Why invest in crypto index funds?

Probably the best known index fund for stocks is the S&P500. This tracks the market value of 500 large US stocks. By investing in the S&P500 (via Vanguard,  Schwab, Blackrock or State Street), one can get exposure to the performance of the US stock market. Crucially, investing in index funds provides the benefit of wide diversification (roughly across 500 stocks) without high fees (typically less than 0.25%) and without needing to proactively manage one's investments.

Analogously, one can think of building an index fund that tracks the crypto market. To do this, one needs to invest in cryptos proportional to their market capitalisation. Let's start by taking a look of the market cap of the biggest cryptos on coinmarketcap.com :

At the time of writing - August 16th 2021 - the total crypto market cap is $2.01 trillion. This means that Bitcoin ($877B) accounts for 43% of the value of cryptocurrencies, and Ether ($379B) accounts for a further ~20% of the total value of cryptocurrencies (by contrast, Apple accounts for about 2% of global equities). So, at the time of writing, I can get about 63% exposure to the overall cryptocurrency market by owning just Bitcoin and Ether. Actually, my correlation with the overall crypto market would be even greater than 63%, because other cryptos have tended to be correlated with Bitcoin and Ethereum.

A simple market cap based index fund

One simple way for me to get exposure to crypto is to only buy Bitcoin and Ether in proportion to their market cap. Today, that would mean me buying 70% Bitcoin, 30% Ether. [Technically, some periodic adjustment of holdings would be required over time because the total supplies of Ether and Bitcoin are increasing over time, but these adjustments are small and slow.]

A simple equal weight based index fund

Another simple approach to diversification is to invest 50% in Bitcoin and 50% in Ether. There are three ways I do this:

  1. I could either do buy an initial 50% BTC and 50% ETH and then hodl (i.e. don't do any rebalancing). This is the simplest approach and something I have done when giving a gift to someone.
  2. I could buy 50% Ether and 50% Bitcoin, and then rebalance quarterly to keep my holdings roughly in this proportion. (I have done this historically and it is a bit annoying because it takes work and there are quite a few taxable transactions).
  3. I could invest in a wBTC-wETH Balancer pool that automatically rebalances (while earning transaction fees) to a 50-50 split:

Note that there are the following caveats with Balancer.fi pools:

a. The tokens in the pool are "wrapped", meaning that there is an extra layer of code - and often a custodian - that takes a token (such as BTC) and uses it as collateral to create a wBTC (wrapped BTC) token that can be traded on the Ethereum blockchain. This introduces the risk that additional smart contracts might fail, or the third party custodian of the BTC could get hacked or steal the tokens.

b. Balancer pools (like Uniswap pools) are subject to impermanent loss, which is a loss associated with price changes in the pool versus the external market.

c. Balancer is constantly upgrading versions, so - over time - one may need to move funds from one version to another, which could require taxable transactions.

d. Balancer itself could have smart contract issues that result in a loss of funds.

Market Cap vs Equal Weight: Which is Best?

The practical answer is that either approach is decent. Each provides diversification and a systematic approach that can be followed programmatically. However, which approach proves best over time is hard to predict. It could well be that it will prove best to have simply held Bitcoin, or to simply have held only Ether.

The more theoretical answer is as follows:

  1. If returns were normally distributed, and variances/co-variances could accurately be measured, then a market cap weight approach provides the highest possible reward to risk ratio.
  2. If returns are not normally distributed and/or variances cannot be accurately measured, an equal weight approach performs better because it reduces error in estimating the optimal portfolio weightings.
  3. In scenarios where there is high uncertainty (and fat tailed behaviour), it is typically wise to diversify among even more assets. This would favour trying to hold more cryptos than just Bitcoin or Ether and goes beyond the simple strategies I have proposed above.

Index Investing Risks:

I am sharing the above as my approach and thinking on index funds, not specific investment advice for you or anyone else. As I say in all of my posts, with crypto, I recommend only investing what one can afford to lose. Furthermore, I recommend limiting the percentage of one's liquid net worth that is invested in crypto. For nearly everyone, I think this should be no more than a few percent of net worth, and only if one can afford to lose that money.

Your questions:

Let me know of any questions in the comments section below and I'll be happy to try and answer them.

You can also get my weekly newsletter, in which I plan to write more about index funds, by subscribing at Pinotio.com .

A note on Celo vs Ethereum blockchain:

On Celo, a close equivalent to the wBTC-wETH pool on Balancer is the cBTC-cETH pool on Ubeswap in which I have pooled $100 worth of tokens. Note that this is a small pool, so impermanent loss effects may be large (although transaction fees are lower on Celo than on Ethereum.