Oil and Water: Crypto Index Investing

Passive investing. Index funds. To many investors, the very mention of these terms brings up the feeling of safety and familiarity. Indeed, investing in the index that represents the market as a whole seems to make sense for many investors, as the huge flows to index funds over the last decade indicate.

Investing in crypto, on the other hand, most likely does not bring up those same emotions. Safety? Familiarity? Try excitement and volatility instead.

Even so, it’s hard to deny the allure crypto investing has had for many consumer investors, especially for those on the younger and tech-savvy end of the spectrum. Many believe this is the birth of a meaningful new asset class, and that the volatility is simply an artifact of an early market.

These two investments trends cannot be in more contrast with each other — one represents a bet that you can’t beat the market, while the other is a bet that you can be so meaningfully ahead of the global asset market that your bet will produce 5x, 10x, or even 100x returns.

Yet, like medieval alchemists laboring over turning lead into gold, there are already those toiling over combining these two trends. Oil and water shall mix, and crypto index investing shall become a reality when the entire asset class represents just over 200 highly unregulated billion dollars.

Truth be told, it doesn’t sound like a bad idea. With almost 2,000 crypto-assets listed on CoinMarketCap (for comparison, there are less than 4,000 publicly-traded domestic companies in the US), many of them being marketed with arcane tales of technical nature, who’s to say which ones will go to zero and which ones will “moon”? Instead of making a wrong choice and being left with the bag, we can #hodl a bag of everything and our asymmetric wins will outweigh our losses.

Indeed, the reasoning to investing in a crypto index investing is not necessarily wrong. However, for investors considering this path, it’s important to understand that crypto index investing does not represent a bet on beta or market performance with respect to crypto assets the way buying a SPDR represents such a bet with respect to US large cap equities.

The reason goes back to why index investing makes sense at all, in the context of public equities. Investing in the index usually means buying the S&P500 — an index of the biggest, most liquid stocks trading in the highly-regulated US stock market. Being ‘merely’ the biggest is not enough, though — there are actually rules governing the stock selection, including “financial viability” (companies that consistently lose money cannot be included).

It is generally agreed that the S&P500 index is a good representation for the performance of the market as a whole. Investing in that index thus means that you choose to get the market’s performance — you’re not trying to beat the market.

In practice this means that if you go and ask 10 finance professionals who trade in large-cap public US equities, they may be active or passive investors, quants or stock pickers, value investors or growth investors. But they are all likely to agree that the S&P500 is a good representation for beta — aka, for the market’s performance in this sector.

If you go and ask 10 professional crypto investors what’s a good proxy for the market performance, you will not find such an agreement. You are likely to hear different lists of assets, different percentages, different selection criteria, different methodologies and most likely, some suggestions that Bitcoin is the only asset that should be included in such an index as it best represents the beta of the crypto asset class.

Really, if market participants can’t yet agree on what constitutes the market index, then there is no viable index to invest in. Any self-proclaimed crypto index fund simply represents a discretionary choice of assets. It might be good or it might be bad, but it doesn’t represent an agreed-upon market beta. Instead, it represents the good judgment of the fund manager — or lack thereof.

Some things just don’t mix.

Hopefully I’ve managed to convince you that any so-called crypto index fund right now represents a highly discretionary choice of assets, and not an agreed-upon notion of market beta as one might expect from so-called index investing. But what’s out there in practice? Are the self-proclaimed crypto index funds “bad”?

First, it’s worth noting that if you take a quick look across the landscape, you’ll see that most crypto indexes are maintained by the body that actually manages the money. There is no separation between the firm maintaining the index (e.g. Standard and Poor’s, in the equities parallel) and fund management firms (e.g. Vanguard, BlackRock, etc). This puts the firm at a position where it is likely to try and prioritize the index’ performance over the accuracy of its reflection of the market (as a fund manager should!).

As for the indexes themselves, there’s a nice variety out there. You’ll see indexes that include 14.6% Ripple, 9.4% and only 9% bitcoin. Others that include a specific subset of assets that happen to be tradable in a specific exchange. Others choose to include one “next-gen smart contract platform” but not another. Still others choose only to include assets that employ Proof-of-Work. And there are those that employ creative math to avoid having Bitcoin dominate the index.

Don’t get me wrong — all of these choices are totally valid, and maybe they’ll produce alpha. That’s the thing though — they’re definitely not beta.