Next Generation Crypto Sector Indices — An Approach for Web3 ETFs for the Growing Web3 Ecosystem Beyond Bitcoin
As the world of crypto assets continues to expand, it can be overwhelming for investors to keep track of the multitude of assets available. While FTX and other imploding companies have led to more cautiousness on behalf of investors in the short term, the long term interest in crypto assets is steadily increasing. Yet, the interest in crypto assets and Web3 is still increasing. “Interest” though, does not necessarily mean that investors are ready to invest — events such as FTX usually force investors to step on the brakes. — Authors: Maximilian Bruckner, 21e6 Capital; Philipp Sandner, Frankfurt School Blockchain Center
Introduction
While some investors may have a clear preference for a specific token, others may have a broader interest in a particular sector of the industry or the market as a whole. A sector could be smart contract platforms, tokens from decentralized finance (DeFi), or tokens from the metaverse or the web3 space in the future. Much like the chemical industry or the automotive industry, indices for such industries provide a way for investors to invest in a coherent group of companies (or tokens). While such an index cannot replace the value of investing into a single token, it can provide valuable insight into the overall health of a specific sector. Additionally, these indices can be a powerful tool for evaluating the overall correlation of the crypto ecosystem. Currently, correlations among crypto assets are high. With the growth of the ecosystem, a decline in correlations and a stronger emergence of sectors can be expected. In traditional capital markets, index-based investing (that is, the growth of the ETF segment) has become an important part of equity investing due to the value and simplicity it can bring.
The case for crypto sector indices
Well-constructed crypto indices will become highly sought after among all investor groups and are a vital next step toward further adoption of the asset class as a whole. The case for crypto indices is easy to understand if we keep in mind what we already know from global equity markets.
The market is hard to beat. In fact, the market is very hard to beat. This is true for all asset classes, and it will be not different for crypto assets. According to S&P SPIVA, between 80% to 90% of large equity funds worldwide underperformed the S&P 500 index over a period of 15 years.[1] Year after year, reports emerge which further support this argument: observing Barclay’s hedge fund indices, we can see that hedge funds also underperformed the S&P 500 in the last 10 years — every year. Partly due to this reason, significant inflows into passive index funds in equity markets occurred throughout the last decade. It would be foolish not to expect a similar story in crypto assets.
Furthermore, a managed index is probably the easiest way to invest into any market. As such, entry barriers for both retail and institutional investors are almost non-existent here. First, the obvious: no need to self-construct an asset selection and deal with rebalancing, as well as deep-dive into hundreds of crypto assets (currently, thousands of tokens are available on the market). Second, an index tracker in the form of an exchange trade product (ETP) is liquid and tradeable daily on traditional exchanges (as the name suggests). Investors can therefore use the same infrastructure they already have in place for trading any other exchange traded assets — this eliminates switching barriers. They can simply add crypto indices to their existing financial portfolios. Thanks to clear and advanced regulation in the EU and Switzerland, ETPs issued here can deliver physical backing and licensed custody models. This effectively removes technological or trust-related barriers associated with setting up an in-house custody solution or being forced to trust unregulated third parties (like those domiciled in offshore destinations).
Several issues prevail in existing index solutions
NASDAQ recently made headlines when the index powerhouse announced their partnership with Hashdex to expand their business to crypto assets. However, their first available index, the NASDAQ Hashdex Crypto Index (NCI) is plagued by the same issues as many of their existing peers:
- Limited market representation: The index is constructed with a discretionary asset selection based mainly on market capitalization, with some exclusions due to market making and custody availability. While there are good reasons for a pure representation of the market through a focus on market capitalization, this is distorted by discretionary exclusions of certain assets. There is another, bigger problem resulting of such strict market capitalization based weightings: high concentration and little diversification.
- Little diversification effects: Inheriting a weighting logic from equity indices (based entirely on market capitalization) results in a crypto index with a 60% to 90% concentration in Bitcoin and Ethereum, the top two assets. Consequently, the index primarily tracks the prices of these two assets and becomes useless as a benchmarking tool or plausible investment. The appeal of an index, diversification and easy market representation, is at stake.
- Issues with outliers: High volatility in crypto asset markets leads to frequent short-term visitors in the top 10 or top 20, which may drop out again rapidly (in some cases, only to reappear weeks later). As such, inflexible index rebalancing may result in the inclusion of an outlier for a long period, simply by chance of the outlier entering the top 10 on the selection day. Again — inheriting the construction methods of equity indices does not result in sound crypto index products.
A new index methodology for the next generation of crypto indices
In co-operation with the International Token Standardization Association (ITSA) and OpenMetrics Solutions, 21e6 Capital suggests a solution to the previously explained issues prevalent in existing index solutions. Figure 2 shows an overview of the issues and how 21e6 Crypto Sector Indices propose to solve them.
Firstly, a well-structured market classification can help improve the current limited market representation displayed by other index families. Based on a broadly recognized classification system provided by ITSA, the 21e6 Crypto Sector Indices can achieve a better market representation. Furthermore, the new index family introduces the innovative concept of crypto sector indices. Crypto sectors can be viewed as coherent groups of crypto assets selected based on objective criteria.
Secondly, advanced mathematical and statistical procedures by OpenMetrics Solutions (an ETH-Zürich spin-off using state-of-the-art research and technology) allow for enhanced capital weighting techniques. By using market capitalization dampening factors, this technique reduces the high concentration of a few top assets prevalent in other approaches. Because of this, better diversification is achieved, and the index offers a real added value when compared to investing only in the top two assets (Bitcoin and Ethereum).
Third, issues with outliers. An inherent outlier resistance comes with using sector classifications. In addition, the methodology developed by OpenMetrics Solutions includes various considerations to significantly reduce the risk of including a short-term visitor into any index during volatile market periods.
Selecting six relevant sectors based on ITSA
The International Token Classification (ITC) developed by ITSA is a holistic standardization framework for the classification of DLT- and blockchain-based cryptographic tokens according to their inherent characteristics. This framework is based on a flexible and adaptable approach to classify crypto assets based on the design of various modular dimensions, which allow describing different aspects of a crypto asset in a multi-level hierarchical structure.
Currently, six classifications of the ITC framework meet the necessary criteria to not only be published as an index but also to launch investible, physically backed trackers. These six sectors are displayed in Figure 3. Some considerations include a minimum total market capitalization within the sector, sufficient volume and liquidity for institutional investment sizes, and high relevance to current and future trends in the market.
Upon first glance at Figure 3, one may complain about the lack of a “Metaverse”, a “Web3” or “DeFi” index. While the necessary classifications for constructing such indices are available, these sectors do not yet have sufficient liquidity at this stage to launch ETPs. These sectors will make more sense in the future once the crypto sector grows, and are sure to receive recognition then.
We believe that Index III and Index V may be particularly interesting here. While the first offers a smart solution to the often debated issue of energy consumption and thus ESG-related ramifications of crypto assets, the latter represents the most dynamic and important sectors of the growing crypto asset economy: smart contract platforms.
Index III — Ex Proof-of-Work: Tokens on proof-of-work blockchains are excluded here in favor of more sustainable and energy efficient consensus mechanisms such as proof-of-stake. Proof-of-work is a consensus mechanism used by some crypto assets, primarily Bitcoin, that requires miners to solve complex mathematical puzzles in order to validate transactions and add new blocks to the blockchain. This process requires a significant amount of computing power and electricity. It is frequently criticized due to its high energy consumption. By excluding proof-of-work tokens from the index, investors with ESG concerns can avoid supporting crypto assets that have a higher carbon footprint than others. This can help to align their investments with their values and priorities, and can also reduce the risk of their investments contributing to environmental degradation.
Index V — Smart Contracts: Smart contract platforms like Ethereum were one of the major narratives pushing adoption throughout 2021 and 2022. The use of smart contract technology is increasing in a variety of industries, including decentralized finance, NFTs, Web3, the metaverse, and gaming. By investing in a crypto index that focuses on these technologies, investors can gain exposure to a range of companies and projects that are using smart contracts to innovate and disrupt traditional business models. Because the market for smart contract platforms is relatively new and still evolving, there are likely to be a wide range of different projects and companies that investors can choose from. The uncertainty regarding which of the manifold smart contract platforms will gain market share in the future makes it a formidable case for an index. This can help to reduce the risk of any single investment having a significant impact on the overall performance of the index.
Conclusion
In conclusion, the adoption of crypto sector indices is likely to grow as the industry matures. These indices will provide investors with an easy and accessible way to invest in the market, and can offer valuable insight into the overall health of a particular sector. By offering a diversified portfolio of assets and reducing the risk of underperforming individual tokens, crypto indices can be a valuable tool for investors looking to make informed decisions about their investments. At the same time, crypto indices allow an easy integration in existing financial portfolios and remove technical hurdles such as the setup or maintenance of custody services. As the market for crypto assets continues to evolve, sector-specific indices will become increasingly important, like their equity-market counterparts.
About 21e6 Capital
21e6 Capital is a Swiss investment advisor, connecting professional investors with tailor-made crypto investment products. We focus on risk management of crypto and digital asset exposure for family offices and institutional investors. Our expertise in crypto asset management stems from a team combining decades of experience in traditional financial services with native and in-depth knowledge in digital assets.
21e6 Capital has analyzed over 1,000 crypto hedge funds across the world and condensed them into a selection that can yield crypto-exposure with minimized downside risk. Our risk management solution, provided by OpenMetrics Solutions, is also trusted by the largest Swiss pension funds.
The 21e6 Capital team builds upon strong academic roots with a track record of leading crypto asset and decentralized finance (DeFi) publications and research, ensuring state-of-the-art crypto investment solutions for professional investors, family offices and asset managers.
About the authors
Maximilian Bruckner is Head of Marketing & Sales at 21e6 Capital AG. Prior to this, he was engaged as Executive Director of the International Token Standardization Association (ITSA) where he focused on research and classification of crypto assets according to the International Token Classification (ITC) framework. He was heavily involved in the creation of the world’s largest token database for classification and identification data on tokens (TOKENBASE). Maximilian also did academic research at the Frankfurt School Blockchain Center. You can contact Maximilian via e-mail at maximilian.bruckner@21e6.io to request more information on 21e6 Capital AG or ask any questions regarding this article. You can also follow Maximilian on LinkedIn (https://www.linkedin.com/in/max-bruckner/) to stay up to date.
Prof. Dr. Philipp Sandner has founded the Frankfurt School Blockchain Center (FSBC). From 2018 to 2021, he was ranked among the “top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. He has been a member of the FinTech Council and the Digital Finance Forum of the Federal Ministry of Finance in Germany. He is also on the Board of Directors of FiveT Fintech Fund and Blockchain Founders Group — companies active in the field of blockchain startups. The expertise of Prof. Sandner includes crypto assets such as Bitcoin and Ethereum, decentralized finance (DeFi), the digital euro, tokenization of assets, and digital identity. You can contact him via mail (m@philippsandner.de) via LinkedIn or follow him on Twitter (@philippsandner).
References
Remarks
This article is an informational document and does not constitute an investment recommendation, investment advice, legal, tax or accounting advice or an offer to sell or a solicitation to purchase any securities and therefore may not be relied upon in connection with any offer or sale of securities. The views expressed in this letter are the subjective views of 21e6 Capital personnel, based on information which is believed to be reliable. Any expression of opinion (which may be subject to change without notice) is personal to the author and the author makes no guarantee of any sort regarding accuracy or completeness of any information or analysis supplied.
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