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DeFi boom gives tokenized crypto index funds another shot at success

2021.04.27 Robbie Liu

With the rapid growth of DeFi and NFTs, investors may consider index funds for diversification. 

Index funds are investment vehicles that track a particular market index, comprising a preset basket of assets in varying ratios. These funds typically protect against extreme volatility and reduce downside risk compared to investing in any single asset. In addition, they simplify the process for most investors, especially as market participants find it challenging to stay updated on the scores of new crypto protocols emerging each quarter.

For example, if there were an index that comprised BTC and ETH at a 30:70 ratio, it would mean that investors in the index would be exposed to 30% BTC and 70% ETH in relation to their investment, and their portfolio will automatically be affected by the combined performance of both assets.

In the traditional stock market, Warren Buffett has repeatedly recommended low-fee index funds for the average investor. In Berkshire Hathaway’s 1993 letter to shareholders, he wrote, “By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals.” Index funds have been growing rapidly over the past decade, in September 2019, for example, they surpassed actively managed funds for the first time, in terms of assets under management.

However, index funds in the cryptocurrency market were not very successful until last year, as most indexes at the time were based on weighted market capitalization. This means the components of those indexes (i.e., assets such as BTC, ETH, etc.) are included in amounts that correspond with their total market capitalizations. As a result, the index gives more weight to large-cap assets and smaller altcoins have less of an impact on the overall returns, thereby reducing risk.

Consequently, index investments were highly correlated with Bitcoin price because the market leader consistently held more than half of the total market share. Because of this heavy reliance on BTC, crypto indexes struggled to diversify risks. 

For example, in 2018, Coinbase shut down its passive index product after just four months of operation. The product was offered to U.S.-based accredited investors with matching returns against the market-cap-weighted movements of BTC, BCH, ETH, ETC, LTC and ZRX. The main reason for the failure was a lack of investor interest in Bitcoin and, more so, in altcoins during a bear market.

Change, however, was seen starting last year because of the massive growth posted by decentralized finance protocols and nonfungible tokens. More niche sectors — such as automated market makers, borrowing and lending, derivatives, yield aggregators, etc. — have emerged with significant user volumes and, consequently, very solid fundamentals. According to data from DeFi Pulse, on the Ethereum network, the total value locked in assets has not fallen below $3 billion since early February. 

This growth has created an ideal environment for crypto passive index products to have another shot at success.

Total value locked in assets surged to more than $3 billion since early February. Source: DeFi Pulse

Apart from the changing market conditions highlighted above, we’re also witnessing a technology shift in the newly launched crypto indexes, which are markedly different from their predecessors. As discussed in the following sections, these new indexes are tokenized and are circulating on decentralized exchanges, allowing investors to trade and hold them using Ethereum wallets and DEXs, without the need for middlemen or brokers. Additionally, some of them even have additional mining rewards associated with them.

DPI index is making DeFi more accessible

In the DeFi sector, the DeFi Pulse Index, or DPI, is arguably the most well-known passive index that tracks the performance of decentralized financial assets across the market. The index is co-designed by DeFi Pulse and Set Protocol, and it acts as the gateway for crypto investors who want exposure to DeFi but lack expertise. 

The index is weighted based on the value of each token’s circulating supply, and it currently consists of 14 DeFi tokens, all of which have exhibited significant usage and potential. Among them, UNI, AAVE and MKR have the highest price allocation at 26.48%, 17.47% and 12.67%, respectively. FARM, CREAM and MTA, which account for the smallest share, are less than a combined 1%, as of April 21.  

Investors can mint DPI tokens through the smart contract, and, when redeemed, the DPI tokens can be exchanged for a corresponding basket of DeFi tokens. Created on Sept. 9, 2020, DPI currently has a market capitalization of $134 million and over 11,000 holders. The index has risen nearly 280% since its inception with a max drawdown of 56.7%. 

In addition, investors can be rewarded with INDEX tokens by providing DPI/ETH liquidity on the Index Coop platform. This additional mode of return is not available for non-tokenized index funds. On the other hand, more than 70% of AUM under DPI never received liquidity rewards. This proves the attractiveness of this product, as investors are willing to hold the index regardless of the mining incentives. 

DPI has realized 280% since its inception. Source: TokenSets

High risk-reward opportunities are also cropping up

Other index funds with higher-risk, higher-reward are also created by market participants. For example, the Degen Index — named after the moniker for “degenerate gamblers” — was launched on Indexed.finance at the beginning of March. It’s designed to capture upside from emerging tokens during their most rapid growth phases, when their market cap grows from $50 million to $2 billion. If a token’s market cap outgrows the $2 billion threshold, it will be automatically replaced upon re-indexing with the largest market cap token from a preexisting list of alternates.

The index currently includes heavily weighted tokens including RUNE, REN, RSR, CRV, etc. From a return perspective, the index has seen limited and volatile gains since March, but it gives investors a more aggressive and experimental option. Moreover, liquidity providers can currently earn an extra 41% APY by staking DEGEN/ETH. 

Degen Index has seen limited and volatile gains since March. Source: DEXTools

Index funds are also available for the NFT space

Index funds are now also feasible in the NFT space, which has been quite hot these days. In a recent NFT Snapshot article, OKX Insights discussed the strategy of buying single NFT index funds on platforms such as ShardingDAO or Unicly to track the floor price of a collection. However, if investors want to maintain overall exposure to the NFT sector, buying an index fund with a basket of related tokens would be more effective. 

Metaverse Index, or MVI, was designed by the Index Coop community and aims to capture the trend of entertainment, sports and businesses shifting to virtual environments. Looking at its current price allocation, ENJ, MANA and WAX have the highest weights at 18.33%, 17.61% and 11.53%, respectively. However, as MVI was launched on April 3, it missed the hottest phase of the NFT sector in February and March, and its return since inception is currently at negative 12%. Given the continued mainstream adoption of NFTs, the potential of this index should not be dismissed as yet.

A similar index tracking the NFT sector is called PLAY, which is co-designed by the PeiDAO and NFTX communities. There is some overlap with the selection of MVI’s components, but a sentiment score assessing each project’s innovation, community ecosystem and growth potential adds another layer to this index.

The MVI gives investors a simple option to follow the NFT sector. Source: TokenSets

Competitive index products likely to continue emerging

Due to the rapid growth of DeFi, we are likely to see more sophisticated index funds designed to facilitate investors seeking more passive opportunities. An example of this is the TokenTerminal Smart Beta Index, proposed by data analytics website Token Terminal. Its methodology is to select assets based mainly on their price-to-sales ratio, which compares a protocol’s market cap to its revenue. The index selects 10 DeFi tokens with low P/S ratios, implying that they are undervalued.

Looking at the current index composition, UNI, SUSHI and COMP each account for 20%, while LRC, CRV and ZRX together account for just under 2%. Backtesting shows that this strategy can outperform DPI, the market-cap-weighted index. However, this model also needs to be refined further and tested in varying market conditions.

TokenTerminal Smart Beta Index has outperformed DPI in backtesting. Source: Token Terminal

For investors, while passive index investment can significantly lower the barrier to participation in DeFi, it is still important to understand the mechanism, risk factors and historical returns behind these index funds.

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Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involve significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.