Did you ever think there is a connection between a herd of cows and an Index Fund? In a literal sense, there probably isn’t, but if we ignore the financial terms used, here is what we mean:
Let’s say you are organizing a cow farm and you are interested in the production of milk, which is why at first you thought you would own only Holstein cows. It is a good investment, but soon you realize that other breeds also have potential!
For example, to improve milk production you would need some Brown Swiss, and if you want to make butter you would need to buy some Jersey ones.
Because you want your cows to not be very highbrow and adapt to any conditions, you find out that the Simmental breed is good. Breeds like Yaroslavl or Lakenvelder could also represent good options for your farm.
Well, it is time to diversify, so you probably won’t stop at just one cow breed and you will prefer to own an entire herd.
I hope my impressive cow knowledge didn’t make you zone out, because I had a point to make – simply put, an index fund offers simultaneous exposure to the stocks of several companies in which you wish to invest.
For example, instead of investing sporadically in the stand-alone stocks of companies you need to find, study, and evaluate, all separately, if you decide to invest in an index fund, you are actually investing in an entire stock portfolio belonging to already-selected companies with a potential for development.
Stay with me if you want to find out what index funds are and how they can help you in crypto.
What Is An Index Fund?
An index fund is a portfolio of stocks or bonds meant to mimic as much as possible the structure, composition, and performance of a financial market index. As a strategy, this kind of fund is focused on the concept of passive investment with lower expenses and commissions than actively managed funds.
Index funds try to level the turnover with the risks of the market based on the theory that in the long run, the common market will surpass any occasional investment in the stocks of just one company.
There is an index and an index fund for just about any existing financial market. In the US, the most popular funds follow the performance of companies in the S&P 500.
But there are several other stock indexes used on a large scale, including:
Dow Jones Industrial Average (DJIA), made out of 30 prominent companies;
Nasdaq Composite, made out of 3.000 stocks listed on Nasdaq;
Wilshire 5000 Total Market Index – the largest equities index in the US.
How To Understand An Index Fund Example?
For example, in the case of an index fund following Dow Jones Industrial Average, the administrators of that fund would buy the stocks of the 30 companies that are part of the index in the same percentage as the stock index as a way of duplicating the performance of the index.
If the price of the stocks of those companies grows, the value of the index fund follows the movement. Naturally, the opposite is also possible.
Index funds are interesting and attractive because they can be constantly readjusted and then rebalanced periodically in order to minimize the risk
For example, a fund based on a weighted index readjusts the percentage of the actions according to the companies in that index based on the market cap.
Basically, if the price of the stock of a company drops significantly, the market cap will also drop. The index gets readjusted at the same time, the percentage of stocks for that company in the index fund is reduced and it gets equilibrated by adding stocks from a company with a better performance.
For a simple analogy, let’s compare a weighted index fund with a pack of M&Ms. Inside you have candy of all colors in various proportions. If you start eating only green M&Ms, their percentage in the pack will drop.
But what if instead of having the total number of candies drop as well, you could replace the eaten ones with red, blue, and yellow ones, that basically replace the green ones so you can always have the same amount of candy in the pack?
According to this scenario, the total number of candy remains the same, only the total amount of green M&Ms will be lower.
What Is a Crypto Index Fund?
If you understood the main idea of an Index Fund, well, you’ll be glad to know that a crypto one isn’t that different.
Instead of having exposure to company stocks, in this case, you are buying the token of an index fund and you have exposure to several crypto assets at the same time.
Let’s take a simple example – let’s say you want to invest in Bitcoin in the long run, in some altcoins based on the promising technology they use on their blockchains, but also in some tokens of various projects, because they have the potential of growing fast.
Instead of buying all of these assets separately and keeping an eye on all of their prices, you decide to invest in the token of a crypto index fund that closely follows the price movement of the crypto assets it represents.
This type of index fund can include a number of cryptocurrencies but in different percentages. The token can either represent 10 cryptocurrencies at once, like ILSI – Invest like Stakeborg Index, or even 20 assets, like the C20 token of the CRYPTO20 fund.
If the price of a crypto asset starts to plummet, in order to minimize the risks of the investor, the ratio of that asset in the fund can be lower based on the price movement, leaving room for percentages of cryptos with better prospects to grow.
Since the initial proportion of cryptos can vary a lot, and because their prices do the same, at certain intervals of time the funds will experience a rebalancing in order to bring the fund back to the initial proportions.
How Does A Crypto Index Fund Evolve?
Let’s take as an example the ILSI token of Invest Like Stakeborg Index which follows the price of 10 assets. The fund was launched including WBTC, which represents Bitcoin on Ethereum and ETH of Ethereum, both in percentages of around 20%.
It also offers exposure to Terra’s LUNA, initially in a 15% percentage, LINK from Chainlink with 12%, and FTT of FTX Token with 10%. The percentages for ENJ (Enjin) and AAVE (Aave) tokens were established at 7%. SNX(Synthetix), DYDX(dYdX) and BOND (BarnBridge) each have 3%.
In order to lower the risk of the investment, if the price of ETH drops, and the price of LUNA grows, the percentage of LUNA will grow to be the biggest, while the one for ETH will be reduced.
In the case of this precise example, the rebalance is done manually every three months which means that at that moment, all percentages will return to their initial state.
Other crypto index funds can have different rules for adjustments and rebalancing, but, in general, they are seen as safe investments even by institutional investors.
What Advantages Come With A Crypto Index Fund?
Among the best-known advantages of index funds we can mention:
Lower risk for unprofitable investments – This advantage stems from diversification because the portfolio of a crypto investor can include many assets without actually holding them.
Plus, an index fund allows simultaneous exposure even for people with a limited amount of crypto knowledge and it is preferred by institutional investors or by passive ones who tend to buy and hold the assets.
This way you don’t have to keep an eye on the prices every day, letting you invest without having to check your phone dozens of times a day.
Low spending and fees for investors – Unlike actively managed funds, you don’t need a lot of money to manage an index fund. The administration would theoretically include payments towards advisers and managers, transaction fees, taxes, and accounting commissions.
Since the admins of an index fund are simply reproducing the performance of a benchmark they won’t need the services of analysts or other people.
Long-term investment – this is based on the idea that, in the long run, even if the price of a crypto asset or of a stock is to drop dramatically, overall, the price of multiple crypto assets or stocks will grow and the market will also increase over time.
Conclusion
An index measures the performance of a group of assets that are similar such as stocks, bonds, and more recently, crypto.
The fund of a certain index offers exposure to the corresponding assets of an index with variations regarding the price, helping investors follow the performance of the group on the market more easily.
In crypto, an index fund proposes one token which follows the movement of different crypto assets which are represented in that fund in various proportions.
Index funds are passive investments but, as always, there are also risks associated with them since the price of the cryptos included in the fund can be highly volatile. Also, this type of solution is not recommended for investors who are looking to get big gains in a short amount of time.