Index Fund Definition: What is an Index Fund?

Investing in index funds, or “indexing”, is a passive, low-cost investing style which 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.

Index Funds vs. Active Traders

Recent research has shown that 95% of all active traders fail to beat indices in the long run. Even professional fund managers find it extremely difficult to beat index funds.

It is so difficult in fact, that Warren Buffet famously bet and won $1 million dollars for predicting that the S&P 500 index would beat a collection of a Protégé Partner hedge funds.

The S&P500 beats the hell out of the average hedge fund

When trillions of dollars are managed by the Wall Street managers charging high fees, they are usually the ones who reap the 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, it seems to be pretty obvious that when index funds emerged on the cryptocurrency market, the community became extremely excited about the opening investing opportunities. Let’s take a closer look at them.

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:

  1. Investable.
  2. Completely transparent.
  3. Systematic & rule-based (no personal judgement).

But just because an index fund follows these rules, it does not mean they are all the same. The biggest differences between them is decidedly based on which segment of the market the index wants to track. There are 4 major index categories which we will cover in detail:

  1. Total market — tracks the performance of the entire market.
  2. Size-classified — segments based on size (low cap, medium cap, etc.).
  3. Category-classified— segments based on coin category (privacy coins, utility coins, store of value coins, etc.).
  4. Smart beta — segments based on fundamental metrics (e.g. NVT ratio).

Let’s take a closer look at the four index categories and compare traditional index funds to cryptocurrency index funds.

Total Market Index Fund: Stock Market vs. Cryptocurrency market

Total market index funds attempt to track the performance of the entire market.

Within the stock market, the S&P 500 and Russell 3000 are examples of indices which approximate the performance of the entire US stock market. If the S&P 500 and Russell 3000 are down, then the overall stock market is very likely to be down as well (and vice versa).

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. So 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 weight 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.

Size-Classified Index Funds: Stock Market vs. Cryptocurrency Market

Rather than trying to capture the performance of the entire market, some index funds try to capture the performance of a smaller segment.

In equity markets, the S&P 600 includes 600 small-cap companies that have a market capitalization between $450 million and $2.1 billion. The S&P 600 approximates the performance of small-cap companies in the US stock 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)

The interface for creating a personalized cryptocurrency index fund. Takes 5 minutes to set-up.

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 small-cap cryptocurrencies are much riskier than the riskiest small cap equities. ROI on emerging technology companies typically follow a power law distribution, meaning that a few survive and the rest die.

Industry-Classified Index Funds: Stock Market vs. Cryptocurrency Market

Since the entire market can be so vast, some indices try to only capture the performance of a single industry vertical.

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.

In cryptocurrency markets, industry segments are not as well defined. There is a lot of functionality overlap between different cryptocurrencies so it is much more difficult to distinctly draw the line between different segments.

Smart Beta Index Funds: Stock Market vs. Cryptocurrency Market

Smart beta index funds select assets based on indicators which have historically resulted in market outperformance.

In equity markets, there are 6 main indicators:

  • Volatility — low volatility & low draw-downs.
  • Value — low price/earning 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.

These factors are not well defined in the cryptocurrency market due to the fact that the cryptocurrency market is very immature.

There is still no general consensus as to how we can fundamentally assess the quality of a certain cryptocurrency.

Additionally, the historical data available for backtesting is not sufficient. Immature data with high noise to signal ratio can lead to over-fitted models with no predictive value.

The strong intercorrelation between top coins is even further proof that it is simply too hard to discern the fundamental value of a cryptocurrency. It has been suggested that the only method that would work right now is a momentum based indicator based on historical risk-adjusted returns.

A Crypto Index Fund vs a Mutual Fund

An index fund is actually a type of mutual fund, for cryptocurrency investing. In other words, it’s an investment portfolio designed to provide a wide market overview at a low cost. This translates as a passive investment for long-term gains, not day trading.

Active vs Passive Management. There are two types of cryptocurrency index funds: active or passive. Active ones actively trade cryptocurrencies while passive ones hold certain coins and tokens on your behalf.

Those Listing All vs Select Cryptocurrencies. Most cryptocurrency index funds only invest in the highest market cap coins and tokens, though some capture the whole market. The way they choose tokens differs, too. Passive investment prevails here.

Manual vs Automated. Some cryptocurrency index funds have the option to manually select and weigh each cryptocurrency. Others will create a basket of coins and tokens on your behalf based on your desired returns and their predictions. A passive investment is the primary outcome on either method too.

How to invest in crypto Index Funds

Investing through an index fund can be beneficial for a crypto trader but only under certain circumstances. First, many will provide greater returns than just investing in a single cryptocurrency. Also, high volatility comes as a risk to traders and investors, therefore you may want to minimize incurring such volatility-related loss by hedging your capital across an array of coins and tokens (we can only say minimize because avoiding the effects of volatility is impossible in the current market state!).

In addition, excessively frequent trading is associated with high fees and some performance drag. Some cryptocurrency traders simply do not have a lot of time to investigate how each cryptocurrency performs in order to invest.  For some traders and investors, a crypto index fund may be an effective way to steer away from unproductive mindsets and opinions regarding a given digital asset.

Besides the aforementioned benefits, a cryptocurrency index fund is good for passive investors interested in maximizing long-term benefits by keeping the value of investment to a minimum.

The best cryptocurrency index funds to keep an eye on in 2019

Coinbase

Coinbase first rose to fame as an exchange platform, and recently they started to offer an index fund. This crypto index fund tracks seven digital currencies: Bitcoin, Ethereum, Bitcoin Cash, Litecoin, Ethereum Classic, 0x Protocol and BAT (Basic Attention Token). As expected, Bitcoin takes up over 75% of the fund, followed by Ethereum at around 15%. This is a limited selection of cryptocurrencies. However, it focuses on coins with large market capitalizations which tend to be much less volatile than smaller market cap ones.

Bit20

Bit20 is one of the first cryptocurrency index funds ever launched, and it exists in the form of a CFD (Contract For Difference). This index fund consists of the top 20 cryptocurrencies by market cap. The fund revises which cryptocurrencies that make up the top 20 each month. Since it’s one of the oldest cryptocurrency funds, it has proven to be a relatively stable form of investment.

Cryptos Fund

Cryptos Fund claims to have the lowest management fees of all funds, and the reason for this is because they track the Cryptocurrency Index 30, which gives an objective picture of the state of the crypto market. When you buy into a Cryptos fund, your investment is spread over a wide portfolio of cryptocurrencies. This helps to protect investors from volatility.

Bitwise

Bitwise Asset Management holds the Hold10 index which tracks the top 10 cryptocurrencies. This index is weighted by an inflation-adjusted market cap. It only allows US citizens and accredited investors to enter. The annual management fee is around 3%.

Iconomi – BLX

This index has tools which allow both beginners and expert traders to invest in cryptocurrency. BLX lists coins that represent 78% of the sector by market capitalization. It offers simple, user-friendly investment options that are ideal for beginners who are still not certain what to invest in.

Bottom line

If one looks to invest in cryptocurrencies, crypto index funds may be an ideal option. Cryptocurrency index funds usually result in less volatility and also offer less risk than direct investments in crypto coins. Each of the above crypto funds have different characteristics. These different cryptocurrency characteristics suit different types of investors. However, one thing needs bearing in mind: no investment is 100% safe from risk, and for a beginner in the investment world, it may be best to consult a specialist before jumping into the deep end.