Numerous studies have proven that a passive index tracking approach to fund management outperforms an actively managed approach when it comes to investing in the stock market. Index Tracker funds replicate the holdings of an index, such as the S&P 500 US Large Cap Stock Index, by buying the same securities found in the index with the same weighting. This allows investors to “buy the index” at a lower cost as opposed to purchasing a more expensive actively managed US Large Caps stock fund, where the portfolio manager will try to outperform the S&P 500 by picking “winners” and avoiding “losers” among the S&P 500’s constituents.
Cryptocurrency Index Funds are Coming
Currently, there are several startups looking to apply the same concept to the world of digital currencies. An example would be the decentralized, blockchain-based fund management platform Iconomi. They successfully completed their initial coin offering in October and are working on building the ICONOMI.INDEX FUND, that aims to replicate the overall performance of the cryptocurrency space by holding a subset of the most commonly traded cryptocurrencies.
Another startup looking to create a cryptocurrency index fund is UK-based DLT Financial, which is working on building an investable index composed of ten digital currencies including bitcoin. Private and institutional investors can invest in the index to gain exposure to digital currencies without having to invest in each currency separately and deal with the technical and the security issues of buying and storing several different cryptocurrencies.
Invest in Bitcoin Or a Subset of Cryptocurrencies?
Given the historical outperformance of index tracker funds over actively managed funds in traditional capital markets and several, upcoming cryptocurrency index funds, we have to look at whether such an approach would also work in the cryptocurrency sphere or whether simply putting your money into the largest and most prominent digital currency, bitcoin, is still the way forward.
Entrepreneur and cryptocurrency enthusiast Willy Woo looked closer at this question by running a set of price performance simulations of an index of altcoins versus the bitcoin. The findings were published on his blog, where the results have turned out to be very interesting for cryptocurrency investors.
Woo compared the price performance of bitcoin with the price performance of the top 10 altcoins, rebalanced every 30 days to include new entrants, from October 16, 2013, to October 16, 2016. This time span includes two bull markets and a bear market for BTC-USD, making it an excellent time horizon to create justifiable results for such a simulation. The simulations also compared the price performance of bitcoin with the top 20 altcoins and with the 11-20 “small cap” cryptocurrencies during in two further simulations.
For all simulations the outcome was clear; the price of bitcoin performed better during the three-year time period than the indices of altcoins. While altcoins tended to perform better in bull markets, they greatly underperformed vis-á-vis bitcoin in bear market;
- In the bitcoin versus top 10 altcoins simulation, bitcoin outperformed 3.8 times over the market capitalization weighted altcoin index.
- In the bitcoin versus top 20 altcoins simulation, bitcoin outperformed the altcoin portfolio by a factor of 3.4.
- While in the bitcoin vs. top 11-20 altcoins simulation interestingly bitcoin outperformed the altcoin portfolio only slightly by a factor of 1.2.
Woo also ran a simulation of the price of bitcoin against the top 20 altcoins but with an equally weighted, as opposed to market capitalization weighted, altcoin portfolio for the same time period. The result in this simulation was that bitcoin provided a return to the factor of 4.6 versus a return to the factor of 0.64, that is a significant loss, for the equally-weighted altcoin portfolio.
This, of course, begs the question whether cryptocurrency index funds, such as the proposed ICONOMI.INDEX Fund, will make a sensible investment once it launches. Woo also addressed to this question in his analysis by simulating the performance of Iconomi’s proposed index fund, with the data currently publicly available, against the performance of bitcoin. Echoing the previous results, he found that a buy and hold investment in bitcoin would have outperformed the ICONOMI.INDEX Fund by a factor of 3.78 during the selected simulation period.
Simulations Indicate Bitcoin Trumps Altcoin Index Funds
The results of Woo’s simulation point clearly to bitcoin serving as a better buy and hold investment than broad cryptocurrency index funds. However, as every investor knows, past performance does not guarantee future results.
Should altcoins, such as Ethereum’s ether for example, continue to grow and substantially rise in value, future cryptocurrency indices may end up outperforming bitcoin. Hence, this analysis needs to be taken for what it is; a simulation run on historical prices on a range of different cryptocurrencies and not a model to predict future price performance.
Also, Woo’s simulations did not run the past performance of bitcoin versus portfolios of the 10 or 20 most traded cryptocurrencies that include bitcoin as a major portfolio component. Such portfolios would have outperformed the pure altcoin portfolios that Woo used in his simulations. A further analysis on such cryptocurrency portfolios’ performance would be useful to investors as well as startups looking to launch investment vehicles with cryptocurrency indices as the underlying asset.
Therefore, to state that bitcoin outperforms cryptocurrency index funds, more analysis would be needed. Nevertheless, Woo has made a very good point in the publication of his findings that the fast-moving altcoin space is very volatile and new digital currencies can disappear again as quickly as they appeared and, also, that during a bear market, bitcoin is still the smarter investment in the cryptocurrency space.
The idea of holding a basket of digital currencies through one single easy-to-use investment vehicle to gain long-term exposure to cryptocurrencies is certainly an attractive prospect, especially since digital currencies will most likely play a major role in how we handle all types of transactions in the future.
However, Woo’s analysis does highlight that, for the time being, a pure bitcoin holding might be the optimal investment until future cryptocurrency index funds have proven that they can deliver better returns than the world’s leading cryptocurrency.