How Does the Cryptocurrency Index Fund Work?

Zeroing in on a sound investment strategy, balancing the returns and risks, especially when emerging markets are in focus, can be time-consuming and tricky. Everyone is now aware of cryptocurrencies and the fact that they bring higher returns at the cost of higher risks. But the cryptocurrency technology is often misjudged or underrated, and it’s easy to burn your fingers handling it. You need to understand the crypto risk model and learn how the cryptocurrency index fund works to decide if it’s a viable investment model for you.

The traditional approach of studying individual cryptos for assessing investment opportunities becomes a complex process where you’d be unprotected without professional or institutional assistance. There are very few investors that hold their own and manage colossal cryptocurrency portfolios.

Perhaps in a bid to overcome the disadvantages of traditional crypto investment options, we’re seeing a massive expansion in the market for cryptocurrency index funds, with individual investors and institutions pushing index funds aggressively.

The Core Philosophy Underlining the Cryptocurrency Index Fund Model
The cryptocurrency index fund represents an uncomplicated, minimal-expense driven method of making the best of the market’s higher rate of return without the risk of handling individual cryptos.

The cryptocurrency index fund tracks the price, capitalization, performance and many other variables of a group of cryptocurrencies in the same manner as the S&P500 index tracks stocks. The financial data available in the blockchain domain is used to calculate the performance index of any cryptocurrency group transparently. The entire process of indexing is automated with minimal scope for human error, arbitrariness, or interference.

Each cryptocurrency index fund hands out tokens representing the investor’s share in the fund. The index administration is centralized on a dedicated server using blockchain inspired smart contracts.

The Lowdown on How the Cryptocurrency Index Fund Is Created and Managed

If you take a closer look at a stock market index like the S&P500, you’ll see that you’re exposed to a basket of stocks representing 20 or 30 of the top performing stocks in a segment of the economy. The stock market index, at any moment, reflects the changing value of individual stocks. Even if some stocks move adversely, you’re insulated from that change because you’re tracking the overall performance of the index in which you hold only a fractional share.
In the same manner, the cryptocurrency index fund exposes the investor to the crypto market as a whole without being tied to the fate of any single crypto. Instead of being hostage to the fate of one crypto, you’re taking a call on the performance of a broader basket of cryptos with minimal risk.
Generally, you’ll find two ways of creating the cryptocurrency index fund – there are crypto indices that are categorized as price-weighted or capitalization-weighted.

1. The Cryptocurrency Index Fund Which Is Price-Weighted

This is an index where cryptos are held in proportion to their value, with the higher-priced cryptos raising the index more aggressively than changes in the lower-priced cryptos. The price-weighted index reflects the average price movements of all the individual cryptos in the fund.
Let’s assume we’re dealing with a cryptocurrency index that contains three cryptos C1, C2, and C3 currently priced at $5, $10, and $15 respectively. The 123 index level would be calculated as $30/3 = $10. Therefore, crypto C1 would have a weightage of $5/$30 or 1/8 of the entire index.
In this kind of price-weighted fund, the index treats all cryptos on an equal footing regardless of which crypto is performing well or is not performing. So if the value of crypto C1 goes up and the value of crypto C2 climbs down, the fund offloads C1 and buys more of C2 to balance and equalize the index.
Because of frequent buying and balancing of individual cryptos, we’ll see price-weighted indices facing more volatility. But these indices gather steam and position themselves as consistent performers yielding higher returns in the long-term.

In leveraging the price-weighted crypto index, you’ll be diversifying across a much broader basket of cryptocurrencies covering a larger swathe of the growing crypto market. What the strategy implies is that you’re maximizing your gains on the winning cryptos and you’re reinvesting in your losing cryptos, and by doing this kind of risk balancing you’re adding value to your investment over time.

2. The Cryptocurrency Index Fund Which Is Capitalization-Weighted

This is an index where assets are held in proportion to each crypto currency’s market capitalization, with the higher-capitalized cryptos moving the index upward more aggressively than changes witnessed in low-capped cryptos. The proportion of each asset’s capitalization to the whole fund determines how many individual cryptos the fund will hold.

Let’s work on the assumption that we have an index fund with a mix of Bitcoin (BTC) (market cap $67.13bn) holding 64% of the aggregated market cap, Ethereum (ETH) (market cap $15.64bn) holding 14% of the fund’s market cap, and Ripple (XRP) (market cap $14.96bn) holding 13% of the fund’s combined market cap. In this fund, 64% of the investment will be focused on Bitcoin, 14% in Ethereum, and 13% in Ripple in line with each crypto currency’s capitalization.
In the market-cap-weighted index, investors will be holding more heavily capitalized cryptos because these cryptos carry more weightage. So you’ll see less diversification of cryptos in these indices. One disadvantage of market cap weighting is that the index will be primarily tied to the movement of the largest cryptos. Reverting to our example, if Bitcoin suffers a reversal, it will impact the performance of the index considering that Bitcoin cornered the most significant chunk of the fund invested.

In the price-weighted strategy, the larger cryptos don’t exhibit an earth-shattering impact because the weight assigned to them is lower. The movement of singularly large cryptos will not impact the overall index as long as other performing cryptos bridge the performance shortfall and rebalance the portfolio.

A Note of Abundant Caution: Emerging Cryptocurrencies Are Not Risk-Free

It is understood that investing in single cryptocurrencies is riskier than placing your bets on a cryptocurrency index that reflects the performance of the market as a whole. Having said that, we can’t ignore the risks investors are exposed to when an index attempts to duplicate the performance of the cryptocurrency market.

Broadly Speaking, There Are Four Risk Factors That a Crypto Index Fund Investor Faces –

1. The risk of constant volatility in prices of individual cryptos that populate the fund (you see that more in price-weighted indices)

The demand and supply of cryptocurrencies are mostly fueled by speculation, and prices can change dramatically and unpredictably without warning. There’s a limitation capping the global supply of Bitcoin, and this fuels volatility in Bitcoin’s speculative trading. Because there is no quantitative increase in Bitcoin to match increasing demand for the coin, you’ll see prices fluctuating wildly to accommodate demand variations.

2. Lack of liquidity is an issue that confronts cryptocurrency traders

In the cryptocurrency market, gains are more of a long-term phenomenon, and it is not easy for traders to move in and out of currencies with corresponding cash flows. The mere existence of a tradable currency does not necessarily guarantee cash convertibility. So we aren’t in a market that promises short-term gain.

3. The risk of regulatory changes that nobody can foresee or be warned against

Western nations have by and large addressed the legality of Bitcoin (if not as a currency but as a tradable asset), but in many other countries, Bitcoin continues to be banned or placed in a “no-policy” limbo. China termed initial coin offerings (ICOs) as an illegal form of public financing. The anomalous regulatory framework and constant changes impact crypto pricing and spur currency volatility.

4. The increased risk of severe cyber threats like crypto jacking

This is the practice of deceptively hijacking your computer for the private mining of cryptocurrency without your knowledge or permission. But this can be overcome by installing ad-blockers and using anti-crypto mining extensions on web browsers.

High-Risk Perception of Cryptos Is Pushing Investors to Cryptocurrency Index Funds

The global tsunami in cryptocurrency investment funds (as the boom in crypto capitalization indicates) is capable of smothering the dust storms that risk assessments generate. We have already observed that traditional investment in solitary high-risk cryptos is increasingly being replaced by a heightened interest in low-risk and steady-return crypto indexes.

You can upscale the safety factor by choosing a stable cryptos fund that overcomes volatility with balanced exposure, ensures higher returns, limits the cost of investment, and guarantees the kind of delta security that cocoons your cryptocurrency assets within an impenetrable force field.

Conclusion

The cryptocurrency arena is known for being a very volatile and risky market, and traditional investors following individual cryptos are aware of potential potholes in the freeway that come in the way of smooth trading. But token holders of cryptocurrency index funds are quietly cruising an alternate highway of steadily improving returns riding on indexed benchmarks based on the best performing cryptos in the market.

The philosophy of the crypto index fund was best summed up by its creator, John Bogle who succinctly asked why to search for the needle in the haystack when you have the option of buying the haystack. He should know – as the founder of Vanguard he’s sitting on $3 trillion worth of index funds.

Author bio: Agnieszka Podemska is an SEO specialist and content strategist at MiroMind SEO & Digital Agency. Avid blog reader and tech enthusiast, she likes to share her insights with others.

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