Blockchain
Exploring the benefits and growing popularity in 2024
The cryptocurrency market has grown significantly over the past 15 years, peaking at a $3 trillion valuation in 2021, with over 26,000 cryptocurrencies listed. This growth has attracted retail and high-net-worth investors, family offices, college endowments, and even pension plans.
The entry of reliable TradFi companies such as Goldman Sachs Consulting Firm, FidelityAND Black rock in the crypto space highlights the growing institutional acceptance and maturity of digital assets and has facilitated broader market participation.
Despite the strong demand for digital assets, there is still debate over how to best gain optimal exposure and manage risk. Many investors hold cryptocurrencies like Bitcoin or Ether, or have invested in spot BTC ETFs, but there is a third option: crypto index funds. These funds offer diversified exposure to digital assets.
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Sophisticated investors recognize the need to diversify portfolios, anticipating that as inflows into Bitcoin ETFs slow, so will volatility, reducing the potential for attractive risk-adjusted returns. Institutional investors are increasingly seeking exposure to a broader set of cryptocurrencies to complement traditional equity holdings, which is where index funds come in. Crypto index funds are investment vehicles that track the performance of a basket of various cryptocurrencies, giving investors diversified exposure to the digital asset market without the need to directly purchase individual cryptocurrencies. Currently, more than a dozen crypto index funds are being marketed to investors, ranging from $1 million to several hundred million dollars in assets under management.
Historically, good or bad news (idiosyncratic risk) about a specific crypto asset tends to be quickly priced into the market. That is, current market prices generally reflect what is currently known about these assets, creating a degree of pricing efficiency. Ideally, investors should rebalance their portfolios frequently to capitalize on market movements and manage volatility. However, most active managers do not offer sufficient liquidity for this frequent rebalancing, resulting in most investors maintaining very small position sizes. Given these challenges and the nascent nature of the market, adopting a diversified index strategy makes sense for those seeking broad exposure to this opportunity set.
Cryptocurrency index funds offer institutional investors a simplified approach to gaining exposure to digital assets. While typically distinct from venture capital investments, these index funds share a similar strategy of managing risk through diversification. By investing in the top crypto assets by market cap, they offer a way to mitigate some of the initial risks associated with individual cryptocurrencies, much like venture capital spreads investments across numerous startups to balance the high failure rate with the potential for substantial success.
A key consideration for index funds is the number of cryptocurrencies they represent. While opting for the top ten cryptocurrencies by market cap has been the norm, expanding the index to 25 represents 92% of the total cryptocurrency market cap. Some may seek to diversify even further with the top 50, but this would only marginally increase the 3% market cap coverage.
There are drawbacks to expanding the cryptocurrency universe included in an index fund. Investors should be aware if an index fund includes meme coins, which have minimal development goals and are typically viewed more as artistic expression or cultural commentary. The increased volatility associated with meme coins also makes them unsuitable for an institutional portfolio.
For long-term investors who can forgo intra-month liquidity, staking assets held by the index can help protect against dilution as the protocols’ coin supply grows over time. Staking assets allow investors to participate in the transaction verification process of proof-of-stake blockchains, with the potential to earn rewards similar to stock dividend yields.
As institutional adoption of digital assets continues, it is critical for investors to evaluate how best to gain exposure to the space and work with trusted partners to navigate the complexities of the cryptocurrency ecosystem. While an index fund is not the only way to invest in digital assets, there is a strong argument for considering it as a cornerstone of an institutional portfolio to gain more controlled and diversified exposure.
Note: The views expressed in this column are those of the author and do not necessarily reflect those of CoinDesk, Inc. or its owners and affiliates.