Understanding crypto index funds

Multiple questions come to mind when you first learn about crypto index funds.

  • Do I need to be an accredited investor?
  • How many cryptocurrencies should be included in an index?
  • Can I pick which coins are in the fund?
  • How can I participate?
  • Do I retain my private keys?

All these questions and more will be answered as we take an in-depth look at crypto index funds in today’s marketplace.

This is not investment advice; this article is for informational purposes only. Please get professional advice and do your own research before investing in cryptocurrencies.

For starters, we’ll give a few short definitions. If you already know what an index fund is, feel free to skip this section.

In order to fully understand what a crypto index fund is, let’s break down the terminology. We’ll define index, index fund, and then finally, crypto index fund:

What is an index?

An index is a tool of measurement that tracks changes in certain financial markets. It often provides a theoretical portfolio that hones in on a specific part of the market. Investors and fund managers use indices to track market movements and create and manage investment portfolios.

As an example, the S&P Index tracks the performance of the top 500 US stocks by marketcap. It’s also known for being one of the most accurate representations of the overall US stock market. The historical performance of the S&P looks something like this:

learn about crypto index funds by looking at S&P 500 index
Wikimedia

By tracking the performance of the top 500 companies, investors and fund managers can gain valuable insight into how a market is performing. They can use the S&P Index as a benchmark when building portfolios for clients or themselves.

Examples of crypto indices

There are many different types of crypto indices that can be used to create a fund or portfolio. For example:

  • CryptoIndex.ai aggregates news and sentiment data in addition to exchange data on the top 100 cryptocurrencies using artificial intelligence.
  • Bloomberg’s BGCI Index provides a benchmark measuring six of the largest cap cryptocurrencies. 
  • The CCi30 index tracks the top 30 cryptocurrencies by marketcap, serving as a tool for passive investors.

What is an index fund? 

An index fund allows investors to have a core allocation that proportionately matches the index. So, going back to our example, when using the S&P index fund, investors and fund managers attempt to replicate the index in their portfolio by using the same weighting mechanism (in this case, by marketcap) in their allocation percentages.

If Apple has the highest marketcap out of the top ten companies, then you would have more Apple stock in the S&P index fund than any of the others, and so on. The percentage of each security in the portfolio fund would match the percentage to marketcap from the index.

Essentially, an index fund is made up of assets that are allocated in the same ratio as the chosen index. So the main goal is to mimic index performance, whether it’s a stock or crypto index.

Vanguard 500, the largest index fund in the world, tracks the performance of the S&P 500, replicating its portfolio and asset ratios in direct relation to the S&P 500 stocks.

The two main types of index funds

  • Mutual funds – This type of diversified index fund is an investment program that fund managers design for other investors using the index as a benchmark. Investors put money into the mutual funds, pay the fees, and then in return, the fund manager trades the funds across diversified holdings on the investor’s behalf, according to the index and acting as a professional manager of the fund. These index funds are thus actively managed. As indices become finer tuned and tracking algorithms more complex, even this active management melds into automated passivity.
  • ETF – Similar to mutual funds, Exchange Traded Funds (ETFs) track a basket of assets or an index. But ETFs are different in that they are traded on exchanges just like a stock and most often not actively managed. Instead, ETF index fund managers, such as investment banks and brokerage firms, create ETFs that are automated according to an index and offer that portfolio as an investment product for their clientele. ETF index funds are often passively managed.

Definition: crypto index fund

Now we’re getting to the good part! With a crypto index fund, professional traders attempt to trade in relation to the overall crypto market by tracking an index that gives a statistical sampling.

Since cryptocurrency ETFs have not been enabled quite yet, we can say that:

“A crypto index fund is a mutual fund with a portfolio that reflects a market index, enables diversified holdings, and is professionally managed and/or run automatically using algorithms.”

Special considerations

Crypto index funds use varying indices that may track anywhere from one cryptocurrency (i.e. Bitcoin) to 100 and beyond. But there are special considerations when it comes to crypto. Because of the high volatility of the nascent crypto market, the market cap is very top-heavy. What this means is that Bitcoin as the top crypto asset maintains about a 70% market dominance currently. Because such a large percentage is concentrated in Bitcoin and just a few other coins, some fund managers feel that fewer coins are better than having fewer when creating an accurate snapshot.

On the other hand, investors may not want to miss out on the next “Apple”, with so many new crypto projects emerging. Generally, investors may want to use both large-cap and small-cap indices that adjust frequently in order to optimize earnings in their crypto index funds.

Which platform to use

Another consideration is the platform you use when investing in a crypto index fund. The choices will include seasoned fund management offerings by Bloomberg, all the way through to the simplest of crypto index apps as with Abra. Your appetite for risk, as well as how much you have to invest, will help you determine which index fund will work well for you. At the end of the article, we’ve provided a compare/contrast of different funds so you can get a glimpse of the different features they offer.

But what about stablecoins?

One final consideration. You won’t see stablecoins as part of any of the index funds we’ve covered. That’s mainly because in investments and trading you need some volatility in order to make money. Cryptocurrencies in general certainly meet that need. However stablecoins, since they are usually pegged to a fiat currency, do not.

The benefits of crypto index funds

Below are some of the ways that crypto index funds may benefit investors:

  • Provide a new and unique investment opportunity.
  • Hedge risk by covering a basket of assets as opposed to just one cryptocurrency asset.
  • Offer simplicity and ease to investors who may not be technically savvy enough to manage private keys for individual cryptocurrencies.
  • Give investors a chance to invest in smaller-cap cryptocurrencies without undue risk.
  • Fees are generally low (sometimes as low as .05%) due to automation and lower blockchain-based transaction fees.
  • Low level of trading skill needed to enjoy potentially strong portfolio performance based on data.
  • Saves time; investors don’t have to research all the crypto projects in their portfolio (although this is not a bad thing for investors to do!). Neither do they have to manage it.
  • The automation used by many crypto index funds makes them systematic, based on rules and without personal judgment. Thus, they offer a way to trade that is more impervious to FUD and FOMO than trading manually and actively.

Drawbacks

  • The private keys to the crypto assets being invested are often not held by the fund managers. This goes against the ‘not your keys, not your Bitcoin’ mantra that stresses keeping your own keys as the safest way to hold crypto.
  • Full financial privacy is often not possible as of yet because fund managers need to be fully compliant with KYC/AML in order to operate.
  • This is a new market and a new product. Not surprisingly, the industry is rampant with bad actors, so extreme caution is necessary.
  • The cryptocurrency market is highly volatile.
  • Data on cryptocurrency market performance does not have the historical breadth as with traditional markets.

Main Features of crypto index funds

While there is a variety of crypto index funds available, they usually share some of the same main attributes:

  • They are rebalanced on a regular basis, such as every 30 days or in real-time.
  • Generally, they include a high percentage of Bitcoin in the fund, since Bitcoin dominance is at about 70% at this writing. This excludes any funds that are offering an altcoin specific index fund (i.e. a small-cap index).
  • Most crypto index funds track the top 20 or so cryptocurrencies. Some feel that 10 is too few and 30 is too many. To them, 20 is just right to get the most accurate glimpse of the market as a whole.

Do you have to be an accredited investor to participate?

No. Unlike with traditional index funds, some of the crypto versions we have available today do not limit their clients to accredited investors. So you don’t have to have a net worth of $1 million or an annual income of $200,000+. As such, with crypto index funds retail investors are often welcome to participate (at their own risk).

Another difference would be the minimum amount to participate. Some crypto index funds enable retail investors to start with as little as $25, while others will require a $25,000 initial investment. With algorithms, automation and blockchain ledgers, microtransactions are no longer an issue as far as management and costs.

Examples of crypto index funds 

Hopefully, we’ve given you enough background information to really grasp what crypto index funds are all about. Now it’s time to delve into some of the platforms that are offering them. We tried to select funds that were completely different from each other. That way you get a wide scope of what these products can do.

crypto index funds

Can I create my own crypto index fund?

Yes! There are also several platforms for experienced crypto traders who want to build their own crypto index fund. To set one up, you follow specific steps, including:

  • Choosing which crypto assets you want to include
  • Selecting the weighting strategy (i.e. weighted by market cap)
  • Determining a rebalance period (i.e. monthly, weekly, when a new coin is listed/delisted, etc.)
  • Backtesting and running historical data
  • Executing

For example, Shrimpy.io allows its users to create their own automated index fund, giving you choices as to coins and rebalancing periods. Hodlbot, the creator of the HODL20 as shown in the table above, also offers a do-it-yourself crypto index fund creator. Both companies enable retail investors to invest (at their risk) in index funds, which historically have been restricted to accredited investors. 

Conclusion

Blockchain technology and cryptocurrencies have opened up the world of finance so that not just the wealthy have access to potentially high performing investment projects. Crypto index funds are just one example of the financial applications now available to the masses.

Remember to do your research and consult with an expert before investing in or creating your own crypto index fund. This guide is not investment advice and is purely for educational purposes. Invest safely and enjoy the ride!

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