Wwith over 9,000 cryptocurrencies in the market, proper diversification and subsequent asset management can be an extremely time-consuming endeavor, especially with the rise of the DeFi industry. One of the most common ways to create investment portfolios for products like index funds is by weighting based on market capitalization. This practice has traditionally worked well for publicly traded companies, but the emerging cryptocurrency market is fundamentally different.

On its own, market capitalization is a relatively meaningless measure. Calculated by multiplying the last market price by the circulating supply, market capitalization is a very transitory indicator of perceived value; In fact, it can often create a false sense of worth. This is because, in crypto in particular, the circulating supply of a cryptocurrency is not properly defined and often does not take into account lost or blocked coins, among others. Specifically, market capitalization is only truly representative of the last known price of a cryptocurrency rather than its intrinsic value.

But overestimating market capitalization isn’t the only problem with adopting traditional investment strategies within crypto.

The maturity of the crypto market means that many projects are closer to the type of investment venture capitalists typically target as opposed to what you can find on Wall Street (Andreessen Horowitz, for example, is very active in the crypto). This is a lot of early stage companies listed on the stock exchange, but it is early stage nonetheless. Unfortunately, this does not lend itself as well to an “indexing” approach.

Another gap between traditional and crypto investing comes in the form of diversification. Most of today’s major cryptocurrencies tend to move in unison. Even if you have 20 unique positions, it can hardly qualify as true diversification if they all rise and fall together, and choosing projects based on market capitalization alone makes this outcome too likely.

For example, take a look at “Grayscale”Large Cap Digital FundWhich allows investors to gain exposure to a market cap weighted portfolio of large cap digital currencies including Bitcoin (BTC), Ethereum (ETH), XRP, Bitcoin Cash (BCH) and Litecoin (LTC) . Using a rules-based portfolio construction methodology, the fund targets coverage of the top 70% of the digital currency market and is reassessed quarterly.

While the overall performance of this index is strong, many investors are “unaware” that they are paying well above the token market rates. Why would you pay 2.5% to own 80% BTC and 20% ETH and a little dust from 2 other assets? Zooming out into the wider marketplace also shows a much wider range of opportunities than what is shown in grayscale.

Other funds, like Bitwise’s 10 Crypto Index Fund, offer a slightly wider variety of exposure but still place around 90% of the total portfolio in Bitcoin and Ethereum, which means smaller assets are arguably under. represented when they perform better than the big players. Looking through other indexes, it is not uncommon to find similar distributions in most of the products available.

Missed opportunities and liquidity risks

Market cap weighted index investing is particularly problematic because the crypto market is inefficient. For example, it can take a long time for a coin to be recognized and rank in the top 30 or 50. Additionally, Bitcoin’s dominance is usually so high that you have to cap maximum holdings somewhat arbitrarily, or you end up with ~ 80% Bitcoin.

As such, market capitalization does not sufficiently capture the value of projects early on, especially since many of these in the digital asset space are rather new and still small. Any portfolio built purely around market cap would gloss over opportunities for sizable returns and ignore promising startups until they have already generated sizable success.

Ethereum, Cardano, and Chainlink all play a role in DeFi, for example, but their current market caps of around $ 185 billion, $ 32 billion, and $ 11 billion, respectively, would never indicate any kind of clear correlation. And putting them together in an index would certainly deserve more than a market cap weighting.

Additionally, a large market capitalization does not guarantee the liquidity of crypto as it tends to do in traditional markets. For example, if you take a look at some of the top 100 coins on Coin Market Cap, you will find that some have very low liquidity. It is likely that trying to liquidate even a $ 1,000 position would have a noticeable impact on the price, making it a poor choice for a top performing crypto index fund.

And finally, indices don’t filter out quality, and you can easily end up with a significant portion of your portfolio in fairly worthless ranges with little to no future (much like BCH in the grayscale example). ).

Rebalancing is also problematic

Portfolio rebalancing is a simple strategy that institutions in the traditional financial system have used for decades. Rebalancing smooths out the profitability of crypto investments, forcing users to buy low and sell high.

Implementing rebalancing as a strategy for a portfolio means that the investor must first determine how much of their portfolio they want to allocate to each asset. In the case of cryptocurrencies, each asset would be a coin or a token.

Users are often forced to specify which 4, 6, or 10 coins to hold and what percentage to allocate to them, with the bot essentially making sure the balance doesn’t change. But in the end, you still only have those same coins. If the value of any of them drops completely while you’re not looking, you’ll sell your best performing assets to reinvest in your worst performing assets.

And since the “edge” risk is much greater in crypto than in traditional markets (where entry is regulated), if you don’t pay much attention to it, you could end up putting all your money in. a single worthless asset. in order to keep a previously defined relationship.

We believe there are better ways.

Automated portfolio managers

Typically, these platforms provide powerful tools for investors to build their own unique strategies. However, a downside is that they usually require users to understand and configure these settings on their own. This means that if bad choices are made early on, it can lead to underperforming returns until the entire system is manually recalibrated.

Additionally, a majority of these auto trading bots use an exponential moving average (EMA) as the primary strategy for analyzing the market, programming the bot to take action once the EMA rises or falls to certain thresholds.

While users can set their thresholds based on their risk profile, the main drawback of EMA is that it is based on past history, which as we know with any investment is not indicative. future performance – especially where volatility is common.

The other downside is that since EMA is a trading metric that everyone looks at, it’s hard to have an edge. Also, it could be good for trading, but not so much for long term investing.

A new approach

Fortunately, thanks to advances in artificial intelligence – in this case, operations research (OR) and machine learning (ML) – things are starting to change.

Modern portfolio theory has come a long way since Markovitz wrote about it in 1952 (and won the Nobel Prize a little later). And thanks to modern computers, it is now possible to evaluate hundreds of assets and their entire price history and calculate the ideal and diversified portfolio every 15 minutes.

Narrow AI is supposed to take some of the most powerful tools for asset analysis and automate them efficiently so that portfolio creation and rebalancing can be done with minimal oversight.

Crypto projects come with significant regulatory, business, and technological risks that users must manage dynamically. By using a strategy-driven portfolio builder to do the heavy lifting, new and experienced users can gain a noticeable advantage over traditional strategies used to build and balance portfolios.

We’ve already covered some of the logistical reasons why market cap weighting is not ideal for cryptocurrency indices, but now let’s take a look at some data to back it up. A diversification ratio (D ratio) is a measure of a portfolio’s diversification, and a higher ratio usually means lower risk. Looking at Bitcoin’s D ratios, the Crypto20 index strategy, the S&P 500, and the crypto-based portfolio construction algorithm, Autopilot, during 2020 we can see a noticeable improvement in our manager’s diversification. portfolio compared to indexation strategies. .

Overall, it’s clear that not all traditional approaches to portfolio building work effectively in the cryptocurrency market, and this is especially true for market cap weighting. Innovative, thoughtful, and fast-paced platforms seek to offer investors, new and old, a chance to engage with digital assets smarter than ever. More interestingly, AI-based strategies give these investors the opportunity to benefit from an institutional quality service without paying institutional experts. All of this combined is aimed at making investing in cryptocurrency in 2021 and beyond more accessible, less risky, and possibly more profitable than ever.

About the Author

Mathieu Hardy is Chief Development Officer at OSOM.Finance, trained as a cultural anthropologist with a good dose of macro and behavioral economics. Curious about how the digital realm offered a new playing field for the social sciences, Mathieu started working in IT change management and quickly turned to innovating digital business models. At OSOM, he found many opportunities to harness technology to rethink business models for more human-centric finance.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.