Things to look out for when passively investing in digital assets
With the digital asset space reinventing itself at such a fast pace, index-linked solutions are gaining popularity for individual and institutional investors alike.
With the growth in decentralised, blockchain based-assets, investors are now presented with a variety of new investment opportunities. However, navigating the digital asset space can be difficult at times, due to the heterogeneous characteristics across digital assets, and because there are no widely agreed fundamental valuation models or widely accepted benchmarks. Passive investment products can offer an easy and transparent way to access this emerging asset class.
A non-exhaustive overview of digital assets is provided in figure 1 below:
However, a copy-paste approach of index methodologies from traditional to digital assets can result in suboptimal results. Therefore, investors should keep in mind the following unique characteristics of the digital asset market.
First, the digital asset market is not one market but rather made up of several markets of different kinds of digital assets, as reflected in figure 1. Second, token structures vary greatly in their supply models and governance. The lack of a “best practice” metric for supply leads to further ambiguity. Finally, market capitalisation is flawed due to the blockchain industry still being in its nascent stage. It should not be considered as the market’s view, primarily because supply models are so diverse, and to a lesser degree because erratic and sometimes manipulated price movements can create distortions.
An index methodology should be just like a cooking recipe. It should define what ingredients to use (construction), the amount of each ingredient (weighting), the preparation (calculation) and seasoning (maintenance). The characteristics outlined above make it difficult to establish an index with a defined universe, and meaningful weighting executed by a neat rules-based approach. Therefore, many of today’s passive products are in fact active products in disguise. The methodology of passive indices often includes active rules which intentionally lead to deviations from capitalisation weights. In the most extreme cases, this defeats the very purpose of an index which is to objectively measure the performance of the market and eliminate subjective selection of tokens.
For example, most digital asset indices commonly define the relevant universe as “everything except stablecoins”, while not clearly defining other implicit exceptions (potentially because the category of tokens might have been too immature for consideration when the index was created — e.g., non-fungible tokens, or NFTs). Thus, confusing the clear economic basis of the index.
Another issue is that index weightings often may not reflect the true relative prominence of the projects. While some funds avoid this issue by using equal weighting, others try to engineer weights in such a way to minimise the dominance of Bitcoin. Aside from the liquidity risk of overrepresenting small tokens, we leave it to the reader to decide whether these indices can be regarded as a fair reflection of the market.
All our findings are reflected in the methodology behind the Sygnum Platform Winners Index. This is the first index to only track native blockchain protocol tokens, excluding copies and forks, while using a fully rules-based approach. Neither the weighting nor construction include any element of subjective selection. Selection, weighting, and maintenance of tokens in the index is based on an equally weighted, holistic set of factors, which include capital invested, interest from the financial market, ecosystem growth, and developer resources committed. Finally, the underlying assets are always fully collateralised and securely stored with an institutional-grade custody solution.
You can download the factsheet for the Sygnum Platform Winners Index ETP here.
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