Crypto index funds explained

If you're new to crypto trading and find the act of picking individual coins and tokens for your long-term holdings daunting, you're not alone. That's where crypto index funds come in. These funds essentially simplify the entire crypto trading process by allowing you to gain exposure to the crypto markets by tracking a specific crypto index. This, in turn, allows traders to enjoy the performance of a specific crypto market segment without the hassle of picking and managing positions individually.

Curious to know how to get started with crypto index funds? From breaking down what crypto index funds are to highlighting the strengths and weaknesses of trading crypto index funds, here's all you need to know.

What is a crypto index fund?

A crypto index fund is a pooled fund that passively tracks a chosen crypto index with the aim of mirroring its performance. By choosing to include crypto index funds in your long-term holdings, you gain exposure to multiple crypto projects without picking them individually. This offers diversification, reduces risk, and offers a simpler entry point compared to actively trading single coins and tokens.

By trading a crypto index fund, crypto traders effectively gain exposure to the entire index without having custody or ownership of the cryptocurrencies involved. While this might sound bad for crypto natives who subscribe to the "not your keys, not your crypto" mantra, owning crypto is typically the biggest problem for institutional and major individual traders, as it comes with its own set of regulatory and security problems.

For those with TradFi experience, a crypto index fund works just like any other traditional index fund would. It simply tracks the performance of a particular cryptocurrency index, which consists of a basket of cryptocurrencies. Crypto index funds represent a much more familiar approach to getting exposure to the crypto markets. While institutions and wealthy TradFi traders aren’t scared of volatile assets, they may be reluctant to engage with crypto due to the lack of regulation and difficulties involved with on-ramping their funds. This is exactly why crypto index funds were introduced.

How does a crypto index fund work?

Want to learn more about the inner workings of crypto index funds? Here's a brief breakdown of the mechanics involved:

• Choosing the index: Fund managers select a crypto index based on specific criteria, like market cap or a focus on specific sectors like DeFi.

• Tracking performance: The fund holds a basket of cryptocurrencies that mirror the chosen index. The fund's value fluctuates based on the combined performance of these underlying cryptocurrencies.

• Rebalancing: To maintain alignment with the index, crypto index funds periodically rebalance their holdings. As they're run by professional fund managers, this might involve buying more of a coin or token that's dropped in price, or selling some of a coin that has significantly increased in value. This ultimately creates diversified positions rather than being significantly concentrated on a specific crypto project.

In short, crypto index funds offer traders a simple and passive way to diversify their crypto portfolio. By gaining exposure to a group of crypto assets, crypto index funds can help mitigate risk since the risk of individual project picking is spread across multiple projects. If one coin or token within the basket of cryptocurrencies were to perform negatively, a well-diversified crypto index fund will help dampen those losses.

Advantages of crypto index funds

Trading crypto index funds comes with many benefits you should be aware of. Apart from providing diversification, crypto index funds are also managed by financial experts. Therefore, you don’t have to worry about which crypto assets are included, which saves a lot of time otherwise spent researching various projects.

Another benefit is that you no longer have to worry about liquidity, which is a common concern in crypto trading. Traders sometimes want to buy an asset that lacks liquidity. This makes it risky to hold, especially considering how volatile crypto is. However, buying assets with sufficient liquidity is the first step in effective risk management.

Lastly, we should also note that a big advantage of crypto index funds is tax efficiency. Not only are crypto funds tax-efficient, they also offer certain tax advantages. As there's only one fund, traders aren’t penalized for cashing out on multiple cryptocurrencies.

Disadvantages of crypto index funds

While crypto index funds have their advantages, there are a few disadvantages to keep in mind. For example, you don’t really have any control over what assets are contained in the index. You simply have to trust that index managers know what they're doing.

Another point to remember is that index funds typically come with higher fees that eat into your overall gains. If you bought multiple coins and tokens directly, you'd likely pay less in fees than what you pay through an index.

Finally, crypto index funds may offer fewer opportunities to improve your knowledge about the crypto space. As you simply trade the fund, there's no major need to research the specific coins or tokens within the crypto index fund, as you'll typically trust the asset manager to deal with that side of the trade.

What are some examples of cryptocurrency indexes?

Traditional stocks have hundreds of indexes available. However, the same can't be said for cryptocurrencies as indexes are still a relatively new product within the space. However, there are a few options out there.

The Nasdaq Crypto Index is a leading fund for its diversification across 11 major coins and tokens. As one of the top crypto index funds that has a heavy weightage on blue-chip coins like Bitcoin and Ether, the Nasdaq Crypto Index fund provides diversified crypto exposure for fund buyers who are more risk-averse and want exposure to high market cap crypto projects.

Another popular choice among crypto index funds is the Bitwise DeFi Crypto Index Fund, which focuses on offering exposure to noteworthy DeFi projects. Unlike other crypto index funds that include BTC and ETH, Bitwise has made the conscious decision to only include DeFi projects like Uniswap (UNI) and Maker (MKR) to make sure fund buyers have concentrated exposure to DeFi trailblazers.

Crypto index funds vs traditional index funds

One common question asked about crypto funds is how they compare to traditional index funds. The two are similar in that they track baskets of assets. Additionally, they share diversification as their biggest advantage over other financial vehicles. However, the two are far from being identical.

One major difference between the two is the underlying assets that they track. Traditional index funds focus on stocks, bonds, and other securities. On the other hand, crypto index funds track digital currencies, which are listed on crypto exchanges.

There's also a major difference in risk and volatility. Traditional index funds aren't nearly as volatile as cryptocurrencies. This is why risk management is fundamental for anyone dealing with crypto. That, of course, includes crypto funds.

Lastly, another big difference is that traditional index funds track regulated, established assets. Stocks and bonds alike are all recognized by the government and fully regulated. However, the same can't be said for all coins and tokens in the crypto space.

What are other ways to gain exposure to digital assets?

Apart from including crypto index funds in your long-term holdings, there are several other ways to get exposure to crypto. For example, you could:

Buy cryptocurrencies on exchanges

The most established and direct approach is to purchase crypto on an exchange. This comes with its own issues, such as management, security, and a lot of research. However, if you choose this option, you have total control and ownership of your holdings. Of course, the riskier the assets you choose, the greater the chance of experiencing losses. With this in mind, be ready for a lot of trial and error before you become an expert in this field.

Buy equities with exposure to digital assets

Another option is to purchase shares of publicly traded crypto companies like MicroStrategy or various crypto mining companies. This approach doesn't offer exposure to cryptocurrencies directly. However, certain traders may prefer this option, since it leans into ownership of regulated companies with balance sheets and cash flows.

Buy spot crypto ETFs

You could also consider buying spot crypto ETFs like the spot BTC ETF or the upcoming spot ETH ETF. These ETFs function similarly to traditional ETFs you might be familiar with in the stock market. They hold the underlying asset directly, in this case, Bitcoin or Ether, which means their price directly tracks the price of those cryptocurrencies. This offers the benefits of direct exposure and trading flexibility but involves slightly higher expense ratios compared to some crypto index funds due to the costs associated with directly holding and managing the underlying cryptocurrency.

The final word

Considering the insight shared above about the pros and cons of these crypto index funds, trading and owning them ultimately comes down to personal preference.

Many market participants and experts have concluded that it is worth having exposure to digital assets in this form. Crypto index funds allow you to get exposure to crypto without having to buy the coins. You don’t have to become an expert in crypto trading, or learn everything about every coin and token. You don’t have to worry about securing your wallet, remembering private keys or managing your assets. You simply buy a single fund, and let others do the heavy lifting. However, as mentioned, there are some disadvantages to crypto index funds, such as high fees and lack of control. It's therefore crucial that you carry out your research and make your own decision about them.