The Narrative for Passive Index Investing - DeFi vs Crypto

In today's post I’m going to discuss passive index investing and list out why I see it as one of the best ways to gain exposure to sectors within crypto as well as crypto as an emerging asset class.

Active investing requires a hands-on-approach, typically executed by a portfolio manager of a fund, although, within the cryptocurrency space, it's more likely an individual. To execute this strategy, you have to be confident in each position you hold, maintaining a deep understanding of each investment and the overall sectors you have exposure to.

For those managers that can accomplish this, the rewards are lucrative with returns that outpace the benchmark indices. However, it is often difficult to maintain these excess returns over a long period of time due to several factors.

The first is assets under management. As successful managers attract additional capital their funds can become too large to deploy into the existing strategies that brought them excess returns. As a result, fund managers are forced into more liquid underlyings which tend to make up large parts of the benchmark index and thus the funds performance converges with that of the index.

The second factor is the fund manager. Successful fund managers are sought after and often poached away by other funds offering illustrious compensation packages. Naturally, due to the scarcity of such a skillset the funds performance typically suffers, losing its excess returns, after the departure of a successful manager.

The third factor is the use of leverage. Leverage can exacerbate returns in good times but can equally destroy value in bad times. This creates a larger variance of returns, increasing the portfolio’s standard deviation and reducing the risk adjusted return.

This thesis has largely proven to be true over recent history with actively managed large cap funds continuing to lag behind the S&P 500 for the ninth consecutive year. In fact, the longer the time horizon, the fewer funds that have outperformed the S&P 500, with only 8% of large cap actively managed funds beating the index.

Passive investing involves a longer-term investment strategy that looks to increase returns by minimizing active buying and selling on a day-to-day basis. In traditional finance, passive investing is very popular with 18% of total equity exposure represented by index-type products.

Passive index investing solves the problem of not knowing which investments are the right ones to choose. This is particularly useful when viewed through the lens of decentralized finance ‘Defi’ or any other crypto asset sector. Chiefly, this is due to the rate of innovation that exists in the cryptocurrency landscape. For example, the recent Defi sector expansion brought a slurry of projects to the market of varying quality. It would require a full time commitment to ensure investment into only the best projects whilst avoiding the many scams and contract vulnerabilities.

Continuing with the Defi example, a non-passive approach would have to consider what the top Defi projects will be in 5 years time? Will they be the same projects I see today or will new entrants come to the market? Ultimately, no one knows and through passive investing institutional or individual investors don't really need to care either. With an index tracking the 'Top 10 Defi Projects' by market cap will guarantee ownership of those top 10 projects in 5 years time; represented with one single token which can be redeemed or exchanged on the open market.

If you, the investor, have a long-term view on decentralized exchanges or believe crypto-insurance will play a bigger role within the cryptocurrency space as it continually grows. Then investing into an index product might be the most efficient method of gaining exposure. It provides easy access to sectors without having to purchase all underlying assets individually, and offers exposure to an asset class without requiring deep technical knowledge.

At this early stage in the development, decentralized indexes will disrupt traditional finance. Building this upon a Web 3.0 infrastructure. Ultimately, index technology hasn't changed since its inception in 1975.

If you look at traditional crypto exchanges, they suffer from having to list all the individual assets, with a crypto index maintained by the exchange, they wouldn’t have to go through this laborious procedure. I believe as time goes on, this will be a growing trend.

In summary, for investors with long time horizons, seeking access to a sector or asset class, an index remains the best vehicle for obtaining, expressing, and managing that outlook.

Someone I’m following in the space is PhutureDAO, they provide a range of benchmark, programmatic indexes with real underlying assets, auto rebalancing functionality, and a non-custodial architecture. Essentially, the closest comparison would be a user first, Vanguard type Index provider, built upon a Web 3.0 foundation. Open for all to build upon.

Through their platform they provide the facilities for investing into a range of benchmark indexes. More importantly, they empower you to create your own index that others can invest into; allowing for the creation and dissemination of your own investment strategy.

With this model, indices will always iterate with the fast pace of innovation in the cryptocurrency ecosystem ensuring a plethora of investment vehicles. Whilst, index creators can benefit from investor interest in the latest cryptocurrency segments/sectors.

Best regards EXCAVO