The range of investment choices in the crypto market often daunts the fresh investor. Should they invest in just Bitcoin and Ethereum, or should they participate via a mutual fund, and what type of fund is best suited to this new asset class?
Lessons from history
History has proven that it is near impossible to forecast human ingenuity, and blockchain will certainly test the limits of inventiveness.
Few accurately predicted the importance of the internet, let alone subsequent smart phones, and social media. In fact, something as pervasive and influential as social media defied conception; we’re only now seeing its effects on politics, socialization, and society at large. Similarly, blockchain and crypto’s mature stages will likely spur equally unpredictable yet paramount innovations.
In terms of a blueprinting a crypto fund, backtesting points to the benefits of broad exposure. A diversified pool of crypto assets ensures that there will be sufficient “winners” to offset the losses of poor performers.
Should A Crypto Fund Use Active or Passive Management?
Generally, index funds consistently outperform their active counterparts. In fact, according to a study conducted by Standard and Poors, for the five-year period ending December 29, 2017:
Less than 16% of U.S. stock funds managed to outperform their respective indexes,
Less than 30% of international stock funds managed to outperform their respective indexes, and
Less than 48% of global income funds managed to outperform their respective indexes.
There are situations where active funds outperform passive funds, but this typically occurs in instances of high-predictability, such as bond markets. Cryptos are more suited to passive-style investment, as the predictability of future performance is low.
Many factors give indexes an edge over actively-managed funds. For one, passive-management leverages lower ongoing costs and thus cheaper fees. The compounding effect of reduced fees over years of investment can have a tremendous impact on long-term performance. Additionally, passively-managed funds effectively eliminate emotion in allocations.
The world is gravitating towards passively-managed index portfolios, evidenced by the explosive growth in the global market of exchange traded funds (ETFs), which are predominantly passively-managed index portfolios. Equity ETF’s have skyrocketed from $500 billion to $4.6 trillion in the past 10 years.
How Should A Crypto Fund Weight Assets?
Most passive-style approaches weight individual assets according to their market capitalization, so that the largest assets have the highest weight in the portfolio. However, most stock indexes would have performed better in an equally-weighted portfolio, compared to a market cap portfolio.
At this stage of development, the crypto market seems eerily similar to tech stocks during the Dotcom boom, where equal weighting would have captured the highest returns.
The crypto market is currently dominated by Bitcoin and Ethereum, which together make up more than 50% of the total crypto market capitalization. A market cap basket would therefore have significant concentration risk in these two cryptos. Equal-weighted portfolios are advantageous in less mature asset classes because smaller assets are effectively over-weighted relative to market cap-style indices. The smaller market capitalization cryptos (“altcoins”) have larger potential for growth and an equally-weighted portfolio would favor altcoins.
Altcoins have historically had a strong performance record and an equally-weighted style index offers a better way to benefit from this growth.
Conclusion: A Crypto Index Fund
With their unpredictability, young asset classes complicate projections of future performance. Given the similarities between blockchain and the innovations that came from the internet, backtesting the Dotcom bubble provides insight when designing a fund for the crypto market.
Historical data reveals that a broad exposure index would have been the best strategy in the Dotcom era, and the same is true for the crypto market. An index’s diversification provides a cushion against volatility and the fickle sways of innovation. A diversified basket of crypto assets would have outperformed the general market, and individual allocations in Bitcoin or Ethereum.
In terms of strategy, a passive management style would optimize returns with the compounding effect of low fees and emotionless trades. Equal weighting would minimize concentration risk and favor assets with the highest potential for massive growth.