Cryptocurrency index funds: crypto for lazy investors

Choosing a good investment vehicle was never an easy task. Even if you know how to calculate returns and risks, this process is rather time-consuming. This is especially tricky when it comes to dealing with emerging markets. Such investments can bring high returns, but they come with higher risks. Another problem lies within the risk assessment model itself. Risk management methods that worked for the traditional economy might fail facing a new paradigm. By now, everyone has heard of cryptocurrencies and the benefits they offer, but the risks that come with the new technology are often misunderstood or underestimated.

This is one of the main reasons why only a small fraction of people who speak about crypto own a significant amount of cryptoassets - it’s complicated and risky. The investor has to research which cryptocurrencies are worth investing in. This takes time and expertise. As with the traditional investments, a straightforward solution would be to delegate the decision-making to a professional or an institution. That is why since 2017, when the cryptocurrency market became big enough to attract the money of institutional and uneducated investors, so many crypto investment funds and hedge funds appeared. However, for many crypto-enthusiasts the model of a traditional investment fund where the decisions are made by the management team lacked transparency and decentralization. That was again the middleman they were fighting. That’s when a cryptocurrency index funds entered the scene.

What is a cryptocurrency index fund?

Historically the idea of an index fund belongs to classic investment expert John Bogle, business magnate and the founder of the Vanguard Group. He proposed to balance the fund portfolio dynamically using a market index. As he says, “the index fund is a sensible, serviceable method for obtaining the market’s rate of return with absolutely no effort and minimal expense. Index funds eliminate the risks of individual stocks, market sectors and manager selection, leaving only stock market risk.”

In traditional stock markets, an index consists of a hypothetical portfolio of assets and represents the statistical change in this group. An index can be derived from a number of parameters including price, capitalization, performance and other metrics. Popular index examples are S&P500, NASDAQ Composite, and Dow Jones Industrial Average. The index idea naturally adapts to the cryptocurrency market: when financial data is public on the blockchain, the index calculation is transparent, devoid of manipulations and human influence.

An index fund portfolio consists of assets allocated in the same proportion as in the index, so the price of the fund share closely mimics the index performance. This allows the investor to bet on the performance of a particular market segment or the whole market performance.

In the cryptocurrency market, share distribution is easily implemented with token distribution: the fund can issue its own cryptocurrency with each token representing a share in the portfolio. And the balancing of the portfolio can be done in a centralized way on a dedicated server or in a decentralized way using smart contract mechanics.

Constructing a cryptocurrency index

There are two major ways to build an index:

1. Price-weighted index includes an equal number of assets in the basket. The index is calculated as the average between the individual prices of all the assets in the index. In this type of index, the higher price assets move the index more than those with lower prices. Dow Jones Industrial Average (DIJA) is a price-weighted index.

2. Capitalization-Weighted Index includes assets in an amount proportional to their market capitalization. In this type of index, the assets with the largest market cap will affect the index the most, even if the individual asset price is low.  An example of a capitalization-weighted index is S&P500.

Comparing with the traditional financial markets, cryptocurrency indexes introduce a number of specific risks, including the high volatility of individual assets, uncertainty over regulations, and data provider errors.

Crypto indexes and index funds you should know about

Coinbase Index is designed for institutional investors looking to invest from $250,000 to $20 million in seven cryptocurrencies weighted by market capitalization. The product was announced in March 2018 and went live in mid-June. Later, however, in early October Coinbase confirmed they will shut down Coinbase Index and introduce a new product - Coinbase Bundle - open to all Coinbase customers.

CRYPTO20 is a tokenized fund offering a token called C20. The ethereum-based token represents a share in a fund of 20 cryptocurrencies balanced by market capitalization in accordance with FTSE Russel’s capping methodology. Tokens were distributed in April 2017 via an ICO. Although some token functions are implemented on ethereum smart contracts, the fund is centralized and charges a 0,5% management fee.

Bit20 is an index fund created using a Bitshares smartcoin. The fund’s token BTWTY works as CFD smart contract (Contract for Difference) and comprises the performance of the top twenty cryptocurrencies by market cap. Since Bit20 depends on BitShares smartcoin technology, it is traded exclusively on Bitshares exchange.

Bitwise Hold 10 offers top 10 cryptocurrencies weighted by 5-year diluted market cap. The assets are kept in cold storage and rebalanced weekly. The offer is open only for the U.S. accredited investors and starts from $25,000.

Bloomberg Galaxy Crypto Index (BCGI) measures the performance of the largest cryptocurrencies traded in USD. The index includes different categories of digital assets weighted by market capitalization, including stores of value, mediums of exchange, smart contract protocols and privacy assets.

Lykke Cryptocurrency Index (LyCI) is an index of top 25 cryptocurrencies weighted by market capitalization and dynamically rebalanced. The cryptocurrencies that are pegged to fiat currencies or other cryptocurrencies are ignored. The index will be soon investable and traded on the Lykke Exchange as a token.

TaiFu indexes is a family of three market-capitalization weighted indexes. TaiFu 30 Index tracks the largest 30 cryptocurrencies. TaiFu™ 30 Altcoin Market Index does the same only excluding Bitcoin and Bitcoin hardforks. And The TaiFu™ Bitcoin Aggregate Index tracks the total market capitalization of Bitcoin and hardforks with the same genesis block. Indexes are updated on a daily and hourly basis.