What Is A Crypto Index Fund? – A Detailed Guide For Beginners

Introduction

The outbreak of COVID-19 has left long-lasting impacts on most of the economies around the world. Many countries are still struggling to compensate for the socioeconomic losses they faced during the past few years. Common people faced many difficulties earning money for their families, and many households became unbanked.

In addition, high inflation in property, lower wage rates, and an increase in government debt made it hard for the common person to make both ends meet. Several financial advancements were made after the global economic crunch of 2008. As a result, several crypto assets based on blockchain technology emerged, such as Ether, Bitcoin, and others. However, these assets faced many ups and downs because of mismanagement and the high volatility of the crypto market.

This led to the development of tokenized securities backed by real-world assets such as company shares, commodities or real estate. These securities use blockchain technology to issue, represent or trade any asset integrated with it. These securities derive their value from the value of the underlying asset.

On the other hand, cryptocurrencies such as Bitcoin are not backed up by any other physical asset and their value is determined by their demand in the market. A crypto index fund is an investment fund that carries a collection of cryptocurrencies. Crypto index funds behave in the same way as traditional stock index funds.

In this guide article, we will discuss the working and purpose of crypto index funds. Moreover, the benefits and drawbacks will also be explained to the readers. Furthermore, they can learn how to invest in these funds and the features that distinguish them from other cryptocurrencies and mutual funds.

What is Crypto Index Fund?

Usually, the performance of any specific market index is tracked by using an investment fund known as an index fund. Therefore, in the crypto space, the crypto index fund is an investment that aims at tracking the behaviour of any specific crypto asset in the market. These assets may include the topmost 10 or 20 tokens participating in market capitalization.

Crypto index funds have the same function as the traditionally used index funds. These index funds are used to trace the performance of specific indices in the stock market, such as the S&P 500. The performance of almost 500 major companies in the US is tracked by S&P 500. However, these crypto index funds are quite different from traditional crypto exchange-traded funds (ETFs) as they track a collection of crypto assets and currencies to be traded on the stock exchange. This quality makes them similar to traditional ETFs. Crypto ETFs hold their underlying derivatives, such as futures contracts, in the same way, traditional ETFs hold their underlying assets.

Also Read: The Future of Bitcoin and Crypto in 2023

Bitwise’s 10 Crypto Index Fund and Grayscale Digital Large Cap Fund are known examples of crypto index funds. These index funds track the top 10 coins and cryptocurrencies by market capitalization and calculate their market liquidity.

One of the major benefits that crypto index funds provide investors is diversification. It enables the investors to spread their risk along different crypto assets instead of a single coin by investing in a collection of crypto assets. This also decreases the volatility risk that is integrated with crypto assets usually.

In addition, a team of professional fund managers manages crypto index funds such as Grayscale Digital Large Cap Fund. These managers are assigned the duty of selecting coins that create the index and rebalance the portfolio of any particular cryptocurrency. This reduces time and effort, where traders would individually select the coins and do their research.

It should be remembered that crypto index funds are still growing, an innovation in the crypto space. There is still massive uncertainty regarding the regulations imposed on these funds in different countries. However, investors should thoroughly research and study before finalizing the crypto index fund.

Working of A Crypto Index Fund

A crypto index fund helps investors in the diversification of their crypto portfolio. Investors can disperse the risk among different cryptocurrencies, which might help compensate for any loss if a certain currency does not perform well in the market, thus balancing the fund’s performance.

An expert investment manager usually deals with crypto index funds where they diversify the portfolio of different cryptocurrencies aligning with the index being traced. The performance of the underlying collection or index greatly affects the performance of funds. Investors can also increase their exposure to the underlying crypto assets by buying shares in the funds.

This will eliminate the need to buy those assets directly, helping investors who feel uncomfortable buying cryptocurrencies individually. As the fund’s manager is not actively participating in buying or selling underlying assets, one can consider the crypto index funds as a passive investment strategy.

Normally a management fee is charged by the fund for providing expert management services. The fund manager charges this management fee to compensate for the charges of managing all funds. In addition, an expense ratio may also be charged by certain crypto index funds. The expense ratio is used to compensate for other expenses integrated with funds, such as custody fees or trading charges and is usually derived from the fund’s assets.

Advantages of Crypto Index Funds

Crypto index funds allow investors to invest in multiple crypto assets instead of buying them individually. Several advantages provided by crypto index funds are discussed below.

Risk Diversification

Crypto index funds help investors in dispersing the risk along different assets and projects by helping them invest in a collection of cryptocurrencies.

• Liquidity

Crypto index funds are usually traded on exchange platforms. Therefore, these funds can be sold or bought similarly to any other asset or token.

• Expert Management

Crypto index funds are managed by a team of experienced professionals that take decisions regarding the inclusion of coins and their rebalancing, thus saving the time and effort of individual traders.

• Efficient Taxation

Crypto index funds might offer tax benefits to the traders as they are considered tax-efficient in the crypto market. Traders can only utilize a single index fund instead of several equities if they are kept in a taxable count.

Disadvantages of Crypto Index Funds

Despite providing increased exposure to the traders in the crypto market, crypto index funds also have certain drawbacks discussed below.

• High Charges

As crypto index funds need to be managed properly, they often have higher charges than other individual crypto assets or tokens in the market.

• Lack of Control

The investors who invest in individual tokens or currencies have more control over their assets than the ones investing in crypto index funds. The decisions, such as purchasing or selling coins, are made by the manager looking over the funds instead of the trader himself.

• Hurdles in Access

Crypto index funds are still not allowed in many underdeveloped countries where crypto exchanges do not have permission to operate. Moreover, if the exchanges are present in certain countries with poor economic conditions, the population does not have the potential to invest in crypto index funds.

• Lack of Knowledge and Research

While trading in crypto index funds, beginners may lack the essential information and knowledge regarding investment in funds which may result in missing many opportunities. Moreover, the investors also have no idea which projects may benefit them or earn them good capital.

Method To Invest in Crypto Index Funds

Investors can increase their exposure to the crypto market by investing in crypto index funds instead of purchasing individual assets by selecting them manually. In order to buy crypto index funds, investors need to follow the steps discussed below.

• Research

First, the trader needs to look for the crypto index funds of his choice from the given options. The preferred move is to go for the funds managed by reliable companies with good track records. It is important for the trader to overview the past performance of the crypto index fund he chooses and to go through the reviews of other clients.

• Choosing the Fund

After choosing the crypto index fund of your choice, the next step is to open an account integrated with the fund manager. One can open an account using an online platform by providing certain credentials such as proof of identity and some personal details.

• Adding Funds to Account

After opening an account, the trader needs to add funds to an account in cryptocurrency or cash. However, the minimum initial deposit may vary depending on the crypto index fund.

• Buying Shares

After adding funds to the account, the user can buy shares in the crypto index funds. The Net Asset Value (NAV) of the crypto index fund determines the price of a particular share. The Net Asset Value of any fund is calculated through the value of the underlying fund integrated with it. The net asset value of a crypto index fund moves simultaneously with the pattern formed by the index it is following. 

• Monitoring Your Investment

The trader needs to monitor the performance of the crypto index fund after purchasing the share. It ensures that the investment is made at the right place and that the performance is according to expectations. Users can also trade certain shares in the secondary markets if allowed by the crypto index fund. However, certain funds may require their shares to be held for a certain period.

• Keeping track of Losses and Gains

After investing in crypto index funds, traders want to keep track of the gains and losses made. For this purpose, one has to check the Net Asset Value (NAV) of that particular fund. The gains and losses can be calculated by comparing the NAV and the initial investment made by the trader. However, one should consider certain factors before investing in crypto index funds such as Grayscale’s Digital Large Cap Fund.

It is important to have knowledge and information about the cryptocurrency market and Grayscale’s Digital Large Capp Fund. One has to understand the potential returns and risks integrated with investing funds in the crypto market and make decisions accordingly.

Before finalizing any crypto index fund, please go through the documents and prospectus of the fund and know the details, such as its investment strategy, fee structure, etc.

Next, one should look for a broker that allows one to invest with the fund and open an account. This could easily be done online.

After opening an account, add funds such as crypto or cash into it. Before choosing a broker, go through the fee structure and initial deposit demands of the broker and add funds accordingly.

Funding the account enables the traders to buy shares in Grayscale’s Digital Large Cap Fund. This can easily be done online via mobile phone.

The final step is to check the performance of the investment made constantly. This helps in decision-making about selling or holding the share for a specific period.

What are Exchange Traded Funds (ETFs)?

An Exchange Traded Fund on the blockchain is an investment fund or any product integrated with any crypto asset. Similar to the behaviour of stocks in the crypto trading activities or over the blockchain, ETFs have an investment speciality in crypto assets. It is not necessary that blockchain ETFs invest in companies that deal with cryptocurrencies only.

Therefore, when a trader purchases an ETF, he gets access to its underlying asset. This helps the trader to claim a percentage of the profit earned by the asset in the market. Crypto ETFs are used for tracking the value of any particular crypto asset; however, ETFs are still not following many security guidelines ascribed by the regulatory authorities.

Difference Between Crypto Index Funds and Crypto ETFs

Before investing in crypto index funds, users must understand the difference between crypto index funds and crypto ETFs. A few differences between them are discussed below.

• Types of Assets Held

Crypto index funds derive their value from actual cryptocurrencies, while the crypto ETFs hold the derivatives of crypto assets.

Also Read: What Are Token Standards? A Comprehensive Introduction

• Regulation

Crypto ETFs are completely regulated bodies and have to follow the guidelines issued by the higher authorities. On the other hand, crypto index funds are not completely regulated yet.

• Liquidity

Crypto index funds have low liquidity, whereas the liquidity of crypto ETFs is relatively higher in the market.

• Taxation

Crypto ETFs are subject to capital gain tax in the market, whereas crypto index funds are usually not taxed like traditional securities.

Difference Between Crypto Index Funds and Traditional Index Funds

Crypto index funds are similar to traditional index funds in performance as they diversify the portfolio of the trader while offering him exposure to a wide collection of assets. However, certain differences between the two are discussed below.

• Underlying Assets

The underlying assets tracked by the funds create a major difference between the two. Crypto index funds track different cryptocurrencies present in options on the crypto exchange. On the other hand, traditional index funds track the bonds, securities, stocks, etc., available at traditional exchanges.

• Volatility and Risk

The volatile nature of the crypto market is the biggest issue integrated with it, where the prices rapidly fluctuate in a significantly short period. Considering the risk factor, crypto index funds are riskier than traditional index funds.

• Regulation

Traditional index funds are regulated by central governing bodies such as the United States, and the Security and Exchange Commission regulates them. However, the crypto index funds are not completely regulated, which may be a downside for investors while trading.

Is There Any Difference Between Crypto Index Funds and Mutual Funds?

Crypto indexes and mutual funds help traders diversify their trade portfolios by increasing their exposure in the market and dispersing their risk among different crypto assets.

A crypto mutual fund collects the funds of multiple investors and invests them in purchasing a large collection of cryptocurrencies. The manager of the exchange decides the purchasing and selling of crypto assets. The main aim of the funds is to return capital to the traders more than their initial investment.

However, the crypto index fund is used for tracking the performance of any integrated asset. The fund tries to follow the footsteps of the index it is tracing and earn a good profit instead of outperforming it. In addition, the managers keep rebalancing the fund from time to time to keep it updated according to the benchmark set.

Are Crypto Index Funds a Good Investment?

Individuals who want to gain wider exposure in the crypto market can include crypto index funds in their portfolios. However, the crypto market is known for high volatility and involves higher risk. In addition, crypto index funds have several risks, such as lack of regulation, liquidity and transparency.

Some crypto index funds do not reveal their holdings, too, making the risk assessment difficult for investors. Moreover, the crypto exchange platforms and wallets are vulnerable to cybercrimes imposing another threat to investors.

Conclusion

As the crypto industry grows, crypto index funds are also gaining momentum. The increasing interest of investors in crypto index funds is driving the attention of higher authorities to impose proper regulations upon them. If these funds are accessible to most traders, they may also contribute to the transparency of the crypto market.