Which cryptocurrency should you buy? The problem every investor faces is choice, and when you have over 2,000 assets, making the right one is a nightmare. Will you invest in Bitcoin and regret its small gains or will you invest in Ethereum and worry over how disastrous the ETH 2.0 PoS launch will be? Or will you hunt down assets with smaller market caps like Solana or Terra and track their dApp ecosystem growth?
It’s hard to tell which cryptocurrency will rise to the top and which will crash and burn. But what we all know is that crypto assets have a bullish future and are set to become an even larger market. Instead of betting on individual cryptocurrencies, why not bet on the entire market with a crypto index fund?
What is a Crypto Index Fund?
A crypto index fund is an investment vehicle which allows you to own a diversified portfolio. With index funds, you can invest in a group of cryptocurrencies and scale down risk by allocating capital into assets from different groups. Think of it as playing all sides so that you always come out on top.
It’s the equivalent of investing in the S&P 500 rather than buying stocks from tech giants such as Facebook, Apple, or Microsoft. With the S&P 500, you’re speculating the performance of the entire U.S. stock market. But if you were to buy Facebook and nothing else, your stocks rely on the company’s quarterly performance. And knowing it’s a tech stock, something as simple as a rumor or a metaverse announcement can slash your portfolio half.
Let’s talk in crypto terms. You might love decentralized finance (DeFi), but is it wise to go all-in on a market with an undefined regulative status? The upside volatility makes up for it, but who’s to say that an executive decision to ban decentralized services won’t be signed at the oval office tomorrow? That possibility might turn your crypto holdings into dust, literally.
The goal as an investor is to hedge against risk and maximize capital protection, no matter how juicy the returns seem. When I bought into rebasing protocols earlier this year, I loved earning 8% APY every week. But knowing that they're exclusively backed by speculative value, I only purchased a small amount. I wasn’t phased when rebasing protocols collapsed because 99% of my capital was elsewhere. Other people, too lovestruck, invested their life-savings and weren’t so lucky – a sad story with a good lesson.
Investing in Crypto Index Funds
Earlier, I mentioned DeFi as a risky example, so let’s see how I would mitigate risk within an already risky sector with the help of a crypto index fund. If I had to exclusively invest into DeFi assets, my aim would be to diversify my holdings as much as possible. How would I do this? By targeting different use-cases and market caps.
DeFi has five main sectors:
Decentralized Exchanges (DEXs)
The simplest way to create an index fund would be to invest in one project from each sector. But I can go one step further by buying into more than one project within the same category with different market caps.
An existing solution is the DeFi Pulse Index, a capitalization-weighted index that tracks the performance of 14 assets. The diverse offering means that if one project fails, it won’t affect my portfolio.
By buying the DPI token I expose myself to 14 assets from all the sectors mentioned earlier. Plus, since the weighting is based on the value of each token's circulating supply, I don't have to think much about setting allocations. Moreover, the index provides me with a great chart that allows me to see the progress of the DeFi market and its trend.
Creating a Custom Crypto Index Fund
There are many crypto index funds out there. But why buy someone else’s index when you can create your own? If you keep up with the market and understand it to its core, you can squeeze maximum profits from an index fund.
Like with the DeFi example, you should first write down which use-cases you want to target. Next, you’ll want to pick the best cryptocurrency from each category and decide how much capital you want to allocate to each one.
Cryptocurrencies vary by market capitalization, and this metric often impacts the asset’s volatility. An index fund must be stable enough to catch profits but to avoid heavy risk. What you’ll want to do is allocate a larger portion of your capital to large market cap assets and a smaller one to smaller projects.
For example, you can dedicate 75% of your portfolio to five large market cap cryptocurrencies so that each one has a 15% allocation. You can invest the remaining 25% into another five projects with smaller market caps. By doing so, it’s possible to capture volatile moves and take profits with the riskier allocations while holding the less volatile 75% portion for stable and long-term growth.
Once you make a plan and select the cryptocurrencies you think will rise, you need to purchase them on an exchange and that’s it. But beware, indexes are not always a passive investment strategy. I recommend rebalancing your allocations and converting them into other assets from time to time for the best results.
The Best Crypto Index Funds
If you don’t have the fundamental analysis skills needed to create a custom index, you can invest in one of the best crypto index funds on the market. Even though there are more ETFs for single-item assets than indexes, you still have access to attractive investing options.
The most popular index in the market is the Bitwise 10 Crypto Index Fund. Bitwise’s index fund tracks the market’s 10 leading cryptocurrencies, weighted by market cap and value. Bitwise rebalances the index on a monthly basis, which means that you don’t have to worry about buying into an inefficient index.
The index is heavily weighted towards Bitcoin since it is the most stable asset. But it also holds numerous altcoins which have outperformed most of the market since the bull market began. Bitwise notes that it monitors liquidity, security, regulatory status, market representation, and other factors for its fundamental analysis methodology.
A more volatile option that might provide higher returns would be the NFT Index. The index consists of 10 cryptocurrencies associated with the non-fungible token sector which include:
Yield Guild Games
The weightings focus more on Matic, Sandbox, and Decentraland – which have a great reputation in the NFT market. However, the index contains riskier and more volatile options such as LooksRare and ApeCoin as well.
For yield farming and decentralized lending enthusiasts, I recommend the DeFi Pulse Index once again. The DPI index tracks the performance of 14 major cryptocurrencies from the DeFi market. Moreover, DeFi Pulse also rebalances the index once a month.
If you want to learn more about investing in crypto index funds, I recommend reading the following articles:
Marko is a crypto enthusiast who has been involved in the blockchain industry since 2018. When not charting, tweeting on CT, or researching Solana NFTs, he likes to read about psychology, InfoSec, and geopolitics.