Investing in index funds, or “indexing” is a passive, low-cost investing style that has become much more popular in recent years. Indices use a rules-based, transparent methodology to determine their portfolio constituents ahead of time. Therefore they are very cheap to maintain and do not incur high management fees.
Research shows that 95% of active traders actually fail to beat indices in the long-run. Even professional fund managers, have a very difficult time beating index funds.
It’s so hard, that Warren Buffet famously bet and won $1 million dollars for predicting that the S&P500 index would beat a collection of a Protégé Partners hedge funds.
When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds. — Warren Buffet
The combination of low fees, better or equivalent returns, and low maintenance have made index funds more popular than ever.
In the stock market, there has been a huge outflow of capital going away from actively managed funds, and into index funds.
So, you can see why people are excited about cryptocurrency index funds.
So What are Cryptocurrency Index Funds?
Simply put, cryptocurrency index funds are portfolios designed to track the performance of the cryptocurrency market.
By definition all index funds are:
- Investable
- Completely transparent
- Systematic & rule-based (no personal judgement)
But just because an index fund follows these rules does not mean they are all the same. Their biggest difference between them is decidedly based on what segment of the market the index wants to track. There are 4 major index categories which we will cover in detail:
- Total market — tracks the performance of the entire market
- Size-classified — segments based on size (low cap, medium cap, etc.)
- Category-classified -segments based on coin category (privacy coins, utility coins, store of value coins, etc.)
- Smart beta — segments based on fundamental metrics (e.g. NVT ratio)
Total Market Index Fund
Total market index funds try to track the performance of the entire market.
Stock Market:
In the stock market, the S&P500 and Russell 3000 examples of indices that approximate the performance of the entire US stock market. If the S&P500 and Russell 3000 are down, then the overall stock market is very likely to be down as well. Vice versa.
Cryptocurrency Market:
When it comes to cryptocurrency indices, the idea is very similar. Total market indices attempt to track the performance of the entire cryptocurrency market.
The ideal index consists of every single coin in the market, weighted by market cap. Unfortunately, creating such a portfolio is infeasible because of minimum trading amounts and trading fees. The only option left is to take a sample.
In principle, the larger the sample, the more accurate it will be in tracking the overall market. But as the sample grows larger, the more difficult and costly it is to maintain.
Most indices take the top N coins by market capitalization because the top coins capture a higher % of the total market cap.
But if we simply weighted the top 20 coins by market cap, we would end up with a portfolio that is extremely top-heavy. The index wouldn’t do a great job at capturing the risk & performance of the lower-capped coins.
So what are ways to give more exposure to lower capped coins?Include more coins in the index
With HodlBot, you have the choice of indexing as many coins as you wish. You can index the top 100 coins by market cap if you want to. The only trade-off to consider is transaction fees and exposure to lower-capped coins which typically can be more volatile.
Using a maximum percentage cap
For the HODL20 index we created, we capped every coin to be at most 10% of the total portfolio value. Anything above 10% gets redistributed to all the coins below 10% until the entire sum of the portfolio adds up to 100%.
Using square root weighting
For the HODL30 index, we used square root market cap weighting. This shifts some of the weightings from the highest capped coins towards the lower-capped coins. However, it still keeps a difference in weighting between differently ranked coins.
Size-Classified Index Funds
Rather than trying to capture the performance of the entire market, some index funds try to capture the performance of a smaller segment.
Stock Market:
In equity markets, the S&P600 includes 600 small-cap companies that have a market capitalization between $450 million and $2.1 billion. The S&P600 approximates the performance of small-cap companies in the US stock market.
Cryptocurrency Market:
The cryptocurrency equivalent are index funds that exclusively track the performance of small-cap or medium-cap coins.
On HodlBot you can create such an index by selecting a starting rank, and ending rank. Here a few examples:
- Coins ranked 20–50 (medium cap)
- Coins ranked 50–100 (small cap)
- Coins ranked 100–500 (tiny cap)
For accredited investors, the Bitwise70 is also available. It is an index fund that tracks the 70 largest cryptocurrencies that fall outside the top 10.
In the equities market, many investors presume that small-cap stocks grow much faster than their large-cap counterparts and that any additional risk can be sufficiently mitigated with broad diversification. In the cryptocurrency market, many convince themselves of the same conclusion and prefer to diversify across low-cap coins.
But in my opinion, small-cap cryptocurrencies are much riskier than the riskiest small cap equities. ROI on emerging technology companies typically follows a power law distribution, meaning that a few survive and the rest die.
Industry-Classified Index Funds
Since the entire market can be so vast, some indices try to only capture the performance of a single industry vertical.
Stock Market:
For example, the NASDAQ biotechnology index is comprised of all NASDAQ listed biotechnology or pharmaceutical companies with a $200M+ market cap.
Indices exist for many other industry segments such as metals & mining, oil & petroleum, technology, renewable energy, etc.
Cryptocurrency Market:
In cryptocurrency markets, industry segments are not as well-defined. There is a lot of functionality overlap between different cryptocurrencies so it is a lot more unclear on how to distinctly draw the line between different segments.
Nevertheless, there have been attempts to create indices for different “industry” verticals. The privacy coin index created by altdex is one example.
We’ll likely see more of these as the cryptocurrency market matures.
Smart Beta Index Funds
Smart beta index funds select assets based on indicators that have been historically found to result in market outperformance.
Stock Market:
In equity markets, there are 6 main indicators:
- Volatility — low volatility & low draw-downs
- Value — low price/earnings ratios
- Yield — high paying dividends, consistent payouts
- Quality — high return on equity, low debt to equity, low earnings volatility
- Momentum — strong and sustained risk-adjusted return
- Size — smaller stocks tend to generally outperform
Cryptocurrency Market:
These factors are not well defined in the cryptocurrency market due to the fact that the cryptocurrency market is very immature.
We’re still very far away from general consensus as to how to fundamentally assess a cryptocurrency’s “quality.”
Additionally, the historical data available for backtesting is very immature. Immature data with high noise to signal ratio can lead to over-fitted models with no predictive value.
The closest thing we have currently is something like the NVT ratio, which I am very still skeptical about.
The strong intercorrelation between top coins is perhaps even further proof that it is simply too hard to discern the fundamental value of a cryptocurrency. Perhaps the only thing that could currently work right now is a momentum based indicator based on historical risk-adjusted returns.
What Index Funds Can Invest In Now?
Now that we’ve gone through all the different kinds of cryptocurrency index funds in depth, which ones are actually investable?
What Index Funds Can Invest In Now?
Now that we’ve gone through all the different kinds of cryptocurrency index funds in depth, which ones are actually investable?
Total Market Index Funds
Everyday Investors:
Only Accredited Investors:
Not all indices are created the same. For a deep analysis of how well different total market indices track the market, check out this article.
Size-Classified Index Funds
Everyday Investors:
- HodlBot — Create your own index based on starting coin rank and ending coin rank e.g. ranks 20–100, 100–200, etc.
Only Accredited Investors:
Industry-Classified Index Funds:
Smart Beta Index Funds
About the Author
I quit my job recently to start HodlBot.
We created HODL10, HODL20, HODL30 indices and the first ever application that allows you to create your own personalized cryptocurrency index fund.
To get started all you need is a
- Cryptocurrency Exchange Account
- $200 in any cryptocurrency
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