Crypto Index Funds and ETFs: What are They?

Crypto-backed financial products like crypto index funds and exchange-traded funds (ETFs) have shown their potential to disrupt the tightly-knit world of centralized finance. 

Blockchain technology, the power behind cryptocurrencies, has continually remained on investors’ minds. Cryptocurrencies burst into the global financial markets, promising a disruptive breather in finance and money markets by selling the power of decentralization.

However, while they have the potential to create a profitable business, the trouble is it’s not possible to “invest in cryptocurrency” as you would in the stock market via total market index funds.  

For a long time, players in the stock market remained skeptical or too busy to see through the “promise of change” that cryptocurrencies envisaged. Most failed to realize the emerging potential of crypto to become a modern financial product they could package. While investing in specific crypto tokens is possible, holding diversified crypto assets in your regular brokerage or even retirement accounts isn’t the easiest thing to do. 

For those interested, choosing from over 2,000 different kinds of cryptocurrencies remains nothing short of a nightmare. Do you invest in big coins like Bitcoin and Ethereum, or select the smaller ones? That’s because no one can tell which crypto assets will be bullish or bearish in the future. Crypto index funds and ETFs offer a chance for potential investors to bet on the entire market.

As financial firms begin to package this emerging product for potential investors, our comprehensive guide will dissect the topic of crypto index funds and ETFs and everything you need to know about them. 

What is a Crypto Index Fund?

A crypto index fund is an investment instrument that enables users to have a diversified cryptocurrency portfolio. By allowing investors to choose a group of cryptocurrencies instead of a single crypto asset, crypto index funds allow users to scale down the risk levels since they spread it across the different assets. This is akin to playing all sides so you can eventually come out on top. 

Investing in crypto index funds can be likened to investing in the entire stock market instead of buying stocks from individual companies. The fund managers purchase a similar proportion of all the stocks in the index. When you use such a strategy, you’ll be speculating on the performance of the whole market rather than relying on the stocks of one company.

For example, if you’re a fan of stocks from tech giants like Apple, Facebook, or Microsoft, you’re better off buying all three so that when the price of one falls, you’re still covered by the rest.  

How Crypto Index funds Work

The idea behind index funds is to create an uncomplicated investment product with minimal expenses that helps users make a high return on investment while avoiding the risks associated with handling individual cryptocurrencies. The index fund tracks the performance, price, and capitalization of different variables of a group of cryptocurrencies, similar to the S&P 500 index.  

The fund managers use the data available in the blockchain to calculate the performance of any group of cryptocurrencies using an automated indexing process, thus eliminating the possibility of human interference, arbitrariness, or error.  

Funds use the data available in the blockchain domain to transparently calculate any cryptocurrency group’s performance index. The entire indexing process is automated with minimal scope for human error, arbitrariness, or interference. The tokens offered by different cryptocurrency index funds represent the investor’s shares in the funds. Index funds are administered using dedicated servers that use blockchain-based smart contracts.    

The Impact on the Crypto Industry  

Crypto index funds can be beneficial to crypto investors in the following ways: 

Offer Diversification

Unlike other financial assets, predicting the price of cryptocurrencies is challenging due to their price volatility. As a result, any investor trying to analyze a single digital asset’s performance before making an investment decision will have to do a lot of work. 

Choosing a crypto index fund allows you to purchase a variety of cryptocurrencies in a single purchase. You can build a diversified portfolio, thereby increasing your capital base. Since index funds employ automated tracking, you can rest assured that your assets are safe since they follow and index.    

Attract New Investors

There are still doubts regarding the safety of making crypto investments for millions of potential investors who are still new to the blockchain world. Crypto index funds offer skeptical potential investors a less-risky reason to invest in cryptocurrencies. Investors won’t have to crack their brains analyzing single assets but rather get exposed to various cryptocurrencies via a single fund. This then makes it easier for beginners to want to venture into the crypto sphere.   

Increase Popularity

Despite the teething problems, such as volatility facing the sector, it’s evident that many financial institutions are already seeing the full potential of cryptocurrencies. That’s the reason leading institutions are already launching their crypto index funds.

The growing number of new index funds selling digital assets as a transparent option different from other inflationary and manipulative options has recently increased the popularity of crypto. As various parliaments and financial institutions discuss regulations and benchmarking, there’s every possibility that investing in crypto index funds will soon become more accessible and beginner-friendly.       

Pros of Investing in Crypto Index Funds 👍

Warren Buffet once described index investments as a sensible financial tool for investors. The same is true about crypto index funds when considering the benefits of investing in one. They include: 

Cost-Effective

Since fund managers mimic indexes, the charges associated with crypto index funds are relatively lower when compared to other available options. Also, since fund managers are likely to trade assets less frequently, it reduces the chargeable commissions and transaction fees. 

Diversification

Crypto index funds distribute investor risks widely by allowing them to invest in different cryptocurrencies. Investing in an index fund exposes you to different crypto assets. Instead of researching and buying different cryptocurrencies, you only need to select a credible investment fund for greater profit potential. 

Easier Decision Making

Investing in a crypto index fund saves you the trouble of struggling to predict a particular crypto asset’s performance. Instead of concentrating on one specific cryptocurrency, going for a basket filled with different crypto assets helps reduce emotional investment since you’re not attached to a particular cryptocurrency.  

Predictable Long-Term Returns    

Unlike individual cryptocurrencies that may not guarantee returns, investors in crypto index funds can rest assured of some returns in the long term. The steady income brought by diversification quickly cushions investors against any deep losses.  

Cons of Investing in Index Funds 👎

Some downsides of investing in crypto index funds include the following: 

Smaller Gains 

The presence of poor-performing cryptos in your portfolio could easily drag your returns. In some cases, you could experience delayed gains compared to other aggressive forms of cryptocurrency investments. 

Less Control

The crypto index fund managers are responsible for choosing the crypto assets they deem best at any particular time. As a result, you can’t remove or add any cryptocurrencies to your portfolio. 

Barrier to Entry

While some crypto index funds don’t place any minimum entry requirements, most have a sizeable starting point that could easily scare potential investors.  

What are Exchange Traded Funds (ETFs)? 

A blockchain ETF is an investment fund or product based on an underlying crypto asset. Blockchain ETFs specialize in investing in crypto assets similar to stocks of companies in the blockchain or crypto trading activities. Blockchain ETFs don’t have to invest in companies dealing with cryptocurrencies strictly. 

When as an investor, you buy into an exchange-traded fund, you buy into the underlying assets. As a result, you qualify to get a portion of the profits emanating from the growth of the underlying asset in relation to the value of your investment. Take note, though, that as an investor in an ETF, you don’t own the underlying asset like you would stocks. ETFs are traded in ETF markets, similar to how stocks are bought and sold in the stock market. 

It’s also important to note that there’s a difference between blockchain ETFs and Bitcoin or Ethereum ETFs. While blockchain ETFs are based on the value of blockchain technology, crypto ETFs are based on the value of a particular single cryptocurrency, whether it’s Bitcoin or Ethereum.

Whereas Blockchain ETFs track the stocks of companies that have invested in the technology, a crypto ETF tracks the value of the particular crypto asset. Currently, there’s precise regulation regarding the legality of blockchain ETFs, while ETFs are still at loggerheads with regulators in most jurisdictions.      

How Does a Crypto ETF Work?

Unlike the traditional ETFs that wholly own the underlying financial asset, crypto ETFs are different as they own the crypto stocks, cryptocurrency futures, or any other cryptocurrency-based instrument. Crypto ETFs work by mimicking the price movements of underlying crypto assets.   

Crypto ETFs are not currently approved to hold actual cryptocurrencies since many regulatory bodies still consider them too risky. As a result, they can have a combination of crypto stocks, options, or futures involved in the cryptocurrency sector.

However, since ETFs don’t necessarily hold cryptocurrencies, there are particular times when their movements may not correspond with the underlying crypto asset. In most cases, the ETFs will mirror crypto derivatives, not the crypto assets themselves.    

How the Value of Crypto ETF is Determined

The net asset value of crypto ETFs is determined based on the real-time calculation of the underlying assets. Since the ETF’s price fluctuation is affected by the price of the underlying crypto asset, you can expect its price to mirror the asset’s price. All ETFs explain the finer details on how they calculate their valuation, and, as such, investors are advised to carefully read the prospectus when they consider joining.

Pros of Crypto ETFs 👍

There are several benefits associated with investing in crypto ETFs, such as: 

Exposure to Cryptocurrency Outside of Exchanges

Before ETFs, unregulated and risky crypto exchanges were the only way anyone could interact with crypto investment. Crypto ETFs now offer the exposure to relate with Bitcoin away from exchanges.  

No Security Hassles

Security and storage issues have been hot topics in the crypto sphere, with stories about scams hitting the headlines. However, with ETFs, investors don’t have to hold the underlying asset directly, eliminating the risk of theft. As a result, you’ll never have to worry about forgetting or losing your crypto wallet address. 

Clearer Tax Implications 

There’s a lack of clarity regarding tax implications when you own cryptocurrencies and the profits you make while trading them. However, tax laws are more explicit when dealing with ETFs. 

There are more questions than answers regarding the tax implications of cryptocurrency and gains generated through trading these digital assets. However, tax laws are cut and dried, and those are the laws that will govern taxes associated with these funds. 

Cons on Investing in Crypto ETFs 👎

Like all the good things in life, there’s never been such a perfect investment vehicle in the financial markets. The following are disadvantages of investing in crypto ETFs:  

Lack of Regulation

While crypto futures are regulated, cryptocurrencies such as Bitcoin are not. The lack of regulation has been a thorn in the flesh for crypto assets, and this easily bleeds into any related investment when investors sour on the currency. 

Highly Speculative

Cryptocurrencies and the blockchain are relatively new technologies. While they have promised a shift in the world’s monetary system, there are issues here and there that are still being worked on before they can enjoy widespread adoption. That’s the reason investment in crypto ETFs is still highly speculative. 

Volatility

Cryptocurrencies are highly volatile, which equates to higher risk levels. 

Higher Fees

While investment funds generally accrue some management fees, crypto-based ETFs charge slightly higher fees than regular ETFs. 

No Dividends

Cryptocurrencies aren’t companies, and, as such, you can’t expect any dividends are a part of your return on investment. 

Lack of Diversification

Crypto ETFs are specific to the particular crypto futures only. Unlike traditional ETFs, where you can invest in a wide array of securities or an entire market index, if you choose a Bitcoin ETF, you cannot diversify across other financial assets. 

Should you invest in Crypto Index Funds and ETFs?

When investing in crypto index funds or ETFs, you can’t find a one-size-fits-all answer. While there’s significant potential to gain from crypto-related investments, there’s also a risk due to the volatile nature of crypto assets. However, as far as investing goes, you are a good candidate if you’re young or strong enough to tolerate any risks associated with crypto-related investments. 

The primary crypto index fund or ETF investor does not mind exposure to crypto assets without necessarily holding the assets in their portfolio. Since crypto index funds and ETFs are just beginning to hit the market, many crypto enthusiasts who believe they are the future money are glad to add one more feather to their caps.

Since no one can tell what the future holds, history shows there’s great potential for profit for those who invest in the early days. However, if you choose to invest in crypto index funds or ETFs, do your research, gain knowledge about cryptos and calculate the potential risks. Most importantly, limit your investment to amounts you’re comfortable losing if things go south.