Index funds are slowly becoming a recognizable trademark of the emerging cryptocurrency asset class. Due to their inherent ability to reduce volatility, track the market, and provide dynamic risk adjusting exposure, they can help people get started dabbling with digital assets without requiring extensive effort.

Many traditional investors will turn towards services like Bitwise or Crypto20 to manage their cryptocurrency funds. These services provide a small selection of index funds which are convenient for people who haven’t spent time researching the market and just want to throw their money into anything. However, there will be those people who want more options than a few curated indexes. They will want to strategically design their own index based on what is working the best in the market at this moment.

Developing your own indexing strategy requires some initiative, but the knowledge that’s acquired through the process will become invaluable in better understanding how your strategy is working for you.

Index Strategy Research

There are a number of aspects we should consider when constructing our indexing strategy. Each one of these components will play a crucial role in ensuring we are being effective.

Asset Selection

Before getting into the technical details of the index fund, the first thing we need to do is decide on the assets which should be in the index. This is fundamentally what matters more than anything else we will do with our index.

In general, the most common way to select assets for a cryptocurrency index is to prioritize those with the highest market cap. That means calculating the cryptocurrencies with the highest market cap and selecting the top 10, 20, or 30.

Calculating the market caps of each individual asset can be time consuming, so services like CoinMarketCap can be used to accelerate the process.

Inclusions

There are times when you might want to include specific assets in an index, even if they don’t abide by their asset selection methodology. While this wouldn’t be possible when using services like Bitwise or Crypto20, building our own index fund provides us the flexibility to adjust our index to include assets which don’t abide by a strict selection criteria.

An example would be if we want to create an index of the top 10 assets by market cap, but based on our research, we have a strong belief the asset currently ranked 15 by market cap will soon pump. In this case, we can construct an index which includes assets from rank 1 to 10, but also include the asset which is currently ranked 15 by market cap.

Exclusions

Similar to ‘inclusions’, there are times when you may want to exclude an asset from an index, even when the asset strictly meets the criteria to be included in the index. Constructing a personalized index allows us to make these decisions without impacting our entire indexing strategy.

One example of common assets which are excluded are stablecoins like USDT, TUSD, and USDC. Since most people place their funds into cryptocurrencies to get exposure to digital assets, keeping stablecoins in an index serves no purpose for our intentions. Additionally, your philosophy may dictate that no forks should be included in an index. In that case, it is your prerogative to eliminate assets which are forks of other cryptocurrencies to abide by your philosophy.

Buffer Zone

Most index funds will use a form of dynamic asset selection in order to automate the process of how assets are added or removed from the index. Continuing from the previous examples regarding constructing a market index based on the top ‘X’ assets by market cap, this would allow the allocations to update as the market changes and the top 10 assets are replaced by new assets.

One option for how to evaluate when to add or remove an asset from the index is to use a ‘buffer zone’. This defines a threshold at which point an incoming asset should be considered for addition into the index. A common example is the use of a 5% ‘buffer zone’. When a new asset increases in market cap to become 5% higher than another asset in the index, the new asset is then added to the index, removing the asset which was beat out.

Allocation Distribution

It is not only important to have a clear understanding of the assets which should be in your custom index, but also the weighting each asset should hold in the index. This will influence how much of your total value is placed into each individual asset.

Market Cap Weighted