You do not need Unchained to tell you that crypto is a highly volatile and speculative market—your parents, friends, and camp counselor have likely chewed your ear off to that effect, offering such superficially useful tidbits as “the SEC has declared pretty much all cryptocurrencies securities, don’t-cha-know?’, and “Are you serious?? The price of Bitcoin has halved in the past year.” And yet, there has been an attempt to remedy the volatility of the crypto markets, with a decentralized tool based on an instrument from the world of traditional finance: the index fund.
What Is an Index Fund and Why Would You Buy One?
In traditional finance, aka TradFi, an index fund tracks the average price of collections of stocks or bonds, often hundreds or thousands at a time. The founder of Vanguard, John Bogle, is credited with their invention: his company’s index funds bought all the stocks that best represented an industry, location, or financial instrument (similar to how, for example, the Nasdaq represents the tech industry), and then sold shares in said funds to investors.
Retail and institutional investors buy the shares in these funds on the expectation that buying shares in an index fund is proximate to buying a fund that tracks the success of a given sector or market. In essence, they pose and put to bed the question: “Why bet on a single stock when you can bet on the entire market?”
Such diversification makes a lot of sense when the average retail investor does not have the time to inspect individual stocks, or model them with the accuracy or granularity that rivals the employees of hedge funds or investment banks. In the hope that markets will tend to rise over time, investors in index funds also often reinvest any profits in order to benefit from compound interest. Traditional index funds also, theoretically, reduce volatility in a portfolio.
What Are Crypto Index Funds?
Crypto index funds are an attempt to fulfill the same broad investment criteria. Instead of trying to beat the market through individual coin picking, crypto index funds allow investors to gain exposure to entire markets at once. It is like betting on an entire day at the races at once rather than hoping an individual horse will steam ahead of the pack.
This kind of fund is especially useful in a market where individual coins might collapse suddenly even amid broad price swings. Cryptocurrencies do, however, tend to be highly correlated, so crypto index funds are more likely to collapse all at once. One formerly popular metaverse index fund, MVI, fell about 98% a year into its launch after the hot air dissipated from the sector.
Nevertheless, crypto index funds have proved fairly popular. While the market for cryptocurrencies is diverse, crypto index funds have been able to distill it all into a few obvious categories. Popular funds may track the coins with the largest markets, often referred to aspirationally as “Blue Chips,” like ether and bitcoin. Others track major NFT (non-fungible token) collections, like Bored Ape Yacht Club or CryptoPunks, or smaller niches like rollups, zero-knowledge protocols, exchange tokens, or metaverse coins.
How Do Crypto Index Funds Work?
Like a conventional index fund, crypto index funds track the price of assets in a given class and sell shares in that tracker, albeit in this case in the form of a cryptocurrency token. The hope is that if, say, the NFT market rises as a whole, so too will the price of the NFT index fund token.
Some of these index funds can work under the hood in novel ways. In Vanguard’s index funds, Vanguard literally buys the stock and sells shares in the investment fund to investors. If Vanguard collapsed, the index fund investors would still own the shares. While some crypto index funds do work that way (holding tokens in a vault, then issuing separate tokens that imitate the “underlying” assets), others just track the price without actually holding any tokens, or trade on traditional markets right next to traditional index funds.
Yet more attempt to track real-life assets, for instance Abra or Binance’s short-lived stock tokens. Securities regulators, however, have cracked down on plenty of issuers of tokenized stock.
What’s the Market for Crypto Index Funds Like?
One of the most popular crypto index funds is called Index Coop, and it is an example of the kind of index fund that sells shares in large pools of crypto it holds. Index Coop holds about $65 million worth of funds to offer exposure to such markets as staked ETH, Metaverse, DeFi, and tokens. You buy the tokens just like you would any other ERC-20 token, and then just hold them in the hopes that the market will rise.
Interestingly, Index Coop is run by not a centralized, crack team of analysts but a “decentralized autonomous organization,” or DAO, consisting of “crypto natives” who themselves benefit from the fund’s success. It uses smart contracts, a kind of self-executing algorithm used on Ethereum, to hold the fund together and disburse profits; it also invests in tokens that may be securities, which a standard, regulated fund couldn’t. (Not that Index Coop legally can, either—it’s just tricky to prevent it from doing so.)
Another prominent crypto index fund is Set Protocol, which allows clients to create their own portfolios of cryptocurrencies, back them with the assets contained therein, and then issue an ERC-20 token that represents the fund. It’s a little like managing your own index fund.
Meanwhile, NFT-specific funds, like the Bitwise Blue-Chip NFT Index Fund, offer financial exposure to popular NFT funds. Unlike the other offers, this is offered through traditional financial rails and is only open to accredited US investors.
But remember: while index funds may diversify your investments, they will not insulate you from a market crash that wipes out an entire sector, or even the cryptocurrency market itself.
