TL;DR
A crypto index fund simply takes the idea of a traditional index fund โ an investment vehicle designed to track the performance of a designated market index โ and replaces the underlying assets with crypto tokens instead of company shares.
Introduction
Understanding crypto index funds requires familiarity with market indexes. In short, a market index is a way of using data to track and measure the performance of a stock market, or a specified group of companies and their associated stocks.
A crypto index fund simply takes the idea of a traditional index fund and replaces the underlying assets with cryptocurrency tokens instead of company shares. Crypto index funds, however, are still a new development, with very few currently available.
What Is a Traditional Index Fund?
Before looking at crypto index funds, itโs best to get a foundational understanding of traditional index funds. In the simplest of terms, an index fund is an investment portfolio designed to track a specified basket of underlying assets.ย
More specifically, a traditional index fund is usually described as a type of mutual fund structured to match the composition and performance of a particular financial market index, such as the S&P 500 or Dow Jones Industrial Average.
ย But what is a mutual fund? And what is a financial market index?ย
A mutual fund is a financial instrument for people to pool their money together into a managed fund, which then seeks to make a profit for those involved by investing in assets such as stocks and bonds. A mutual fundโs portfolio is set up to match certain investment objectives established by the fund and its manager.ย
A market index, meanwhile, is a way of using data to track and measure the performance of a stock market or section of the stock market. The S&P 500, Dow Jones Industrial Average, and FTSE 100 are all examples of market indexes.
The S&P 500 tracks the stock performance of 500 large and important publicly traded companies in the US.
The Dow Jones Industrial Average tracks the stock performance of 30 especially prominent companies listed in the US.
The FTSE 100 tracks the stock performance of the 100 largest companies by market capitalization on the London Stock Exchange.ย ย
And so, in the case of an index fund, the investment portfolio is set up to mimic the composition of a specified market index (as designated by the fund). The objective of the fund is simply to match the performance of the market index as a whole.
In comparison, a mutual fund is where the portfolio is designed by a fund manager based on their views of what to actively invest in โ the goal being to outperform the market.
Advantages and Disadvantages of Traditional Index Funds
Index funds are known as a passive investment strategy that provides returns in line with the wider stock market. The goal isnโt to beat market movements but simply to replicate the market indexโs movements. Studies show that passive funds tend to perform better than active funds in the long term.
As such, one of the main advantages of an index fund is that theyโre thought to offer better long-term results compared to actively managed funds. For example, the annualized return of the S&P 500 from 1957 (when the index was first extended to cover 500 stocks) through to the end of 2021 was 11.88%.ย
An index fund also diversifies portfolios as it is basically made up of many little slices of every company in the index. This means your investment isnโt reliant on the success of a single company but tracks the performance of the entire index as a whole. In short, an index fund offers broader market exposure.ย
Additionally, because an index fund simply replicates the composition of the index it is tracking, the make-up of your portfolio rarely changes, which leads to lower operating and trading costs, and lower fees.
The downside, however, is that thereโs very little flexibility. An actively managed fund can drop poorly performing stocks and, with good management, outperform the wider market. If the index goes down, an index fund will also deliver a loss, whereas an actively managed fund can still deliver profits during a downturn.
What Is a Crypto Index Fund?
Now that you know what a traditional index fund is, it's very easy to understand what a crypto index fund is. A lot of developments within crypto can be seen as Web3 updates on traditional markets and products and a crypto index fund is no exception. It simply takes the idea and structure of a traditional index fund and replaces the underlying assets with cryptocurrency tokens instead of company shares and bonds.
For example: an S&P 500 Index Fund invests the pooled money placed into it in a basket of stocks representing the 500 companies on the S&P 500 market index. A crypto index fund, meanwhile, would invest money placed into it in a basket of different cryptos.
Simply put, a crypto index fund is an investment vehicle where you can invest to a fund, which, in turn, invests that money into a specific index of cryptocurrencies. In doing so, the crypto index fund provides access to a diversified portfolio of digital assets without you having to buy each token in the fund individually.
How Is a Crypto Index Fund Different?
Of course, the main difference between a traditional index fund and a crypto index fund is the type of assets in which they invest.ย
Another key difference is that crypto markets can experience more volatility than traditional markets. The result is that crypto index funds may experience greater price movements than traditional index funds, so someone investing in a crypto index fund could make more profit but could also experience bigger losses.
Aside from potentially higher risks and rewards, the other difference to note between traditional and crypto index funds is the number of products available and basic ease of accessibility for consumers. There are hundreds, if not thousands, of traditional index funds available, tracking all sorts of different market indexes. Crypto index funds, however, are still a relatively new development, with very few currently available to the general public.
Closing Thoughts
As crypto continues to develop and mature, itโs likely that we will see more crypto index funds come into existence as investment opportunities for everyday users. These funds are popular in traditional trading and suit a wide range of traders. Crypto continues to reach new places and entice new users, so those who like the idea of trading index funds will likely push for crypto-based ones to become more common.