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A short guide to crypto index funds

Choosing a safe investment is never easy, but navigating the cryptocurrency markets can be particularly confusing and difficult.

Crypto has the potential for high returns, but the risks attached to the more than 2000 virtual currencies out there are often misunderstood.

If you’ve ever tried working out the risk-reward ratio on a traditional investment vehicle, you’ll know how time-consuming it is. The calculus becomes even more difficult when you’re dealing with a disruptive emerging market.

Risk management methods that worked for a mutual fund or equity investment can fall down quickly when applied to the technical and market complexities of the blockchain.

Cryptocurrencies are still relatively new and, as such, come with uncertainty. It’s widely known that many of the pundits who promote or analyse the market only hold a limited amount of crypto assets themselves.

That’s why a new wave of institutions and startups are looking to port over tried & tested risk-reduction models from traditional investing to cryptocurrency. The index fund is one of them.

What’s an index fund?

Index funds are a popular vehicle for passive investment, eliminating much of the risk posed by concentrating on individual asset classes or market sectors, or relying too heavily on decisions made by one group of managers.

They consist of a portfolio (or basket) of equity assets that are valued in aggregate, using metrics like stock price, performance, market capitalization, and other parameters. Well-known examples include the Dow Jones Industrial Average, S&P 500, and NASDAQ Composite.

Indices are designed to track the performance of a market as closely as possible. If the index is well constructed, any change in the overall market will be reflected proportionally as a change to the index.

Crypto index funds make their debut

When the cryptocurrency market caught the attention of institutional and retail investors in 2016/17, a number of crypto-based investment and hedge funds appeared.

In traditional investments, delegating day-to-day decisions to a professional or institution helps manage risk. But for many crypto-enthusiasts, the centrally-managed model these funds were built on sat in direct opposition to two of blockchain’s cornerstone objectives: transparency and decentralization.

That’s when cryptocurrency index funds entered the scene.

The attraction of crypto funds based on indices is their relative safety. As with a traditional index fund, a cryptocurrency index fund uses a portfolio of assets to track the performance of the entire market.

They tend to serve three purposes:
Gauging the performance of the total cryptocurrency market.
Providing the basis for creation of index funds.

Making it easier for retail investors to gain exposure to the entire market.

For blockchain-based currencies the index concept seems a natural fit. Blockchain’s distributed ledger enables financial data to be independently verified and available to all participants. That makes calculations about index value more transparent, while minimising the risk of manipulation and human influence.

Types of cryptocurrency index fund

There are two types of fund:

Price-weighted indices, which allocate an equal number of assets to the index basket. Value is calculated as an average of the individual prices of each assets in the index. In this type of index, higher priced assets tend to move the index more than lower-priced assets.

Capitalization-Weighted indices, which allocate assets proportionally to their market capitalization. Assets with the biggest market cap influence the value of the index most heavily.

Both types introduce a specific set of investment risks, including the high volatility of individual crypto assets, uncertainty over regulatory issues, and data provider errors.

Popular Crypto Index Funds

CRYPTO20 is ethereum-based fund offering a token called C20, which represents a share of 20 cryptocurrencies balanced by market capitalization. Although some token functions are implemented via smart contracts, in the main the fund is centralized and charges a management fee.

Bitwise Hold 10 offers exposure to the top 10 cryptocurrencies, weighted by a 5-year measure of diluted market capitalization. The assets are kept in cold storage and rebalanced weekly. Currently the fund is only available to accredited U.S. investors willing to make a minimum investment of $25,000 USD.

Coinbase Index is designed for institutional investors willing to invest between $250k and $20 million. It measures market performance across an index of seven leading cryptocurrencies, weighted by market capitalization. Opening in 2018, Coinbase has since announced plans to shut down Coinbase Index and introduce a new product open to all Coinbase customers.

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