Crypto Index Funds: What They Are And How To Invest In Them

What Are Crypto Index Funds?

Crypto index funds are investments in a specific crypto index, and are designed to offer investors access to a diversified basket of crypto assets.The performance of a crypto index fund will mirror closely the performance of the crypto index it tracks. 

Key Takeaways

• A crypto index tracks the performance of selected cryptocurrencies. It is considered as an insight into the performance of related assets or assets in a similar category.

• Crypto index funds give investors exposure to a basket of cryptocurrencies at once as opposed to investing singly in each of them.

• When choosing a crypto index fund, considerations include the total assets under management, fund composition and methodology, and historical returns.

With over ten thousand cryptocurrencies listed on asset tracker like CoinGecko, it is rare to find traders who invest in only one of these assets. Many traders adopt a diversified portfolio approach, spreading their investments across different assets based on their research and personal convictions. However, instead of deciding which crypto assets to invest in by yourself and how much to invest in each asset, crypto index funds offer an easier way to invest in an assortment of crypto assets at once. 

Understanding Crypto Index Funds

A crypto index is a selection of different cryptocurrencies and a parameter to gauge their performance over time. Put simply, a crypto index selects a basket of cryptocurrencies and tracks their performance. For instance, a crypto index could track the performance of the top 20 cryptocurrencies.

As a crypto index fund tracks and trades an index, it is an investment fund that diversifies capital across a selected index. Through crypto index funds, an investor can invest in these tracked assets all at once. For example, a crypto index fund for the top 20 cryptocurrencies would let an investor invest in these 20 crypto assets at once, with the amount per asset decided by the fund. Ultimately, crypto index funds attempt to limit risk and possibly maximize profits by buying a portion of different assets at a strategic proportion.

Index funds are not unique to cryptocurrencies; these are common in the tradfi investment space as well. Stock market indices like FTSE 100 measure the performance of 100 blue-chip companies listed on the London Stock Exchange, where an FTSE 100 index fund would spread investors’ funds across these 100 companies.

How Do Crypto Index Funds Work?

Crypto index funds implement professional approaches to the regular diversification done by everyday investors. Instead of randomly buying a bunch of crypto assets, crypto index funds track selected crypto assets and channel investors’ capital into these. On the investor’s end, a one-time investment is made while the index fund management proceeds to split the capital across the different crypto assets in their index.

Crypto indices are weighted in different ways, just like stock market indices. 

Some crypto indices are weighted according to market capitalization, where such crypto indices compute the market capitalization of the different crypto assets they are composed of and split their investments across these assets relative to their market capitalization.  

Other crypto indices are weighted according to price. Price-weighted crypto indices compute the prices of their component assets and diversify their capital based on the value. That is, they may opt to channel more capital to the asset with the highest or lowest price. The index then tracks this price as the known performance of that particular index.

The index fund now proceeds to compute a share value which represents the cost of stake on the assets held and the profits generated. The share price could fluctuate as the performance of the index fluctuates. This price is presented just like the price of a crypto asset – for instance, the Bitwise 10 crypto fund index has a market price of $18.34 at the time of writing, where an investor who commits $18.34 to the index fund buys one share of the tracked assets. Therefore, this investment is automatically diversified and managed by Bitwise.

Managing a crypto index fund involves decision-making as regards which assets are added to the index or removed. It also involves re-balancing the weights of the assets to generate or maintain profit.

Benefits Of Crypto Index Funds

For the regular investor, crypto index funds could be a good approach to investing in cryptocurrency. Here are some of the advantages of investing in cryptocurrencies through crypto index funds:

Diversification

While every investment comes with pronounced risks, cryptocurrencies are one of the most volatile assets known, where the value of crypto assets fluctuates more than usual. Crypto index funds help investors spread their capital across different assets in order to tame the volatility risk of crypto.

With a diversified portfolio, some assets' positive fluctuation can cushion the negative fluctuation of the other assets in the same index. When compared against buying a single asset, diversification, especially through crypto index funds, could be less profitable when the poorly performing asset reduces the profits generated from the well-performing asset. However, this could also make it a more profitable approach in cases where the singly-held asset performs badly, as the other assets in the basket may be less impacted by market forces.

Professional Fund Management

Most crypto index funds claim to employ the services of experienced investors, traders, accountants, and administrators who understand how the crypto space works and are experts in weighted diversification. This creates a team of dedicated professionals who manage users’ funds, as opposed to managing your funds by yourself. Also, with the crypto index fund operators managing these investments, they save investors a load of researching, tracking and handling their investments, which could be tedious at times.

Liquidity

By helping investors diversify their portfolios, crypto index funds ensure that many other crypto assets get a share of the capital that flows into the space. 

For investors, crypto index funds present an easy way to buy and sell cryptocurrencies. They increase the accessibility of crypto assets and in doing such, invite more funds to the space. Instead of working through different centralized and decentralized exchanges to purchase different cryptocurrencies, an investor could simply invest in an index fund that tracks the asset (or a majority of the assets) they wish to purchase. This simplified capital flow creates more markets for crypto assets.

Disadvantages And Risks Of Crypto Index Funds

In spite of these advantages, crypto index funds also have some shortcomings. Here are some of the disadvantages of investing in cryptocurrency through crypto index funds:

Lack Of Control

Investing through crypto index funds is a trust-based process where an investor entrusts the index fund operator with their capital. The success of this investment depends majorly on how well the operators manage the investments, which is out of the investors' control. 

In a case where the operator is not adequately knowledgeable about the space, the lack of control over your investment can result in losses. In addition, running a crypto index fund also involves managing different crypto assets which are markedly different in the way they operate and even their regulatory landscape. This exposes the index fund’s performance to rapid changes in these areas which could have a significant impact on the performance.

Lack Of Liquidity

Liquidity for the different assets in a crypto index also differs, therefore, the ease of buying and selling these assets also varies for the fund manager. If some or all of the assets in an index have poor liquidity, this could pose a challenge for the index fund operator in processes such as rebalancing or making complete sales and purchases. The slippage caused by the low liquidity could affect the overall performance of the crypto index fund. As a precaution, verify the liquidity conditions of the assets in the crypto index you wish to invest in.

Location

While crypto index funds make it easier to invest in a range of crypto assets, some cryptocurrency index funds aren’t available to investors everywhere in the world. There could be geographical restrictions on the operations of certain crypto index funds or deliberate exclusion of certain locations by the index funds operator. 

It is therefore advised that investors do adequate research on the geographical availability of their desired crypto index fund.

How To Choose An Index Fund

Before deciding which crypto index fund to invest in, here are some factors you should consider:

Asset Under Management (AUM)

AUM is a record of the value of assets controlled by the index fund, showing the amount of investor capital entrusted to the fund. A reputable index fund should have a significant AUM, as many investors trust it with their funds. 

These statistics can also be used to provide insights into the performance of the fund. One way is to track the growth of the AUM as a measure of investor activities as it concerns the index fund. A consistently decreasing AUM could be a show of investors’ dissatisfaction and investors pulling away, or it could also mean that the value of the assets in the index’s portfolio is dropping. Either way, this signals the need for more in-depth research on the index fund. Meanwhile, a consistently increasing AUM is generally a show of health for an index fund.

Composition

Index funds track selected assets. Sometimes these assets are connected by certain metrics (like top 20 cryptocurrencies). At other times, these assets are selected based on other criteria by the index fund. In either case, investors' conviction or orientation about these assets might differ. Therefore, before investing in an index fund, check out the composition of the index fund, and do your own research on the individual assets as much as possible before investing.

Methodology

Understanding the methodology behind an index fund also matters. This includes how they weigh between what assets to include and what proportion, and how often rebalancing will take place. This can also include other aspects, such as how an index identifies the accurate price and market capitalization of crypto assets, and how it handles additional network distributions like emissions, airdrops, and staking rewards. 

Returns

It is also important to get an overview of the index fund’s performance over time. Like normal financial assets, ascertain the price development of the index fund and how healthy this is before you invest in it. Reviews from current investors could help in this case, however, a reputable index fund should also have accessible documentation of their periodic returns. Review documents like this and consider the profits and losses made over time as part of your decision-making process. Also, it is important to consider the sustainability of these returns.

How To Invest In A Crypto Index Fund

Considering making your way into investing in crypto index funds? Here’s how to start;

Research And Choose Your Fund

Prior and proper research on available crypto index funds is paramount. If you already have an index fund in mind, then consider assessing them under the factors mentioned earlier. 

An example of a crypto index fund is the Bitwise 10 crypto index fund that track 10 popular cryptocurrencies including Bitcoin, Ethereum, Polygon, XRP, Litecoin, and Bitcoin Cash. Index Coop’s crypto index fund tracks the index of top DeFi project tokens, and eToro also offers several crypto funds on its Smart Portfolios.

As of November 2023, the Bitwise 10 crypto index fund consist of over 68% Bitcoin; you can obtain data like this from official publications and weigh your choices. When you finally decide on an index to invest in, proceed to create your account on the platform.

Fund Your Investment Account And Purchase An Index

Having decided which index fund operator and index fund to invest in, the next procedure is funding your account and purchasing the index fund’s shares. Like any other index fund, the shares give an investor the right to the assets held in the index fund according to their weight and relative to the amount you invested.

Monitor Your Investment

Now that you have successfully invested in an index fund, it is important to keep an eye on the index fund you invested in and the index fund manager as well. Index fund operators manage the AUM and could change the weight of the assets in their index with rebalancing. 

As an investor, follow any changes in the index and find out how these changes affect you. Also, follow up with the performance and consider moving your investments to maximize profits or limit losses. If needed, you can also involve the services of a professional in weighing up the index fund’s performance before taking any action.

Crypto Index Fund vs. ETFs

Like index funds, ETFs (Exchange Traded Funds) allow investors to invest in a basket of assets at once. They pool different assets and give investors an opportunity to own a diversified portfolio of handpicked assets with just a single investment. However, a few differences exist between them:

First, ETFs are traded on exchanges like stocks and cryptocurrencies and can be purchased directly from these exchanges in the same way that assets are purchased, a broker could be involved in this process too. In comparison, index funds are purchased from the fund managers and usually involve the creation of an account on the index fund manager’s platform.

Also, ETFs can be easily bought and sold on the exchange at any time within the official trading hours, but index funds are only cleared in bulk at market closure for the day. Therefore any index fund order (buy or sell) is satisfied at the close of trading for the day at the recorded Net Asset value (NAV). You can also purchase as little as one share of an ETF, but index fund managers specify the minimum amount of an index fund share that can be purchased. Thanks to this difference in buy and sale practice, ETFs are also relatively more liquid than index funds.

Final Thoughts

There are several ways to approach investment and crypto index funds are just one of those ways. For the regular investor in crypto index funds or the index fund operator, diversifying investments in the way index funds do it could save some losses as crypto assets experience differences in price development. It also serves investors looking to dive into crypto investing but seeking a pre-planned investment strategy. We have discussed the pros and cons of resorting to this strategy and how to approach them, but one vital part is running due research on crypto index funds available to you before making a choice.

While assets in the index could perform well, fund management is a huge factor as well. Therefore, it is important to extend your research to the index fund operator and ascertain their capability to navigate the investments through different market situations and their reputation as well. Note that this article is only meant to educate readers about crypto index funds and is not meant to be taken as financial advice. Always do your own research and due diligence before undertaking any investments. 

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Joel Agbo

Joel is deeply interested in the technologies behind cryptocurrencies and blockchain networks. In his over 7 years of involvement in the space, he helps startups build a stronger internet presence through written content. Follow the author on Twitter @agboifesinachi