A listener asked a straightforward question: he was considering an arbitrage fund in the Bitcoin space and wanted to know if I had any real experience with similar strategies. I do, and it’s worth walking through both how these funds are supposed to work and where the theory tends to run into trouble in practice.
How Market Neutral Strategies Work
Arbitrage, or market neutral, strategies involve going long one asset and short a similar one, betting that prices between the two converge rather than betting on the direction of the broader market. A simple example: assume Delta and American Airlines are driven by the same macroeconomic factors and should trade similarly over time. If Delta spikes while American stays flat, you could short Delta and go long American, betting the gap closes. If the market as a whole drops 10%, both stocks likely drop with it, but since you’re short one and long the other, the market’s direction doesn’t matter to your return. What matters is only whether that gap between the two assets converges or diverges. Convergence is profit. Divergence is the risk.
Applying the Same Logic to Bitcoin
The common structure for a Bitcoin arbitrage fund is buying spot Bitcoin while shorting Bitcoin futures, or the reverse, hoping to capture the spread between the two prices as they converge. Say spot Bitcoin sits at $100,000 and futures trade at $110,000. That $10,000 spread is the target. In theory, if Bitcoin spikes to $160,000, your spot position gains, your futures short loses, but the net position could still lock in that original $10,000 gap if closed at the right time. On paper, it’s an elegant, clean trade.
Where the Theory Meets Reality
In practice, these structures carry costs that rarely show up cleanly in the pitch deck. Many of these funds use leverage, meaning the fund borrowed money to establish the spot position, and that borrowed money accrues interest the entire time the position stays open. If convergence takes longer than expected, and it often does, that interest cost eats into the spread you were counting on. Add in transaction costs, counterparty risk around whether the underlying Bitcoin actually exists and is properly custodied, and ongoing fees, and the clean picture on the whiteboard starts to look a lot messier in an actual account statement. I can draw a beautiful chart of two lines converging with a big profit at the end. Making that happen in a live account, with live costs, is a different exercise entirely.
The Back-Tested Data Problem
A lot of these funds lean heavily on back-tested performance, since most haven’t been operating for more than a couple of years. Back-tested data can be accurate as far as it goes, showing what a strategy would have returned in, say, 2022. What it can’t tell you is whether the market would have moved differently if that trade had actually been placed, or whether the volume was even available to execute it at the stated price. The question to always ask is what transaction cost assumption is baked into the back-test. If a manager says they aren’t accounting for transaction costs at all, that’s a serious red flag. If they give you a flat number, that’s often just a convenient shortcut rather than a real answer, because nobody can precisely reconstruct historical spreads and volume after the fact.
Diversify the Strategy, Not Just the Fund
None of this means arbitrage funds in the Bitcoin space are inherently a bad idea. Bitcoin itself has now been through enough market cycles, bull runs, crashes, and comparisons against traditional assets like gold, that it carries more credibility than it did five years ago. But layering a new, largely untested fund structure on top of an asset that’s still building its own track record adds a real layer of risk. If you do decide to invest here, don’t concentrate everything into one fund running one version of this strategy. Spread exposure across a genuine variety of approaches, not three funds all executing the same Bitcoin arbitrage trade under different names.
This post is adapted from a recent episode of the Scholar Wealth Podcast. For more perspective on evaluating alternative investment strategies, listen to the full podcast episode here.