The cryptocurrency space has grown considerably over the past decade. As a result, it can be hard to keep up let alone manage investments. But what if I told you there is a solution? This is where crypto index funds come into play.
In this article, I will be covering the pros and cons of crypto index funds so that you can navigate the space with ease. So without further ado, let’s jump right in.
Crypto index funds are financial products comprised of a specific group of cryptocurrencies. Similar to traditional index funds they facilitate diversification, passive investing, and risk management.
What are crypto index funds?
Simply put, crypto index funds are funds comprised of a basket of cryptocurrencies. This group of cryptocurrencies allows investors to gain exposure to the market or subsectors as a whole.
Ultimately, they track specific financial indexes. These could be the top 10 cryptocurrencies by market capitalization or by a specific sector. For instance, an NFT fund or a DeFi fund.
Crypto funds are automatically rebalanced and changed based on market conditions. Therefore, this creates a more passive way of investing as they are rebalanced on your behalf. Moreover, as the fund is diversified over several cryptocurrencies the risk is scaled down.
Types of crypto index funds
Centralized index funds – this fund is akin to index funds in the traditional finance world such as vanguard funds. Essentially, an intermediary manages the fund. This centralized entity has control and custody of the underlying assets. Trust is placed on the custodian.
Decentralized index funds – in this fund, the basket of cryptocurrencies is transacted on the blockchain. This provides a permissionless and transparent way of accessing index funds. They utilize tokens that can be traded on the open market. Moreover, users have self-custody of their assets, meaning they have complete control.
Pros
Diversification – as mentioned previously diversification helps scale down risk. By creating a group of cryptocurrencies investors are not subject to the volatility of a single crypto. Moreover, in an industry rife with hacks and other risks, diversification is especially important. Ultimately, if one asset in the basket fails it is not catastrophic.
Affordable – the fees associated with crypto funds are low. This is mainly because the corresponding trades are also low therefore there is a reduction in associated fees. Ultimately, as the fund tracks a benchmark there is no need for a team of analysts to pick the correct cryptocurrencies and micromanage.
Lower taxes – when funds sell cryptocurrencies they are subject to capital gains on the profits. This can be anywhere from 20% to 40% in the United States. As crypto funds are traded less frequently and have a lower turnover they also accrue taxes less frequently.
Passive income – as management is outsourced, index funds are considerably more passive. They don’t require rebalancing by investors. Not to mention, they require little knowledge of cryptocurrencies as this responsibility is delegated. Essentially, they are an invest and forget type of asset.
Decentralization – decentralized crypto funds are secured by a network of computers. This provides a system without a single point of failure. Moreover, it is not subject to custodian risks as users control their funds.
Transparent – Index funds are usually transparent in their objectives. The underlying holdings are open to the public. Moreover, thanks to blockchain technology, decentralized crypto funds allow users to verify all the information on the blockchain. This includes the exact holdings and transaction history.
Cons
Lower returns – as index funds are benchmarked against the market they provide limited upside potential. The market determines the returns rather than specific strategies. Investors have no control over their holdings meaning they cannot gain an edge.
Little control – when you buy an index fund you delegate management to someone else or in the case of decentralized index funds the smart contract. This prevents you from buying cryptos you like or selling ones you dislike. For instance, investors cannot support cryptocurrencies with strong ethics or boycott ones with bad ethics.
Static exposure – ultimately crypto index funds track the market. In most cases, if one of the cryptocurrencies becomes overvalued its share of the total index increases. In certain instances it is wise to take profits to reduce exposure and risk, however index funds prevent this reactive capability.
No hedging capabilities – as crypto index funds track the market they are subject to its downside potential. This is especially relevant in crypto with its huge price swings. In more active funds managers hedge exposure and increase cash positions in downturns. However, index funds do not have this capability and thus can suffer the consequences.
Final thoughts
Overall, crypto index funds are a great way of getting exposure to the cryptocurrency market as a whole. They facilitate diversification and hedge risk. However, they offer little downside protection and have static exposure.
Moreover, if you want to outperform the market then it its better to take a more active approach. I hope you found this article useful and thanks for reading.
Want to learn about blockchain bridges? Click here to read my previous article.
