With so many digital currencies to choose from, investors and traders may feel overwhelmed when considering the crypto space. Another factor that can complicate things is the wide range of methods they can use to invest in these innovative assets. Fortunately, there are ways to obtain diversified exposure to digital currencies via index funds.

What Is An Index Fund?

An index fund is a type of mutual fund that provides buyers with exposure to the assets contained in a particular market index.^[1] An index fund doesn't employ a staff to evaluate and pick out investments, so it lacks management fees.

An example of a mainstream index fund would be one that follows the S&P 500 index, a benchmark group of stocks. The S&P 500, a very well-known index, contains stocks granting exposure to major companies based in the U.S.^[2]

Crypto Index Funds

A crypto index fund is just like any other index fund, except it invests in digital currencies instead of other assets, like stocks. To get started, an investor buys shares in the fund.^[3] Then, the money they put into those shares is divided between different digital currencies based on a certain methodology.

The methodology or formula that a crypto index fund uses to invest involves evaluating variables like market capitalisation and price.^[3] More specifically, more than one such fund invests in some of the largest digital currencies in terms of total market value.^[4][5]

Examples Of Crypto Index Funds

Bitwise 10 Large Cap Crypto Index Fund

The Bitwise 10 Large Cap Crypto Index Fund was designed to follow the 10 largest crypto assets by five-year market capitalisation.^[9] The fund, which is open to accredited investors in the U.S., requires a minimum investment of US$25,000.

Grayscale Digital Large Cap Fund

The Grayscale Digital Large Cap Fund gives investors exposure to blue-chip crypto assets.^[10] The fund, which includes Bitcoin, Litecoin, Ethereum, Bitcoin Cash and XRP, aims to retain assets worth 70% of the entire market for digital currencies.

Benefits Of Crypto Index Funds

The approach of passively following an index simplifies things for investors by making it so they don't have to select individual digital currencies. This removes the need to conduct research on each individual digital asset as a potential investment. Evaluating each digital asset, one by one, could prove exhaustively time-consuming, so simply investing in a promising index fund could provide an excellent alternative.

Another benefit provided by crypto index funds is diversification.^[3] Barry Ritholtz, a professional investor and Bloomberg columnist^[6], stated that "The beauty of diversification is it's about as close as you can get to a free lunch in investing."^[7]

Diversification is crucial because it can help a person increase their chances of meeting their investment objectives.^[8] More specifically, by including multiple assets like digital currencies in a portfolio, an investor can reduce the chances that depreciation in one particular asset will substantially reduce the value of their principal. Also, by including multiple assets, an investor will have several opportunities to potentially profit.^[8]

Drawbacks Of Crypto Index Funds

One downside to crypto index funds is that even though they don't charge to have staff actively select assets, their expenses can still be high.^[3] The Bitwise 10 Large Cap Crypto Index Fund has an expense ratio of 2.5%.^[4] The management fee of the Grayscale Digital Large Cap Fund is even higher at 3%.^[5]

In contrast, the average equity index fund has an expense ratio below 0.1%, according to 2016 figures supplied by the Investment Company Institute.

Plus, investing in a crypto index fund may require a significant capital outlay, for example the US$50,000 minimum investment for the Grayscale Digital Large Cap Fund.

Summary

Crypto index funds can provide investors with a means of gaining exposure to a portfolio of digital assets with a single purchase. Instead of researching individual crypto assets for potential inclusion, an investor can simply buy shares in a fund, potentially saving substantial amounts of time.

Further, a crypto index fund can provide an investor with a simple means of obtaining diversification, helping them reduce the risks associated with putting their money in a small number of digital assets.

However, crypto index funds have their downsides, such as high expenses and initial capital outlays that are significant. As always, investors can benefit significantly from conducting their own research.