or power law distributions won’t hold for this industry, and bitcoin and ether will maintain a plurality of the market share vs. 70%+. Seems bold.

For starters, when the institutional money comes in, they’ll invest in what’s (relatively) proven first, and that’s the industry blue chips. Betting against BTC & ETH’s continued proportional market dominance is betting that retail investors rotate out of BTC-ETH into crypto alternatives faster than new big money flows in.

Admittedly, this has already happened a bit already with ETH -> ICOs. People have been betting house money on 2.0 projects after their initial ETH investments skyrocket. I remember a lot of this with Mastercoin investors in 2013, too. It didn’t end well.

Many new token projects are similarly built *on top* of ethereum or pegging to bitcoin. But ERC-20 tokens probably aren’t secure if they become more valuable than their underlying network. So ETH must rise with a successful universe of ERC-20 tokens, but mustn’t necessarily fall if all of them die.

Then there’s the age old, bitcoin maximalism question: what happens if people discover most dapps really just need a base protocol crypto-currency and on-chain escrow mechanism, not a unique “utility token” per se.

As Mr. T would say: “Pain.”

2) Of course the “lol n00bs” will make those mistakes, you say. But you will pick the next 1000x projects that gain relative market share on bitcoin and ether. Because you’re mostly focused on finding the diamonds in the rough in the long-tail, non-ETH/non-BTC markets. Winners there will make up for the many (many, many) other losers you back.

Bold. Bold. Bold. I wish I had cojones like that.

To illustrate why your balls are so big to think like this, I’ll introduce a new term I like: fully-diluted network value.

(Some people are starting to think more clearly about this, but the exact terminology hasn’t been set. Ryan Shea wrote about “price per millionth of 20 year network value” for crypto projects, which seemed similar.)

Here’s the gist:

Cryptos are disinflationary. That is, the rate of new token issuance and investor dilution goes down over time. Conversely, that means in the first few years after a network goes live, there must be *a lot* of net capital inflows relative to its market cap, merely to maintain the price per token.

If you look at the fully-diluted network value (FDNV) or Ryan Shea’s PPM20YNV (the same thing with more precision), you can see how stark this capital requirement will be in the future.

For instance, 90%+ of the Gnosis token is still outstanding, implying a FDNV of $2bn+. ZCash is similar. Less than 10% is outstanding, it trades at an FDNV of nearly $5bn, and has never traded lower than $500mm FDNV. Even crypto OG Ripple has $10bn+ (or some made up number of XRP) “in treasury” that they can tap for future capital — more than currently floats.

All projects have great tech teams and exciting projects, but their future token issuance will dilute current investors significantly and almost certainly dampen returns relative to BTC and ETH, which both already have the majority of their tokens outstanding.

3) Duh, but I’m going to get in on the pre-sale of tokens like these, so the price will be lower and dilution won’t matter as much.

Good luck with that.

ZCash had a seed round with an exclusive handful of venture capital investors (DCG was one, so I was there), then they launched the network and mined the genesis block. Zero entry points in between.

Gnosis went the opposite direction, trying to force sanity by running a reverse dutch auction that would be insanely expensive to the public if oversubscribed. The result was a $300mm FDNV at launch with the GNO team retaining 95% of the tokens. The investment has rallied further since, but perhaps only because the float is low, and new dilution hasn’t yet hit.

The long-term overhang and uncertainty matters for new funds.

And things are getting even crazier with new ICOs. The pre-sale rounds are getting more competitive and more expensive.

If you’re *lucky*, you might get a $100k allocation in a seed round in an ICO-issuing company or a SAFT in a hot new ICO. Most likely, in reality, the OGs (Metastable, Polychain, Blockchain Capital, Pantera, Drapers, etc.) will gobble up the allocations because they have stronger networks and will send higher quality signals to other public sale investors.

So you won’t put capital to work in the ICOs your LPs want access to.

Say you do get in to a larger pre-sale like Filecoin, though. Not in at the Protocol Labs, company-level investment, but maybe an advisor “pre-sale” like part one of the Filecoin SAFT. (Disclosure: I did this, and will write next week about why I invested.)

Filecoin is perhaps the most hyped ICO since ethereum. It priced, even at its most heavily-discounted “advisor” rate, at $0.52 / FIL, which implies an FDNV of around $1bn once all the Filecoin is mined. That’s a starting point which is ~15–20x higher than ethereum’s at its crowdsale. It means your moon case performance for FIL is more than an order of magnitude lower than ETH’s was based on its opening FDNV.

Of course, once the Filecoin public sale concludes, it will likely close at an even higher price. It’s conceivable the implied FDNV will make Filecoin — pre-launch — nearly as valuable as Dropbox, and 10% as valuable as bitcoin on an FDNV basis.

While I do believe Juan is a combination of Elon Musk, Mark Zuckerberg, and the Dos Equis man, that is f*cking insane.

For exciting, high-potential projects like FIL, ZEC, GNO, etc. you need to believe that literally billions of dollars of new net inflows will enter in the short-term just to run in place post-ICO. Good luck if you close your fund in Q4 and start averaging in from there.

(Seriously, good luck! We need you to absorb some of that sell volume!)

Ok, so you can’t get big allocations in hot deals because you’re late and network effects, so you’re forced to buy in at or near quoted exchange prices. Unless you want to be an alpha negative chump, you need to be a bona fide trading wiz.

4) This last point is interesting, and I can sort of buy in to the pitch that in this Wild Wild West of amateur investors, prop traders could clean up. In other words, real hedge fund managers with real trading experience will do well. Not rookie seed investors with Ledger wallets and margin trading accounts on Bitfinex. Real adults.

The long-tail of cryptos are still pretty illiquid. The markets also seem to be hyper-irrational. Add those together and good traders may be able to exploit arbitrage opportunities and make some money.

Still, I’d imagine most of the hedge fund money gets made trading new derivatives and making markets, not speculating on the ebbs and flows in the long-tail of alternative assets. Because professional managers will have an acute awareness of the need to manage counter-party risk, and conduct business with uber-compliant partners.

That brings me to my grand finale of why the crypto fund boom is going to probably end before it even gets started.

5) The SEC is going to absolutely wreck your shit, and they just sent out an initial warning. Go ahead and take a break to read Preston Byrne’s synopsis of what it means. I’ll wait.

Most crypto ICOs probably pass the Howey test. That’s not good. That’s like testing positive at the doctor’s office. You don’t want positive. You don’t want Howey, which says (roughly): “investments of money (1) into common enterprises (2) with the expectation of profit (3) based on the work of others (4) are securities.

There’s a lot of legal gymnastics around doing compliant pre-sales for “utility” tokens, but here’s the general dynamic: investment funds are investing money (1) in new projects (2) in which they expect to generate liquidity on their investments (3) following the work the developer teams do to launch the networks (4). And for good measure, they usually expect to sell their tokens by listing them on an unregistered exchanges (5).

Howey is a four-part test, and most ICOs seems to be passing all of the tests plus one for good luck by working with exchanges to facilitate secondary, public trading of the speculative tokens.

Here’s what could happen to funds if there’s an SEC crackdown:

a) The SEC, at any time, and without warning, could force major exchanges like Poloniex or Kraken to delist certain tokens. Or they could cut the foreplay and suspend trading on the exchanges outright by pursuing enforcement actions against them for failing to register for the proper licenses. There goes your long-tail liquidity, and with it 50–90%+ of asset values.

Two things mitigate this risk, but only partially.

The first is the rise of fully decentralized exchanges — but those will likely be off-limits to crypto funds with compliance teams. The other is that the SEC might look at the biggest exchanges as the “devils-you-know,” and surveil the exchanges vs. shutting them down outright.

b) The SEC pursues a few “low-hanging fruit” projects. That leads to new ICO issuances drying up, or moving to new jurisdictions. Funds in the largest markets (Europe, the US, Asia) have their hands tied. Even if they wanted to move abroad, they wouldn’t have an easy time attracting investor money to follow them. The boom times end.

c) Secondary trading of ICOs becomes mostly illegal. Investors will need to wait for new platforms (like CoinList?) to create secondary trading products that allow them to cash out their ICO stakes. For the time being, these products will only be available to accredited investors, so the pool of speculators is smaller and more sophisticated (lower alpha for funds).

Having fun yet?

All you need to do to produce alpha as a crypto fund is beat BTC & ETH, get early access to cheap, but high-potential token issuances, make money before dilution really starts to hammer the young tokens, invest big money without moving markets, and hope the SEC embraces the crypto boom.

You’ve got this.

As an institutional investor, unless you think you can back the next crypto investing prodigies, and believe the SEC won’t freeze trading in the long-tail of cryptos, you’re better off simply working with a company like Coinbase to custody multi-million dollar accounts of bitcoin and ether. Otherwise, the also-rans of the crypto fund market will significantly and unnecessarily tax your future gains, or squander them entirely chasing too many of the up-and-coming “moonshots.”

When my this-is-not-investment-advice investment advice outperforms most of the funds, here’s where you can send my fees:

BTC: 12D88dkW1BZ9iH51KEbHZdya2Pc8KBnXi9

ETH: 0x249fe5b11214465811831c8dcE72680f54ef2947

I’m not greedy, 2 bps for 2bit would be fine. It’s a 1000x improvement vs. the 2/20 funds.

And isn’t 1000x what you’re looking for?

***

Notes:

+ Believe it or not, I’m still rooting for many funds to raise their ambitious amounts of capital as it will bring better liquidity to the markets and make them more efficient. These funds could also deliver staggering *absolute* returns to investors, and as a hodler, I’m indifferent as to whether institutional money makes direct investments or funnels capital through fund managers. Either way, that rising tide lifts (most) boats.

+ I also recognize that institutional investors aren’t pigeon-holed into one strategy or another. They could very simply invest in aggressively speculative ICO-heavy funds with low bitcoin/ether exposure, and then make direct buys of the more liquid currencies. In fact, if they can get in with one of the top funds, this is probably an optimal strategy.

***

Here’s some other required reading from the past week on the subject of fundamentals, funds, greed, etc.

Muneeb on crypto fundamentals: https://medium.com/@muneeb/5-star-system-6c27a0eb4a1c

Fred Wilson on greed vs. profit motive: http://avc.com/2017/08/greed-isnt-good/

Yann Ranchere on the business model for protocol projects: https://medium.com/@tek_fin/what-business-model-for-protocol-companies-528b2e04dd2c

The future of decentralized exchange (i.e. maybe the SEC can’t squash the ICO market so easily): https://medium.com/@giotto_3438/the-future-of-decentralized-exchanges-with-omisego-a2d04d397548

Elad Gil on crypto’s Netscape moment: http://blog.eladgil.com/2017/07/cryptocurrencys-netscape-moment.html

Plus two final bits:

Alex Morcos MUST-READ on No2x — why SegWit2x needs to die in a fire: https://medium.com/@morcos/no2x-bad-governance-model-97b8e521e751

0x Token Sale details: https://blog.0xproject.com/0x-token-sale-and-registration-details-75d84af11c60