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Index Funds: All you need to know

18 November  2020 | ZebPay Trade-Desk

Index funds

Introduction – What is an Index?

An index helps to track and measure the performance of some group of assets in a standardized way. Index funds typically measure the performance of a basket of securities which replicate a certain proportion of the market.  Indices provide a benchmark, against which performance of a portfolio can be assessed. Indexing is an investment strategy, and it measures the price performance of a basket of securities using standardized metrics and methodologies.

“Indexing” is a form of passive fund management. By mimicking the profile of the index—the market as a whole, or a broad segment of it—the fund is able to match its performance as well. Usually, Index funds are created to track the performance of the index itself, as one cannot directly invest in an Index. These funds contain securities that closely replicate those in an index, thereby allowing an investor to bet on its performance, for a fee. Investors can hence buy a security likely to rise and fall in sync with the market. Despite it’s rising popularity, there are some limitations to index investing. Most index funds are based on a market capitalization principle, meaning the top holdings have an outsized weight on broad market movements. As it is a passive investment strategy it neglects some market factors such as value, momentum, and quality, when evaluating the investment proposal.

However, there are several advantages of index investing. Empirical research finds index investing tends to outperform active management over longer periods of time. Taking a hands-off approach to investing eliminates many of the biases and uncertainties that arise in an asset-picking strategy. Index investing is an effective strategy to manage risk and gain consistent returns. The simplicity of tracking the market without a portfolio manager allows providers to maintain modest fees. Index funds also tend to be more tax-efficient than active funds because they make less frequent trades. More importantly, index investing is an effective method of diversifying against risks, as it incorporates a larger set of assets. This serves to minimize unsystematic risk related to a specific company or industry without decreasing expected returns.

Index Fund Analysis

As we have described above, an Index fund would need periodic rebalancing to closely follow the return of the index it tracks. That period is quarterly for most of the index funds.

Our analysis here shows performance of index holding assets between Bitcoin (BTC) and Ethereum (ETH) and rebalancing the holdings proportion quarterly based on different indexation rules.

Since, ETH is relatively younger than BTC, we chose a past 5 year window for analysis. 

Following is the analysis by Zebpay into a basic crypto-index.

1. Market capitalization weighted index with quarterly rebalancing based on last day’s Market capitalization (Mcap EOQ):

For this index, rebalancing happens at the start of each quarter, with weights assigned in proportion to market capitalization of ETH and BTC on the last day of the previous quarter. BTC has market capitalization more than 5 times that of ETH, hence this would mean more 80% of capitalization is allocated to BTC in this index. We started the index at 100 on Aug 07 2015. Below is the chart depicting the value of the index over the last 5 years. 

2. Market capitalization weighted index with quarterly rebalancing based on last quarter’s average Market capitalization (Mcap AVG):

For this index, rebalancing happens at the start of each quarter, with weights assigned in proportion to average market capitalization of ETH and BTC in previous years. We started the index at 100 on Aug 07 2015. Below is the chart depicting the value of index over the last 5 years

3. Price weighted index with quarterly rebalancing (price wt):

For this index the weights are adjusted at the start of each quarter such capital allocation is in proportion to the price of both assets. As expected since ETH price is less than 3% of BTC, this has extremely high capital allocation to BTC. This makes an interesting index as when the ETH price increases relative to BTC, ETH allocation increases, hence would show positive correlation to momentum strategies (deployed on quarterly basis).

We started the index at 100 on Aug 07 2015. Below is the chart depicting the value of index over the last 5 years

4. Equal weighted index with quarterly rebalancing (Equal wt):

For at the start of each quarter rebalancing is done in such a way that equal capital is allocated to both assets. Which means at start we’ll end up selling the asset that has out performed. Hence, this index will  show positive correlation with mean reversion strategies. We started the index at 100 on Aug 07 2015. Below is the chart depicting the value of index over the last 5 years

5. Volatility inverse weighted index with quarterly rebalancing (low vol):

For at the start of each quarter rebalancing is done in such a way that capital is allocated in inverse proportion to volatility shown by asset in the previous quarter. For example BTC showed volatility of 10% while ETH showed volatility of 5% over the past quarter, at the start of quarter we’ll rebalance in such a way that BTC:ETH capital allocation is in the ratio 1:2.

This is analogous to volatility targeting.

We started the index at 100 on Aug 07 2015. Below is the chart depicting the value of index over the last 5 years

Conclusion

As we have shown above, index funds give an easy for investors to gain exposure to crypto assets basis their requirement. For example an investor looking to gain exposure to only the most liquid assets can choose a market cap weighted index. Rule based indexation is a cheap way for investors to add crypto in a passive way to their portfolio.

To conclude we summarise the year on year performance for the 5 years of above index we analysed above, show differences and similarities in rule based index’s performance.

YearPerformance Mcap EOQ MCAP AVG Equal weighted Price weighted Low vol
2015 53% 54% 1% 54% 39%
2016 117% 126% 462% 131% 380%
2017 1468% 1408% 4364% 1334% 3125%
2018 -75% -76% -76% -72% -75%
2019 71% 71% 35% 84% 41%
2020 till Oct 94% 94% 145% 83% 139%

The analysis done by the ZebPay Trade team aims to provide traders and investors alike, a sound understanding of the principles of Indexing, and how it might help as an investment strategy. index investing is an effective method of diversifying against risks, developing a crypto portfolio, and gaining from crypto assets. 

If you enjoyed this article, read more from our Trade team.

References:

https://www.investopedia.com/
https://coinmarketcap.com/

*Sources of btc and eth price: https://coinmarketcap.com/

Disclaimer :

 This report is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any investor. All investors should consider such factors in consultation with a professional advisor of their choosing when deciding if an investment is appropriate. The Company has prepared this report based on information available to it, including information derived from public sources that have not been independently verified. No representation or warranty, express or implied, is provided in relation to the fairness, accuracy, correctness, completeness or reliability of the information, opinions or conclusions expressed herein. This report is preliminary and subject to change; the Company undertakes no obligation to update or revise the reports to reflect events or circumstances that arise after the date made or to reflect the occurrence of unanticipated events. Trading & Investments in cryptocurrencies viz. Bitcoin, Bitcoin Cash, Ethereum etc.are very speculative and are subject to market risks. The analysis by Author is for informational purposes only and should not be treated as investment advice.

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