The Crypto Index Fallacy

Disclaimer: I am an active manager of a crypto fund.

There is a lot going on in the crypto markets, as always. In early 2019, we’re still in a crypto winter, the longest crypto winter ever, actually. Many tout that though the speculative side of investing is in a bear market there is a lot of building going on and the industry is still growing. Or, they mention the private investment or venture investing is still quite active. Both of those may be true, but as a contrarian I want to look at where no one else is looking — that is in the liquid market of coins and tokens.

For new crypto investors, I think it’s important to lay out the 2 main approaches to investing and why one may not be what it seems. But first, let’s set some context with what typical investors think of when using a passive investment strategy.

Passive Investment Approach with Stock Indexing

Most people are familiar with passive investing using a stock index. Individual investors, family offices and institutional investors often use this investment strategy. The indexed investments have low fees because they passively follow a particular index and adjust their holdings based on that underlying index. The best known example is probably the S&P 500 Index and the various ETFs that follow it like $SPY and $VOO. They work well, particularly in efficient markets like U.S. equities.

One of the components to an equity index that strengthens its value proposition is diversification. It achieves diversification in a variety of ways. The index tracks the top 500 U.S. companies by market cap, which is made of up 10 sectors. Each sector is comprised of many similar companies (e.g the technology sector.) This gives investors investors exposure to companies with various sensitivities to economic growth, interest rates, inflation and commodity prices as each sector will react differently to various market dynamics. Furthermore, each of the companies were started by themselves and grew into their position in the index. Each of these companies help create diversification because each companies has its own teams following their own systems and processes. They are atomic pieces making up a whole. All of these factors help to create a truly diversified investment vehicle.

Passive Approach with Crypto Indexing

When take a passive investment approach in the crypto space, there are several options to choose from. Most of them track an index of the top 10, 20 or 30 crypto assets by market cap (technically network value). You could think of the top 10 as the large caps and the top 20 or top 30 as the mid caps if comparing to an equity index. There are several indices to choose from but the top three are: Hold 10 Index (from Bitwise), the Bloomberg Galaxy Crypto Index (from Bloomberg) or the CCI30 Index. Each track the crypto market using slightly different calculations. As with any index investing, you’re getting lower fees when compared to an active strategy.

A lot of very smart people are building solid investment products in the space. In no way am I refuting that. Additionally, over a long period of time, the passive approach may end up beating most active strategies like in the U.S. equities markets. Only time will tell since crypto is such a new asset class.

The Crypto Index Fallacy

The crypto index fallacy is that you’re getting diversification within the crypto asset class. For me to better illustrate the point, let’s take a walk down crypto memory lane.

In the beginning, roughly 10 years ago, there was only bitcoin. Then slowly over time, many crypto assets were created. Many started by copying the Bitcoin open-source software and adding some variants to create their own crypto asset. Since they were copies of Bitcoin, they had a similar regulatory risk. Once Bitcoin was deemed not to be a security, it allowed its copies to infer their regulatory risk too was reduced. As such, many of the early copies of Bitcoin were added to popular exchanges of the day, like Coinbase, and this drew new crypto investors to those crypto assets.

Open-source software is a powerful trend that’s been building over the past 15 years. It means, as the name suggests, that the human-readable code is public and anyone can access it, review it and, if they want, copy it to start their own project. This is a powerful feature in blockchain as a technology, but changes how a crypto asset might accrue value over time. No longer is having the best technology as a defensible moat of this investment. With open-source software, ingenious entrepreneurs can make a copy of open-source software and start their own project, or in this case, launch a crypto asset.

To date, there are over 2,000 various crypto assets. I distinguish cryptocurrencies as a subset and crypto assets as the super set in the article Crypto Asset Classes. Of the 10 top crypto assets, four are cryptocurrencies and five are smart contracts platforms. There is only 1 utility token in the top 10 and that just happened in the past few weeks. There are no dApp, commodity or security tokens are in the top 10 indices. Moreover, the concentration gets worse when you include the fact that three of the top 10 crypto assets are open-source software copies of either Bitcoin or Ripple.

If we look back at the top 10 crypto assets — Litecoin and Bitcoin Cash are copies of Bitcoin, and Stellar is a copy of Ripple. Just a year ago there was also Ethereum and Ethereum Classic, but the latter has fallen out of the top 20 crypto assets by market cap. There may be distinguishing features of each, but ultimately 50% of the top 10 crypto assets are similar and that does not help an investor who’s looking for a diversified investment in the crypto space. This is the fallacy — that crypto index investing is a diversified approach to investing in crypto assets.

The counter-argument to this could be that since the technology is open-sourced the only truly defensible moat for crypto assets are their networks. Network effects build moats for assets, that is true. However, if a crypto asset is a mere 8-hour coding change from Bitcoin and it was purchased because it was one of the first crypto assets to be listed on exchanges, does it really have any network effects?

There are more factors that contribute to the crypto index fallacy as well. Since crypto assets are mainly software projects, team members can work on multiple projects. Moreover, all sectors of the crypto markets are not represented in the index. For example, there are no governance tokens and there is only one utility token in the top 10. Finally, the fact that 80% of the total market cap is held by the top 10 crypto assets is a ‘bug not a feature’ for current passive index investment. In time as the market matures, I expect this will change, but today it’s the case.

Conclusion

Both passive and active strategies in the crypto markets are valid. The only distinction that needs to be considered is that assumptions from investing in other markets may not hold for the crypto markets. Active management is still expensive relative to passive, but may be able to deliver superior returns in a nascent market that is inefficient and where slightly more knowledge can deliver asymmetric value.

Likewise passive investing still follows an index and reduces expenses but what’s in that index may not be what you might think. They may not be currently diversified. It should be said that this very well may change in the future. As crypto assets, as a new asset class, start to mature and as price starts to greater reflect intrinsic value, the index may become much more diverse. I think it will just take some time. For now, Caveat Emptor — the message is to know what’s you’re investing in; the old Latin phrase too applies to investing.

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