Risks Involved in Crypto Mutual Funds During the Bear Market

The cryptocurrency space has been growing rapidly since 2009. In January 2017, the cryptocurrency market cap was $12 billion, but by November 2021, it had peaked at just over $3 trillion. In the wake of crypto’s growing popularity, several investment products, including crypto mutual funds, coin trusts, and exchange-traded funds (ETFs), have been developed to expose more people directly or indirectly to crypto assets.

What Is a Bear Market?

The cryptocurrency sector has developed a reputation for volatility in recent times. The crypto market is going through one of the worst bear spells in its relatively short history. This bear market has seen Bitcoin (BTC) lose more than half its all-time high value and resulted in several high-profile decentralized finance (DeFi) protocols collapsing or filing for bankruptcy.

A bear market is typically defined as a long-term downtrend accompanied by widespread pessimism and overwhelmingly negative market sentiment. This type of market is also marked by a 10-20% drop in underlying capital value.

Events such as pandemics, wars, political upheavals, sluggish economies, and government intervention have the potential to kick off a bear market.

Bear markets are characterized by declining economic activity and high unemployment rates. Companies may reduce spending during a bear market and lay off employees. Investors tend to sell stocks to reduce risk.

Sadly, all of the above have been witnessed in the crypto space in the last few months.

What Are Crypto Mutual Funds?

As stated earlier, crypto mutual funds are one of the more popular forms of exposure to crypto assets, even in the prevailing bear market. 

Crypto mutual funds are similar to traditional stock mutual funds, but they hold digital assets instead of holding shares in companies. They allow investors to put their money in a basket of cryptocurrencies rather than having to choose one specific coin.

Crypto mutual funds usually invest in a curated mix of the best-performing digital assets and futures contracts tied to top virtual currencies such as Bitcoin and Ethereum (ETH).

The Bitcoin Strategy ProFund is the only crypto mutual fund available to American crypto investors. The fund primarily invests in BTC futures contracts and requires a minimum investment of $1,000.

How Does the Bear Market Imperil Crypto Mutual Funds?

Generally, investors who choose to put their money in cryptocurrencies face some risks. But bear markets, which are hardly conducive conditions for money-making, only exacerbate the prevalent risks in the crypto sector.

Below are a few examples of the risks faced by crypto mutual funds during a bear market:

Low Trading Volumes

Given the negative sentiment prevalent in a bear market, traders tend to move their funds away from stocks and into fixed-income instruments as they wait for the crypto market to rebound. The collapse in crypto market values rattles investor confidence, and as a result, they keep their money out of the market, causing a general price decrease.

Crypto mutual funds thrive in markets with high trading volumes, and a dip in the number of trades will hurt their bottom line.

Heightened Fear and Pessimism

Another risk characteristic of bear markets is the dramatic increase in fear and pessimism among investors and speculators. These feelings are stronger and more pronounced than during normal market conditions.

The Crypto Fear and Greed Index is used to gauge the market’s mood, with values ranging from single digits to 100. Lower scores indicate more fear, whereas scores between 50 and 100 tend to be more optimistic.

Fearful markets usually lead to steep price dips triggered by episodes of panic selling. This means that assets held in crypto mutual funds that may get caught up in the panic could lose value very quickly.

Waning Consumer Confidence

Investors who are unsure of an asset make fewer trades on them. A bear market is often accompanied by a loss of confidence in multiple digital assets. For example, the collapse of Terra (LUNA) back in May caused a widespread loss of confidence among crypto investors and set the stage for the chaos currently being experienced in the crypto space.

Terra’s precipitous plummet, which led to the loss of nearly $5 billion in market value overnight, demonstrated to investors that despite their underlying mechanism, stablecoins were just as prone to failure as other cryptocurrencies.

A loss of confidence in a class of digital assets means they become less attractive as investment instruments for crypto mutual funds, narrowing the choices available to those platforms.

High Leverage Levels

Leveraging means investing with borrowed funds. The leverage amount is usually represented by a ratio, which is the factor a person or organization can borrow in relation to their account balance.

Crypto mutual funds often utilize leverage to increase their potential earnings and position size while increasing their capital liquidity. However, bear runs may cause leverage ratios in crypto markets to become quite high, resulting in increased market volatility and the possibility of considerably higher losses.

Unfavorable Macroeconomic Conditions

Bear markets are usually a result of the convergence of unfavorable macroeconomic conditions, including rising interest rates, rising inflation, and inverted curve yields.

This convergence also leads to general economic instability, which affects the amount of money available to crypto mutual funds and other investment vehicles.

And if the adverse macroeconomic conditions persist for an extended period, there’s a fair chance a bear run can morph into a much more severe crypto winter.

Increased Regulation

Bear markets often coincide with increased regulatory scrutiny of the crypto space. The regulatory environment in the crypto market is constantly changing as authorities grapple with policing the dynamic space.

Given the fear, pessimism, and lack of confidence that come with a bear market, authorities may feel compelled to impose more regulations to ease the situation. Such actions may negatively impact the activities of crypto mutual funds.

For instance, crypto mutual funds are illegal or heavily regulated in some jurisdictions.

Conclusion

Cryptocurrency mutual funds are here to stay. But just like any other crypto investment vehicle, they are still prone to the vagaries of the bear market, including volatility, illiquidity, and significant losses.

However, these risks can be reduced: Invest only what you can afford to lose; avoid funds that offer big returns; thoroughly research each crypto mutual fund, and always consider the state of the broader crypto market.