What is a crypto index fund, and how to invest in it?

While the COVID-19 pandemic’s long-term socioeconomic effects are yet to be known, most economies are still dealing with the effects of the global financial crisis. Moreover, millions of households are under or unbanked, and there are additional obstacles faced by people, including slow wage growth, skyrocketing property costs and government debt as more and more individuals are living hand to mouth.

After the global financial crisis of 2008, financial advancements like blockchain-based assets such as Bitcoin (BTC), Ether (ETH) and more cryptocurrencies emerged. However, they have been through roller coaster rides due to extreme volatility and mismanagement of businesses.

In light of this, tokenized securities backed by real-world assets such as real estate, commodities or company shares came into existence. Tokenized securities use blockchain for the issuance, representation and trading of an underlying asset, whereas cryptocurrencies like BTC are digital assets that are not backed by any physical assets and whose value is determined by market demand. On the other hand, tokenized securities derive their value from collateral.

Related: ICOs vs. STOs vs. IPOs in crypto: Key differences explained

This article will discuss cryptocurrency index funds, including how they work, their pros and cons, how to invest in decentralized crypto index tokens, and how they are different from crypto mutual funds and cryptocurrencies.

What is a crypto index fund?

In general, an index fund is a type of investment fund that aims to track the performance of a specific market index. In this context, a crypto index fund is a type of investment vehicle that aims to track the performance of a specific index of cryptocurrencies, such as the top 10 or 20 coins by market capitalization. 

Crypto index funds are similar to traditional index funds, which track the performance of a specific stock market index, such as the S&P 500. The S&P 500 tracks the performance of 500 large, publicly traded companies in the United States. 

Nonetheless, these funds are different from crypto exchange-traded funds (ETFs), which are similar to traditional ETFs in that they track a basket of assets (in this case, cryptocurrencies) and can be traded on a stock exchange. However, while traditional ETFs hold the underlying assets they track, crypto ETFs hold derivatives, such as futures contracts, that track the price of the underlying assets.

Examples of crypto index funds include Grayscale’s Digital Large Cap Fund, which tracks the top 10 cryptocurrencies by market capitalization, and Bitwise’s 10 Crypto Index Fund, which tracks the top 10 coins by market capitalization, weighting them by liquidity.

The main benefit of investing in a crypto index fund is that it provides investors with diversification. By investing in a basket of cryptocurrencies, rather than just one coin, investors are able to spread their risk across multiple assets. This can help to mitigate the volatility that is commonly associated with individual cryptocurrencies.

Another advantage of crypto index funds like Grayscale’s Digital Large Cap Fund is that they are managed by professional fund managers, who are responsible for selecting the coins that make up the index and rebalancing the cryptocurrency portfolio as needed. This can help to reduce the time and effort required for individual investors to research and select individual coins to invest in.

However, since crypto index funds are still a relatively new and rapidly evolving asset class, and the regulatory environment surrounding them is still uncertain in many countries, it is important for investors to thoroughly research their chosen crypto index fund before investing.

How does a crypto index fund work?

A crypto index fund provides investors with a diversified portfolio of cryptocurrencies, which can help mitigate risk because if one cryptocurrency performs poorly, the other cryptocurrencies in the fund may perform well, helping to balance out the overall performance of the fund.

As mentioned, a crypto index fund is typically managed by a professional investment manager who selects a diverse portfolio of cryptocurrencies that aligns with the index or basket being tracked. The fund’s performance is then closely tied to the performance of the underlying index or basket.

Investors can purchase shares in the fund, which gives them exposure to the underlying cryptocurrencies without having to purchase them directly. This can be ideal for investors who are unfamiliar with or uncomfortable purchasing individual cryptocurrencies. Additionally, index funds are generally considered to be a more passive investment strategy, as the fund manager is typically not actively buying and selling the underlying assets.

The fund typically charges a management fee for professional management, and some funds may also have an expense ratio. The management fee is the fee charged by the fund manager to cover the costs of managing the fund, while the expense ratio is a percentage of the fund’s assets that goes to cover other expenses, such as trading and custody fees.

Advantages and disadvantages of crypto index funds

Crypto index funds provide investors with a way to gain exposure to a basket of cryptocurrencies, rather than having to pick and choose individual coins to invest in. Some advantages of cryptocurrency index funds include:

Diversification: By investing in a basket of cryptocurrencies, index funds can help spread risk across different coins and projects.Professional management: Index funds are typically managed by experienced professionals who make decisions about what coins to include in the fund and when to rebalance it.Liquidity: Since index funds are traded on exchanges, they can be bought and sold like any other asset.Tax efficiency: Index funds are tax-efficient and may even offer a tax advantage since only one index fund is kept rather than numerous individual equities, especially if they are kept in a taxable account.

However, there are also some disadvantages to consider:

Lack of control: Investors in index funds have less control over their investments than those who own individual coins, as the fund’s managers make the decisions about what coins to hold.Higher fees: Index funds often come with higher fees than buying individual coins, as there are costs associated with managing the fund.Barrier to access: Countries without cryptocurrency exchanges, which include many underdeveloped countries, do not permit access to crypto index funds. In addition, an underbanked or poor population cannot invest in index funds, even in nations with cryptocurrency exchanges.Lack of knowledge: Novice investors who lack the knowledge and expertise to pick individual coins may miss out on opportunities to invest in promising projects that are not included in the fund.

How to invest in crypto index funds

Investing in crypto index funds is a way to gain exposure to a diverse range of cryptocurrencies without having to manually select and manage individual assets. Here are the steps to invest in crypto index funds:

Research

Begin by researching the different crypto index funds available. Look for funds that have a good track record and are managed by reputable companies. Check the fund’s historical performance and read reviews from other investors.

Choose a fund

Once you have identified a fund that you are interested in, you will need to open an account with the fund manager. This can typically be done online and may require you to provide some personal information and proof of identity.

Fund your account

After opening an account, a user will need to fund it with cash or cryptocurrency. The minimum investment amount may vary depending on the fund.

Buy shares

Once an account is funded, users can buy shares in the crypto index fund. The price of the shares will be determined by the fund’s net asset value (NAV), which is calculated based on the value of the underlying assets in the fund. An index fund’s NAV moves almost exactly in tandem with the index it follows.

Monitor your investment

After buying shares in the fund, a user will need to monitor their investment and make sure that it is performing as expected. Some funds may allow users to trade shares on a secondary market, while others may require them to hold their shares for a certain period of time.

Track your gains and losses

Finally, users may want to track their gains and losses in the crypto index fund. This can be done by checking the NAV of the fund and comparing it to the price they paid for their shares.

Therefore, a few considerations before investing in crypto index funds like Grayscale’s Digital Large Cap Fund involve the following:

Knowledge about Grayscale’s Digital Large Cap Fund and the cryptocurrency market in general: It is vital to understand the risks and potential returns associated with this type of investment.Review the fund’s prospectus and other disclosure documents to understand the fund’s investment strategy, fees and other crucial details.Open an account with a brokerage firm that allows you to invest in Grayscale’s Digital Large Cap Fund. This can typically be done online.Fund your brokerage account with cash or securities. Be sure to check with your brokerage firm to understand its deposit requirements and any fees associated with funding your account.Place an order to purchase shares in Grayscale’s Digital Large Cap Fund, which can typically be done online or over the phone.Monitor your investment and consider a plan for selling or holding your shares in the future.

Along with the above points, it is important to understand that Grayscale’s Digital Large Cap Fund is an investment in a trust that holds a basket of digital assets, and it is not an ETF, so users must be aware of the differences before investing. Here are a few ways in which crypto index funds and crypto ETFs differ:

Related: Cryptocurrency tax guide: A beginner’s guide to filing crypto taxes

Crypto index funds vs. traditional index funds

Crypto index funds and traditional index funds are similar in that they both track a basket of assets and provide diversification for investors. However, there are some key differences between the two types of funds.

For instance, one major difference is the underlying assets that the funds track. Traditional index funds track stocks, bonds and other securities listed on traditional exchanges, while crypto index funds track cryptocurrencies listed on digital asset exchanges.

Another difference is the level of volatility and risk. Cryptocurrencies are known for their high volatility, meaning that their prices can fluctuate significantly in a short period of time. This makes crypto index funds riskier than traditional index funds.

Additionally, traditional index funds are regulated by government bodies, such as the Securities and Exchange Commission in the U.S., whereas crypto index funds are not yet fully regulated, which can pose additional risks for investors.

Are crypto mutual funds the same as crypto index funds?

Crypto mutual funds and crypto index funds are both types of investment funds that allow investors to gain exposure to the cryptocurrency market, but they have some key differences.

For instance, a crypto mutual fund is a type of investment fund that pools the money of multiple investors to purchase a diversified portfolio of cryptocurrencies. The fund is managed by a professional manager who makes decisions on what cryptocurrencies to buy and sell and when. The fund aims to provide a return on investment that is higher than the overall market.

On the other hand, a crypto index fund is a type of investment fund that tracks the performance of a specific index or benchmark of cryptocurrencies. The fund is passive and aims to replicate the performance of the index or benchmark it tracks, rather than attempting to outperform it. The fund is typically rebalanced periodically to ensure that it continues to match the performance of the specific benchmark.

Are crypto index funds good for investment?

Cryptocurrency index funds can be included in an investment portfolio by individuals who want to gain exposure to a broad range of digital assets, but don’t have the time or expertise to select individual coins. Index funds are also considered a more passive investment strategy, as they are designed to track the performance of a particular market or index, rather than trying to beat it. 

However, the cryptocurrency market is highly volatile, and there is a high risk of losing money. There are several risks associated with investing in crypto index funds, including lack of transparency and liquidity, risk of hacking, and limited regulatory oversight. 

For instance, some crypto index funds may not disclose their holdings, making it difficult for investors to assess the risk of their investments, while others may be difficult to buy or sell, leading to illiquidity. In addition, cryptocurrency exchanges and wallets are vulnerable to theft and hacking, which can result in the loss of funds. Moreover, the cryptocurrency market is largely unregulated, which increases the risk of fraud and other financial crimes.

The future of crypto index funds

Crypto index funds are likely to see continued growth as more investors become interested in the cryptocurrency market and as the industry matures. Moreover, the increasing institutional interest in the crypto market is expected to drive the development of more sophisticated and diverse index funds and increased regulation in this area. 

Additionally, the use of index funds could help to increase transparency and liquidity in the cryptocurrency market, making it more accessible to a wider range of investors. Overall, the future of crypto index funds depends upon the maturity of the cryptocurrency industry and, thereby, inclusion of such funds in an investment portfolio.