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Passive investing strategies have gained popularity in crypto, following the trend set in traditional finance — where benchmark-tracking ETFs and index funds are a huge force. But it’s important to engineer indexes that can grapple with the shortcomings and inefficiencies of the nascent asset class of digital assets.
Indexes weighted by market capitalization long dominated passive investing in stocks. They have their origins in “Modern Portfolio Theory,” which traces back to the works of Harry Markowitz and William Sharpe in the 1950s and 1960s, respectively. Since the creation of the first index fund by John Bogle in 1975, market cap-weighted indexes have been considered the industry standard — not only from an academic practical point of view, but also from a practical one. It was only in 1992 that Eugene Fama and Kenneth French developed a three-factor model that empirically explained stock returns better and was an extension of the Capital Asset Pricing Model. In addition to the well-known beta, small-market caps and low price-to-book ratios were added as systematic risk factors.
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Over the years, new factors and alternative weighting methodologies have been introduced, aiming to exploit market inefficiencies. Some of the most well-known factors include momentum, minimum volatility, quality and dividends. Alternative weighting methodologies include equal weighting, risk parity and maximum diversification.
A buzz term was eventually developed to describe this: smart beta. It was first put into practice in 2003 with the S&P 500 equal-weighted index. Since then, thousands of smart-beta ETFs have been approved for trading in both the U.S. and Europe. Currently, around $1.7 trillion is managed this way in ETFs in equities in the U.S. alone. Despite their apparent success, however, this represents a relative pittance versus ETFs weighted by market cap.
In the world of crypto indexing, benchmark creators have brought over market cap-weighting from traditional finance one-to-one. That approach, however, may not lead to optimal results, especially in the relatively nascent and evolving asset class of cryptocurrencies. It can result in significant market concentration in just a couple of constituents such as bitcoin and ether, thus defeating the fundamental goal of index investing: diversification.
Another mistake made by many crypto index providers is defining the market universe too broadly, creating indexes that are not investable or not sufficiently liquid, especially during crises. To be tradable on traditional exchanges, the underlying index constituents must demonstrate a minimum level of liquidity across widely accessible liquidity venues. Therefore, liquidity-based index exclusion criteria significantly narrow the investable universe.
Additionally, in the crypto sector, it is essential to establish qualitative inclusion criteria. Unlike in the stock world, where companies are thoroughly examined by regulators, banks and auditors before being listed on an exchange, crypto projects and tokens are subject to limited due diligence, resulting in unforeseen debacles such as Terra/Luna and FTX. Rigorous analysis can help avoid such situations.
To address these issues, it is important to avoid the common pitfalls of market cap-weighted indexes and limit the investment universe to the top coins by market liquidity.
While the possibilities are almost endless, we have decided to build an index that is based on a combination of risk parity and market capitalization. The risk-parity weighting scheme aims to balance the risk contributions of index constituents resulting in an index that over-weights smaller coins compared with a market cap-weighted one, achieving higher diversification. Although there may be market phases where such an index lags behind the overall market, there is a high probability that the index will outperform the market over an entire market cycle.
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