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?
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.
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.
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:
Now you know how to construct a cryptocurrency index, let’s learn about the concept of rebalancing.
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.
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.
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.
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.
Next, let’s define the rebalancing strategy. You have a couple of options here:
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.