How to Create the Optimal Cryptocurrency Index?
An index fund is a common investment option for traditional finance. An index fund consists of a basket of separate investments that match a particular market segment or index. For a cryptocurrency index, this means we track several different cryptocurrencies that reside in the top 100 crypto coins.
In this article, you’ll learn about the different types of cryptocurrency indices, what characteristics define a cryptocurrency index, and how you can apply the concept of rebalancing to reduce risks.
But first, what is a cryptocurrency index exactly?
What Is a Cryptocurrency Index?
A cryptocurrency index is not designed to beat the market or to gain larger returns than the average market returns. An index fund is actually created to represent a certain market such as the cryptocurrency industry.
A cryptocurrency index would, for example, contain the following cryptocurrencies:
Those three players represent a large portion of the crypto market. The goal is to mirror the performance of the overall market without gambling on a single or multiple individual cryptocurrencies.
Why Would You Use a Cryptocurrency Index?
An index is often used for the purpose of managing risks. As a cryptocurrency index contains many different crypto projects, it helps balance risks as market swings tend to be less volatile across an index compared with individual cryptocurrency investments.
In theory, markets tend to grow over time. Therefore, an index is an ideal investment strategy as it resembles the market you expect to grow while still being a low-risk investment. Of course, market crashes can occur at all times. However, a well-balanced portfolio should be able to recover over time as the market continues to grow again.
Important Characteristics of a Cryptocurrency Index
Commonly, two types of indices are used.
The first being an ‘equal weights’ index. This means that every asset in the cryptocurrency index has an equal value when creating the index. For example, you want to spread $1000 among ten cryptocurrency projects. For an ‘equal weights’ index, you would buy $100 worth of each crypto project.
The second approach is a ‘market cap weighted index’. The difference with an equal weights index is that you invest your $1000 to the weight of each project’s market cap relative to the other crypto projects in your portfolio. This is a more common approach as it represents the market more naturally.
When considering a market cap weighted index, these are the parameters you should consider when constructing one:
- Number of assets: The number of crypto projects you want to include in your cryptocurrency index. Aim for 10 to 20 cryptocurrencies as you want to have a nice dissection of the cryptocurrency market. Typically, you start by selecting assets with the highest market cap first before including lower market cap assets.
- Minimum asset percentage: The minimum asset percentage defines the minimal allocation an asset should represent in your portfolio. For example, you want to allocate 5% to each asset in your cryptocurrency index. This prevents you from holding an extremely small percentage for a particular crypto project.
- Maximum asset percentage: Like the minimum asset percentage, we want to set an upper bound for the total percentage an asset can take up in your crypto index. The maximum asset percentage is important for managing risks. You don’t want a particular cryptocurrency to grow beyond, for example, 50% of your index. In other words, the maximum asset percentage helps to manage the risk exposure for individual cryptocurrency investments.
Now you know how to construct a cryptocurrency index, let’s learn about the concept of rebalancing.
Rebalancing Your Cryptocurrency Index - Why? How?
So, what is rebalancing? Rebalancing refers to updating the weight of each asset in your portfolio according to the current relative market cap weight each asset represents.
As you know, the cryptocurrency market changes daily. Therefore, a one-week-old portfolio doesn’t represent the exact relative weight of the current market. To continuously represent the latest market changes, you can choose to rebalance after every X days or every X weeks. Commonly, rebalancing happens after two weeks as you have to think about the fees you pay for selling & buying assets in your cryptocurrency index. Rebalancing frequently increases your cost as you pay a lot of transaction fees.
However, it’s important to know that rebalancing is not mandatory. It’s just a method to update your cryptocurrency index so it represents the current market changes.
Further, rebalancing helps with reducing risks. For example, Bitcoin’s total market cap grows with 25%. This means that your current portfolio is largely exposed to Bitcoin. Rebalancing helps with avoiding being over-exposed to a particular asset, and so, reduce risks.
How To Create the Optimal Cryptocurrency Index?
There are many aspects to consider when creating a cryptocurrency index. Let’s present you with an actionable plan to create your optimal cryptocurrency index.
Step 1: Pick Cryptocurrency Projects
First of all, let’s start by selecting cryptocurrency projects you want to include in your index. Typically, you select projects top-down based on their total market cap. Before you start, make sure you know how many projects you want to include in your index. Usually, an index consists of 10 to 20 assets that create a pretty accurate market representation.
Of course, you don’t have to blindly select the top 20 cryptocurrencies. Invest in projects you like or who offer a great product. It’s allowed to blacklist certain projects. Some people prefer to make a portfolio that consists of just popular coins while others like to focus on less-known projects combined with some Bitcoin or Ethereum as a stabilizer.
Step 2: Set the Rules for Your Index
Now you’ve selected the projects you want to include, let’s set the rules for your cryptocurrency index. Define your minimum and maximum asset percentage.
Preferably, an asset shouldn’t take up more than 50% of your crypto portfolio. An index helps you with balancing investments while reducing risks. When your portfolio is exposed for more than 50% of the value to a particular asset, a market swing can have a dramatic effect on the value of your index.
In addition, set rules for when investments should be included or excluded from your index. For example, you can remove an asset from your cryptocurrency index whenever its relative weight goes below 5%. Furthermore, you can set rules for when to include assets again.
Step 3: Define Your Rebalancing Strategy
Next, let’s define the rebalancing strategy. You have a couple of options here:
- Don’t rebalance at all. However, this approach is not recommended. Rebalancing helps with managing risks in your portfolio.
- Periodic rebalancing. This strategy is great as you periodically rebalance the assets in your portfolio. It has been proven that frequent rebalancing outperforms longer rebalancing intervals.
- Threshold rebalancing. This strategy focuses on only rebalancing whenever significant market changes occur. For example, you can set the threshold to 5%. This means that you want to rebalance your portfolio whenever a particular asset deviates more than 5% from its original allocation.
When Will You Create Your Cryptocurrency Index?
To recap this article, let’s focus on the hidden costs of frequently rebalancing. Of course, rebalancing is a smart move. However, when you are shifting balances between more than 20 cryptocurrency investments, fees can add up. Therefore, be conscious of the hidden costs of your rebalancing strategy.
However, fees can be reduced through “smart order routing”. This means you try to find the most optimal path to move cryptocurrencies by reducing the number of transactions. More can be found about this concept here.