Crypto Index Funds: Risk Management Tool, or Risky Business?

One of the core tenets of crypto is decentralization, and that means there's no hotline or 1-800 number to call if you mismanage your investments. No one can get your money back—not even the people who invented the blockchain on which you’re executing your trades—whether you lost it through scams, theft, or just plain bad investments.

For this reason, fintech startups are rolling out index funds for decentralized finance (DeFi) like hotcakes, as a convenient way for investors to gain diversified exposure to a broader swath of the top crypto coins while mitigating all the inevitable risk—in theory. 

However, DeFi investing of any kind comes with its fair share of caveats, so let’s take a look at what crypto index funds are and what investors should know about them.

Broadly speaking, a crypto or DeFi index fund is a type of security that allows investors to have diversified exposure to a particular group or category of crypto tokens. 

For instance, investors may buy shares in a DeFi index that represents the top 10 cryptocurrencies in the market. That way, even if one coin or project tanks, there are nine others that could still perform well.

Crypto index funds can refer to shares that are publicly traded on a traditional stock market or the new decentralized indices that exist purely in the DeFi world to be traded in the form of crypto tokens. 

Examples of crypto indices include:

• The Index Coop DeFi Pulse Index 
• The Index Coop Ethereum 2x Flexible Leverage Index
• The Index Coop Metaverse Index
• The Bitwise 10 Crypto Index Fund
• The Galaxy DeFi Index Fund
• Amun’s Solana Ecosystem Index
• Amun’s Polygon Ecosystem Index
• Amun’s DeFi Index Token
• S&P Bitcoin Index
• S&P Ethereum Index
• S&P Cryptocurrency MegaCap Index
• The Grayscale Digital Large Cap Fund 
• The Morgan Creek Digital Asset Index Fund

Some of these products are capitalization-weighted funds that select assets to include in the fund based on market cap, while others—like Index Coop’s Ethereum 2x Flexible Leverage Index and Amun’s Solana Ecosystem Index—are based on choosing underlying tokens from specific projects. 

Some of the indices on the above list are publicly traded, while others are tokenized cryptos that represent a tiny share of diversified ownership of all the cryptos included in the index.

As of now, most publicly traded crypto indices are available to high net worth accredited investors and institutional investors only, with a few emerging options available for retail investors.

For this reason, a number of decentralized crypto indices have been developed that give anyone fluent in DeFi with enough crypto to afford it the opportunity to partake in diversified crypto investing. These tokenized DeFi indices are available to anyone with a DeFi wallet and willingness to learn how crypto works. 

“Crypto offers a lot of opportunities,” says James Wang, head of tokens at Amun. “For people who want to do the homework and who love researching technology, I think [index tokens are] probably the highest bang for the buck activity.”

DeFi is unregulated at present, so participation is always at the investor’s own risk. And the U.S. exchanges are not keen on listing index tokens because regulatory guidance from the Securities and Exchange Commission (SEC) is still evolving.

“They don't want to arguably list anything that resembles a security,” says Wang. For this reason, he says, Amun is incorporated in the Seychelles, a sovereign island state off the eastern coast of Africa. 

“We've chosen a fairly friendly regulatory base,” Wang says. “And we've made the contracts as decentralized as possible. It's not really us running the code. We're not managing your money. We don't really take your money. It's managed by a smart contract.”

“When you buy something on the traditional exchange through fiat or traditional payment railways, it is very standard and safe,” says Armando Aguilar, an independent digital asset strategist formerly at Fundstrat Global Advisors. These options appeal to investors looking to balance out their portfolio with some crypto exposure and liquidity. 

The DeFi crowd, however, prides itself on operating with a healthy dash of independence: “It's a nascent area that's growing in a lot of demand,” Aguilar says. “[Anyone is] able to just go and buy [DeFi indices] on blockchain …it's usually the crypto native crowd, or the crowd that has more appetite for risk.”

When buying a DeFi index token, such as one of Amun’s offerings or one of the Index Coop DeFi products, you have to remember that historical data to determine which of the top cryptos by market cap gets to be included is still new.

“It's so hard,” says Wang. “Whatever answer the data will show [as a top cryptocurrency in the past] will likely not work going forward. If you did the test in 2015, it would be very Bitcoin-centric. If you did it in 2017, it’d be Ethereum-centric, and in 2020, Solana-centric. The one constant in crypto is change.”

His advice? Compare every index you’re interested in buying, as every company will have a unique way of determining what belongs in their product lineup. And that will sit differently with each individual investor. 

“It’s very much a function of what does the investor believe in and where do they want to place their risk?” Wang says. In Amun’s DeFi index, for instance, the company gave equal weight to the allocations across its top eight coins. 

“It’s pretty unbiased and also gives a chance for the smaller participants to outperform market volume,” Wang says. “ And what's great about these index tokens versus ETFs, is that the buyer really holds the underlyings and they can get the underlying. So you know, if you buy the DeFi token for example, and it contains CURVE and AAVE and whatnot, if you wanted to own the underlying tokens you can take the tokens and on our website, click the ‘burn contract,’ and it will literally burn our token and give you the eight underlyings. It really shows the power of DeFi.” 

You can’t take your shares of an S&P 500 ETF, click a button on Schwab and get 500 of those shares, Wang argues. “With crypto, you really own the underlying assets.”