Crypto index funds simplify investing but challenge blockchain ethos

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There are thousands of cryptocurrencies out there, with hundreds being created daily to fill every potential gap in the market. While this means there are limitless opportunities for investors, it also means there are many challenges to navigate, including which cryptocurrencies to invest in.

Most cryptocurrencies end up being abandoned after failing to catch on, but others thrive and see their holder numbers grow over time for a variety of reasons. Fear of missing out, or FOMO, is, therefore, a big part of the cryptocurrency investor’s mindset, and while Warren Buffett says we don’t have to swing at every pitch, investors are always looking for something.

One tool investors have at their disposal is crypto index funds, which offer exposure to several digital assets through a single investment vehicle, effectively scaling down the risk associated with investing in a single cryptocurrency. These funds track the performance of specific digital assets — which are determined by different factors like market capitalization or theme — and follow a particular weighting and rebalancing strategy to decide which coins comprise the fund.

These funds are ideal for those looking to gain exposure to the space, although some argue that investing in index funds leads to underperformance compared to simply buying Bitcoin (BTC).

Who are crypto index funds for?

Crypto index funds aren’t a solution for those looking for riskier investment in the space, nor are they a solution for those who want to explore what’s possible on the blockchain, as holding these index funds means not holding your own private keys.

Speaking to Cointelegraph, Stefan Rust, CEO of independent economic data aggregator Truflation, said there are over 20,000 digital currencies, which is a “complex market for newbies.”

While Rust noted, “Bitcoin and Ethereum are the 800-pound gorillas in crypto and are a good place to start,” he believes everyone should “learn how to navigate their own self-custody tools.”

Rust said investors should also be able to use decentralized finance (DeFi) protocols instead of “relying on and trusting in an established, structurally flawed financial system to look after their funds.”

He added that indexes soften volatility, a boon for passive investors “looking for steady growth and less volatility.” For those investors, he said, indexes “are an optimal investment vehicle.”

Becky Sarwate, head of communications at cryptocurrency exchange Cex.io, told Cointelegraph that crypto index funds may be better suited for traders looking to make long-term commitments, as “building a diversified portfolio is often preferred to placing all one’s value in the same basket.”

Sarwate added, however, that crypto index funds may alleviate the “stress of choosing which projects to support” but may exclude opportunities for those seeking to capitalize on emerging assets.

Lukas Enzersdorfer-Konrad, the deputy CEO of cryptocurrency exchange Bitpanda, told Cointelegraph that there is no such thing as an “average investor,” nor is there an “average strategy.”

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He said there’s no one-size-fits-all approach, and instead, the choice of crypto index fund depends on each individual’s investment style.

Adding to this, Pavel Matveev, CEO and co-founder of Wirex, told Cointelegraph that crypto index funds offer a structured investment approach, with components being selected and weighted based on a clear methodology.

These funds’ balancing rules can impact their performance negatively or positively. Matveev said:

“If a cryptocurrency exits the top 10 ranking, it is replaced by the crypto that enters the top 10. This simple mechanism enhances the index’s resilience compared to a simple buy-and-hold strategy. This mechanism removes underperforming cryptocurrencies.”

However, there’s more to crypto index funds than just broad, simplified exposure to the cryptocurrency market.

Custody risk and return

In traditional finance, there are a number of custodians that hold assets on behalf of clients and index funds. These index funds are often seen as the go-to passive investment strategy, which suggests a similar system could benefit the cryptocurrency space.

Bitcoin exchange-traded funds (ETFs) and other investment products, for example, already rely on trusted custodians.

Crypto index funds, therefore, involve a significant amount of trust in the index provider. Cex.io’s Sarwate said that a “good way to conceptualize index funds is essentially somebody else’s vision of a proper portfolio,” adding:

“This means that all decision-making around which assets to include, and their individual allocations within the index, are determined by a third party. From the jump, it’s a question of trust.”

Per Sarwate, it’s crucial for crypto index fund participants to understand that “index funds are shares of ownership, and not actual coins or tokens themselves.”

Wirex’s Matveev said that various cryptocurrency indexes are centralized, with the funds being held in trusts. This could imply legal risks as the jurisdiction in which these custodians are can affect the funds and bring in legal uncertainties.

If investors hold their own keys, he added, they have a “better chance of recovering tokens post-protocol hacks” while enhancing their returns through staking offerings. Securely holding the private keys to a cryptocurrency wallet can be challenging. If those keys are leaked, anyone who gets access to them also has access to the funds within the wallet.

Does this mean cryptocurrency enthusiasts should be pushing for the adoption and growth of cryptocurrency index funds? The answer is complex, as custodianship doesn’t necessarily align with the cryptocurrency ethos of holding your own coins, but as Enzersdorfer-Konrad says, they offer users exposure to assets they otherwise may have never had exposure to.

Engaging with crypto

Enzersdorfer-Konrad added that with crypto index funds, there is “no hassle, no need to constantly research new crypto projects, just a simple way for everyone to diversify their portfolios.”

Sarwate said that as a passive investment, these may be a good solution, saying:

“Larger sources of value, like index funds, can be similar to ocean liners in their agility and delivery of outcomes: slow and steady. For those who prefer to have their crypto journey on autopilot, index funds can be an attractive pathway.”

She added, however, that those who prefer a more hands-on experience may enjoy engaging with the space more, doing their research and discovering new projects as they go along. With crypto, some simply sit on their tokens, expecting them to be useful in extreme situations, while others regularly engage in decentralized autonomous organizations (DAOs) to help further the space.

At the end of the day, according to Sarwate, choosing between a cryptocurrency index fund and an individual token comes down to what’s motivating an investor to gain exposure to the cryptocurrency space in the first place: looking for significant gains or avoiding losses. Sarwate added:

“Purchasing a few select assets exposes participants to the potential for acute gains if the assets perform well and abrupt losses if their value trends downward. For those trading individual coins, these risks are felt and overcome directly. While one may be less likely to end up seeing massive gains overnight with an index fund, the same goes for excessive losses.”

While crypto index funds offer diversification, stability and simplicity, they do not capture the full potential of the market and fall short of providing investors with the cryptocurrency experience.

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Beyond gaining exposure to digital currencies, investors should also consider the learning journey of using decentralized finance protocols, engaging with Web3 financial innovations and more. Even if an investor chooses the passive route through an index fund, they may want to consider allocating a small amount to an on-chain learning journey.

Ultimately, choosing a cryptocurrency index fund is about investor goals and risk tolerance — personal finance remains personal. Crypto index funds may also be used to complement the educational opportunities available in the space with slow, steady potential gains.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.