What is crypto index trading?
The many faces of the crypto market
From its inception, the cryptocurrency market has been developing at a fast pace. The main factor driving the growth of the global crypto market lies in the use of distributed ledger technology and digital investments.
Even though the demand for digital assets has been on the rise, there is always an ongoing debate regarding finding the best way to gain optimal exposure and manage related risks. Investors usually hold crypto assets such as Bitcoin or Ether, invest in Bitcoin ETFs or take advantage of another option- crypto index funds.
There are thousands of cryptocurrencies in the cryptocurrency market, many of which are being created daily. Although this occurrence means more opportunities for investors, it adds to the challenges of navigating the crypto landscape. Most cryptocurrencies end up being abandoned after not surviving on the market; therefore, investing in the volatile crypto market is always linked to certain risks.
If you are new to the crypto market and all its technical terms, we suggest trying out one of our courses at the Learn Crypto Academy to navigate the crypto landscape more efficiently. It is important to fully understand cryptocurrency trading and how it works to decide whether you can tolerate the associated risks.
In this article, we will explain crypto index funds, an investment strategy that provides exposure to several crypto assets through a single investment vehicle. Crypto index funds monitor the performance of particular digital assets, following a certain rebalancing strategy to decide which assets should be involved in the fund.
Seasoned investors typically comprehend the need to diversify their portfolios to keep up with the market dynamics and manage risks. If you wonder how to create a diversified portfolio, why not read this article: 'The concept of a balanced crypto portfolio'.
At the time of writing, several crypto index funds are marketed to investors, holding from $1 million to several hundred million dollars in assets. However, crypto index funds are not the same- each of them encompasses a selected list of cryptocurrencies at various weights.
Keep in mind that this is no financial or investment advice; this article is for informational purposes only. There are many risks associated with investing in cryptocurrency so you should always rely on your research or seek the advice of a professional.
What is a crypto index?
A cryptocurrency index can be described as a benchmark for tracking the performance of a certain group of assets. These software applications monitor the performance of a particular group of cryptocurrencies and provide the investors with the possibility to track the overall performance of the crypto market.
Crypto index funds closely resemble traditional stock market indexes such as the S&P 500, National Stock Exchange (NSE), or NASDAQ which track the performance of a group of stocks.
There are several different types of crypto indexes, based on the way they weigh assets and criteria they utilise. For example, price-weighted indexes, as the name suggests, weight crypto assets based on their prices, while custom-indexed are tailored to track specific investment strategies within the crypto ecosystem. The most common type of crypto indexes are those that are calculated based on the market capitalization of the underlying asset.
What is a crypto index fund?
A crypto index fund refers to a financial instrument that invests in crypto assets that are listed in a crypto index. The performance of a cryptocurrency index fund mirrors the performance of the crypto index.
Like traditional index funds, a crypto index fund represents a type of mutual fund that consists of a group of investor funds. A traditional index fund doesn’t have a fund manager like a typical mutual fund yet relies on a specific stock index. Therefore, index funds and passively managed funds.
As for cryptocurrency index funds, these are funds that invest in one specific type of cryptocurrency. Crypto index trading is about buying and selling crypto index funds as specific baskets created to gain exposure to several assets simultaneously. Many indices have been designed to represent divergent aspects of crypto assets.
What is the difference between cryptocurrency, stock and bond index funds?
Whether you are investing in cryptocurrency, bond or stock index funds, the main difference lies in the underlying asset. However, due to divergent options and market conditions, the risk level and potential return depend on the type of asset you choose.
As mentioned above, the volatility of the crypto market is bigger than that of bonds and stocks and a crypto index fund could go to greater price movements in comparison to its traditional counterparts.
What is the difference between trading crypto index funds and ETFs?
The main difference between these two financial vehicles lies in their trading mechanism. Simply put, index funds can only be traded at the end of the trading day based on its net asset value, while Exchange Traded Funds (ETFs) trade throughout the day on an exchange similar to stocks.
Since index funds are bought and sold at the end of the trading day, their liquidity is not as available as the liquidity of ETFs.
The U.S. was the first jurisdiction to approve Bitcoin ETFs in January 2024. Three months later, Hong Kong’s Securities and Futures Commission issued conditional approvals to three Chinese Asset managers to start issuing Bitcoin and Ether ETFs. To find out more, check out this article: 'Hong Kong approved Bitcoin and Ethereum ETFs: Could the in-kind ETF model be significant?'.
How does a crypto index fund work?
A crypto index fund equips investors with a diversified portfolio of crypto assets which aids in mitigating risks and balancing the performance of the fund itself. Investors can buy shares in the fund which provides them exposure to the crypto world without the need to buy them directly.
The fund’s risk management strategy is based on the principle of diversification- the more diversified a fund’s cryptocurrency portfolio is, the risk is smaller. For example, if one crypto asset behaves negatively, a well-diversified crypto index fund can aid in offsetting any losses.
Therefore, crypto index funds receive, redistribute, and rebalance funds they get from crypto traders. When crypto traders send money to a cryptocurrency index fund, they get to own a percentage of the crypto index fund’s pool of crypto assets and combine positions depending on market conditions and dynamics. That is how crypto traders acquire exposure to a chosen crypto index.
Crypto index funds resemble another financial product known as crypto mutual funds, but the main difference is that the former only focuses on tracking crypto price indices.
Remember how we mentioned that each crypto index fund is different? Each of them has divergent terms and conditions for joining a pool; for instance, some are available only to accredited investors. The fund charges fees for services known as the expense ratio which amounts to a percentage of each crypto trader’s holding.
Pros of crypto index funds
Cryptocurrency index funds encompass several important advantages. Let’s check them out.
Advanced portfolio management features
Investors can take advantage of a more diversified portfolio since crypto index trading offers advanced opportunities in this department. Crypto traders can gain exposure to several crypto assets across divergent categories ranging from decentralised finance (DeFi) to Proof-of-Stake (PoS) projects.
Dealing with a diverse range of cryptocurrencies helps in diminishing associated risks since losses in one crypto asset can lead to profits in others. Enhanced diversification reduces price volatility and boosts resilience against price movements.
Efficient risk management options
The first feature brings us right to the second one – efficient risk management options which is a significant segment of crypto trading.
Crypto index trading provides advanced risk management techniques that aid in protecting and preserving capital over time. Portfolio diversification mitigates risks associated with technological problems, market manipulation, or regulatory developments.
Passive rebalancing
Passive rebalancing is one of the main advantages of crypto index trading since it is essential for maintaining the consistency of the crypto portfolio.
In contrast to active trading strategies that require constant oversight, passive crypto index funds are able to automatically rebalance holdings in accordance with predetermined criteria.
Therefore, passive rebalancing ensures that the fund’s portfolio maintains aligned with the target asset allocation that is needed for frequent trading and minimising transaction costs and associated tax implications as well as psychological issues linked to emotional decision-making processes.
The implementation of advanced trading and investment strategies
Crypto index funds enable the implementation of sophisticated trading strategies. For example, a fund can utilise the dollar-cost averaging (DCA) strategy or smart strategies which aim to outperform market-cap-weighted trading indices.
The dollar-cost averaging strategy refers to repeat purchases of an investable asset to obtain an average price spread over consistent purchases. If you have problems with understanding this strategy, take a look at this article: 'Dollar Cost Averaging- Bear Market Silver Lining'.
Crypto index funds also provide the opportunity to implement any investment strategy that may be useful and take into account the unique features of crypto index products.
Cons of crypto index funds
Despite many benefits, crypto index funds bring to the table, they are also associated with particular risks and downsides. Let's explain them briefly.
Higher fees and other requirements
Cryptocurrency index funds are typically associated with higher fees than buying individual crypto assets because they are costs linked to the fund’s management.
Index funds have expense ratios to cover expenses related to management and storage. Crypto traders need to take into account these costs when deciding whether to get into crypto index trading.
Additionally, not all cryptocurrency index funds accept retail traders and investors, even in case they can cover the minimum deposit requirement.
Limited trading hours
Most cryptocurrency index funds only trade once a day at the end of the trading day. This feature isn’t important for long-term investors, but it might not be the right choice for swing or day crypto traders.
Lack of control
When traders and investors buy crypto assets through a cryptocurrency index fund, they don’t have direct access to these digital assets or access to private keys to open a wallet. They must trust the fund’s security protocols to keep their assets safe.
Traders and investors in these funds have less control over digital assets than those with individual coins.
How do you start with crypto index fund trading?
Considering how popular digital assets are, we will likely see more cryptocurrency index funds in the future. Investing in crypto index funds is a good way to gain exposure to the crypto space without manually selecting and managing multiple assets. Let's take a look at the main steps for engaging with a cryptocurrency index fund.
Do your own research
The first rule of crypto is to always do your research and educate yourself. Start this journey by checking out several cryptocurrency index funds that are managed by companies with a good track record. Check out the cryptocurrency index fund’s past performance and reviews from other investors and crypto traders that can provide valuable insights.
Crypto funds follow a specific index methodology that determines its rebalancing frequency, composition, and selection criteria. Before selecting any crypto index fund, it is important to comprehend the underlying methodology and make sure that it aligns with your objectives.
Before choosing a crypto index fund, think of your trading or investment objectives. Understanding your goals can help you in finding the right fund. Additionally, take into account your risk tolerance; consider whether you are good with higher volatility or whether you would be comfortable with a more conservative approach.
Once you have chosen an index fund that suits you best, you need to open an account. This can be done online by providing personal information and identity checks.
Buy shares
When you have set up your account, you need to fund it with cryptocurrency or fiat money. Most index funds require a minimum investment amount that can vary depending on the cryptocurrency index fund.
After funding your account, you can proceed with buying shares. The price is usually determined by the index fund’s net asset value which can usually be calculated based on the value of underlying digital assets.
Track gains and losses
When you buy shares in the cryptocurrency index funds, it is recommended to monitor the investment and ensure that it is performing well. Several crypto index funds enable traders and investors to trade these shares on the secondary market while others may set out requirements for users to hold their shares for a determined period.
Users can check their profits and losses by reviewing the net asset value of the index fund and compare it to the paid price. Monitor the investment and make a plan for selling your shares in the future if it turns out to be a better option.