Managing a rally should be straightforward- after all, the market moves in an upward trajectory. However, investors need a strategy, especially when holding an asset class as volatile as crypto. One of the most effective strategies is diversification and products that provide exposure to an index present investors with a ready-made solution. This article explains how index funds work and why they’re particularly useful in a bull market before introducing two exchange-traded products (ETPs) that track crypto indices developed by CoinShares.
Understanding Index Funds
Index funds are a type of passive investment that mirrors the performance of a basket of assets representing a specific sector of the stock market, like US-listed shares. Vanguard founder John Bogle launched the first index fund in 1976, now known as the Vanguard 500 Index Fund Admiral Shares (VFIAX). Legendary investor Warren Buffet is such a fan of these products that he bet Ted Seides, a fund manager at Protégé Partners, $1 million that the VFIAX would outperform five funds of hedge funds over 10 years, starting in 2007. In his 2017 letter to Berkshire Hathaway shareholders, Buffet revealed the VFIAX rose by 125%, whereas the best-performing fund gained 87%. He donated the winnings to a charity in his home town of Omaha, Nebraska.
Index funds are popular with investors because of the diversification they offer compared to holding a single asset like a stock. Diversification is a key risk management strategy which can be summed up by the motto ‘don’t put all your eggs in one basket’. This means spreading money across a range of investments, both within an asset class (in different industries or geographical locations) and across asset classes (such as shares, bonds and crypto). The theory is if one holding underperforms, it won’t disproportionately affect the portfolio’s overall returns.
Research by CoinShares demonstrates how effectively crypto contributes to diversification. A portfolio consisting of a standard allocation (roughly 60% shares and 40% bonds) with a 4% bitcoin holding outperforms portfolios with a standard allocation and a 4% gold holding. It’s also less correlated with a standard allocation than the portfolio holding gold and only slightly more volatile.
Index funds are typically structured as ETPs, investment products issued by providers like CoinShares that buy and hold stakes in the underlying assets on behalf of investors. ETPs are fast becoming the most convenient way to access bitcoin because they trade on mainstream exchanges, so investors can hold them in portfolios alongside traditional asset classes such as shares and bonds and incorporate the returns into overall performance. ETPs are also safer than purchasing crypto directly on an unregulated or underregulated exchange as they’re subject to the same listing rules as other financial products.
Learn more about investing in crypto ETPs.
Benefits of Crypto Index Funds in a Bull Market
One of the main benefits of an index fund is it offers a ready-made diversified investment. Not only does this mitigate the risk of one holding underperforming, it smooths returns over the long term, which helps when investing in a volatile asset like crypto. Bitcoin may be experiencing a bull market in the run-up to the next halving, but previous rallies have been followed by a correction.
Index funds also allow holders to profit when different assets are trending upwards. Many indices are capitalisation-weighted, so they list the biggest assets by market capitalisation. In crypto terms, this refers to the total circulation of a given coin. Investors don’t have to worry about keeping on top of the latest trends in the vast and fast-moving crypto market or trying to forecast the potential value of various coins, which is extremely difficult considering they don’t share the same characteristics as traditional asset classes. The issuer ensures the index holds the strongest performers, rebalancing when necessary.
To put this benefit into context, let’s compare the 2023 performance of bitcoin with three native tokens: Ethereum’s Ether, Solana’s SOL and Cardano’s ADA. ETH and ADA performed well, but not as strongly as bitcoin. However, SOL outperformed the others, rising by a colossal 920%. Investing in an index fund like the CoinShares Physical Top 10 Crypto Market ETP (CTEN) would have ensured holders gained passive exposure to the returns of all four tokens.
Which index should I choose? Discover CS Physical Indexes ETP
CoinShares has built two crypto indices which investors can access through ETPs:
The Physical Top 10 Crypto Market index holds the 10 biggest cryptocurrencies by market capitalisation
The Physical Smart Contract Platform index tracks the performance of the 10 largest native tokens issued by providers of the infrastructure underpinning the crypto eco-system, such as Ethereum, Solana and Cardano
To reduce concentration risk in both indices, the maximum weighting for a single coin is 35%. This feature is particularly important in the case of CTEN given bitcoin’s dominance. CoinShares rebalances the indices quarterly to ensure they constantly reflect market trends. As a coin’s market capitalisation rises, so does its weighting on the index. And as the names suggest, CoinShares holds the ‘physical’ coins backing the underlying assets. It stores them with digital custodian Komainu which is regulated by the Jersey Financial Services Commission.
Key Risks
As with any asset class, buying and holding crypto ETPs involves risks that investors should take into consideration before adding these products to their portfolios.
Investors’ capital is at risk, and holders may lose part or all of their money due to price fluctuations of the underlying asset. For instance, bitcoin has experienced several bear markets, most recently in 2022.
Crypto ETPs are generally structured as debt securities. This exposes the holder to credit risk (the issuer could default on its obligations)
The bid/ask prices of ETPs trading on an exchange likely differ from the price of the underlying crypto. The difference between the bid (the broker’s purchase price) and the ask (its sell price) is referred to as the ‘spread’.
Finally, past performance isn’t an indicator of future returns. Investors should always seek professional advice to ensure a crypto allocation fits with their overall goals and objectives.
Conclusion
Index funds are a type of passive investment that tracks the performance of a basket of securities representing a certain market segment. They’re typically structured as ETPs which buy a stake in the underlying index on behalf of investors. These products are highly diversified as they hold a range of different assets. If one underperforms, it shouldn’t disproportionately affect overall returns.
In addition to diversification, index funds are effective in a bull market because they smooth out returns over the long run, which is important in the crypto markets as crashes have historically followed rallies. They also allow investors to take advantage of market trends as long as they’re capitalisation-weighted, meaning assets make it onto an index based on their market capitalisation.
Learn more about the CoinShares ETPs tracking crypto indices- the Physical Top 10 Crypto Market ETP and the Physical Smart Contract Platform ETP.
