The cryptocurrency market is witnessing a shift towards passive investing, a trend so potent in the traditional finance scenario, but delivering a unique set of challenges for the nascent world of digital assets. Benchmark-tracking ETFs and index funds have become an influential force in finance, bringing on board a need to form indexes proficient enough to grapple with the shortcomings of the digital assets class.
Indexes dominated by market capitalization have set precedents in passive stock investing. These have their roots deeply embedded in the “Modern Portfolio Theory”, a remarkable brainchild of legendary investors Harry Markowitz and William Sharpe. Created nearly five decades ago by John Bogle, capitalization-weighted indexes have been revered as the unsurpassed standard, owing to their balanced blend of academic rigor and practicability.
However, with passing years, the industry felt a need to capitalize on market inefficiencies. This gave birth to alternative weighting methodologies like equal weighting, risk parity, and maximum diversification, and important new factors, including momentum, minimum volatility, quality, and dividends. This emerging trend earned itself the term “smart beta”.
The “smart beta” ideology, first demonstrated successfully with the S&P 500 equal-weighted index in 2003, commands a sway over a trifling proportion – around $1.7 trillion in US equity ETFs – when compared to the colossal capital commanded by ETFs weighted by market cap.
Paralleling this scenario, the crypto-indexing world also adopted capitalization-weighting from traditional finance. This transposition, however, might not yield optimal results. It can lead to an immense concentration of investments in a couple primary constituents like Bitcoin and Ether, thus running counter to the integral aim of index investing – diversification.
Moreover, defining a cosmic market universe may result in indexes that lacks liquidity, particularly in crisis, or those which are not investable. In traditional exchanges, index constituents need to have a minimum liquidity level, progressively narrowing down the investable universe.
In the crypto domain, it is also imperative to set up qualitative inclusion norms. Contrary to the stock world where companies undergo extensive scrutiny by regulators and auditors prior to getting listed, crypto projects usually go through limited due diligence, occasionally leading to unexpected predicaments such as in the case of Terra/Luna and FTX. Through rigorous analysis, such situations could be circumvented.
To overcome these challenges, the investment universe should be confined to the top coins by market liquidity, while evading the common pitfalls of the capitalization-weighted index. One suggested approach could be a blend of risk parity and market capitalization, which balances risk contributions and accentuates smaller coins, offering heightened diversification. Even though it could fall short of the overall market in certain phases, it will likely outpace the market during a complete time cycle.
Source: Coindesk
