Ask HN: Thoughts on Cryptocurrency Indices?

[haggenballs]

Cryptocurrency indices typically take the top 20-30 cryptocurrencies by market cap and apply one of these 3 different methods.

  1. Weighted proportionally by market capitalization 
  2. Weighted proportionally by market capitalization but capped at a certain % 
  3. Weighted by square root of market capitalization

Proportionally weighting makes the index vulnerable to a s single large constituent.

Capped and other weighting methodologies theoretically should diversify risk and reduce volatility. But if there is strong positive covariance between coins, then volatility is not necessarily being reduced in the index as a whole.

What do you guys think? I gave it my best shot and blogged about it here:

https://medium.com/hodlblog/hodlbot-cryptocurrency-investing-on-autopilot-dce2e4c9a7f7

[cimmanom]

Frankly, the same thing happens to a slightly lesser degree with stock and bond markets. Cryptocurrency is more extreme in this regard because most cryptocurrency "investment" is still essentially speculation on the concept of cryptocurrency in general.

Another poster mentioned diversifying your portfolio. There are at least two dimensions to diversification.

One is diversifying among types of assets. That is, stocks vs bonds vs money market vs real estate vs crypto, etc.

Another is diversification with an asset type, which is what an index helps with. You could have a portfolio with a healthy mix of stocks vs bonds vs other assets. But if all the stock holdings were in IBM, that's not actually a diverse portfolio.

So: if you're investing in crypto as part of an otherwise healthily balanced portfolio, a crypto index fund is a good idea. But that doesn't replace having other investments spread across stocks and bonds et al.

Now, take a look at how stock or bond index funds work. Each one has different strategies for balancing how much of which individual securities (individual stocks/bonds) it includes.

Those strategies are mostly intended to protect you from volatility in one stock or bond that doesn't match the market. That is, to make sure that your portfolio goes up in a bull market regardless of whether Enron just crashed, because on average stocks are rising.

However, every index fund moves with the market. When there's a bull stock market, stock index funds will go up and bonds will go down. In a bear market, stock funds will go down and bond funds will go up. The performance of assets in the same class is always correlated.

An index fund will never protect you against the volatility of the market as a whole. It only protects you against the volatility of an individual asset.

I'm sure books have already been written about the tradeoffs between various portfolio weighting strategies within a single asset class. Maybe that would be a good place to start.

[ecesena]

I don't think that "diversify" is used with the correct economic meaning, because to diversify you need independent assets, and cryptocurrencies are not. Let me try to explain my thoughts.

To diversify you typically want to invest in assets that are independent and with a similar expected return. Only if they are independent you're really reducing your risk or, said in another way, the more independent they are, the more you're reducing your risk.

Cryptocurrencies are far from being independent, you can easily tell by charting them together, e.g. https://priceeth.github.io, so I don't think you're really reducing any risk.

[haggenballs]

Yeah exactly. Although there are some pairs that have low and negative covariances.

Check out this: https://blog.enigma.co/markowitz-portfolio-optimization-for-...

[ecesena]

Mmm... I'm not sure I'm reading this correctly, but it seems that these portfolios only win against BTC. So if you just invested in ETH, you'd have done much better.

I guess what I'm saying is that you're not reducing risk by keeping the same expected return (well, unless you arbitrarily claim that all cryptocurrencies have the same expected return, for which there's no data evidence). You're just averaging your returns.

[arcaster]

Awesome to see great stuff like this coming from the Enigma team! Founders are a great group of talented ppl!

[jxub]

"Ask HN:" prefix please

[haggenballs]

Thanks !