Index Fund Tokens – What They Are and How Do They Work
Tech Deep Dives

Index Fund Tokens – What They Are and How Do They Work

Created 2yr ago, last updated 1yr ago

Can investing in index tokens be a good way to get exposure to the market?

Index Fund Tokens – What They Are and How Do They Work

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Cryptocurrency investors are nothing if not spoiled for choice. Bitcoin may have the highest market capitalization, but it doesn’t necessarily see the highest gains. The world’s first cryptocurrency is a great place to start investing in digital assets, but there are thousands of alternatives to choose from, and some of them can be quite a bit more profitable.
Index funds have existed since the 70s and have become a popular investment option for many good reasons. For instance, the S&P 500 is one of the most actively traded indices in the realm of traditional finance, resolving the value of the largest 500 corporations on the New York Stock Exchange into a single, convenient investment.
Unlike indices based on traditional stocks, the advantage with cryptocurrency indices is that they can be redeemed for their underlying tokens, and quite easily. In little over a year, these community-led index funds have captured hundreds of millions of dollars in value from tens of thousands of users.

However, before connecting your wallet to the most accessible index token platform and making an investment, there are a few key points to understand about these products.

In this article, we’ll go through the essentials of what you need to know about index fund tokens, how they work, what you can do with them and the risks associated with investing in them.

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Save Your Time and Money

Knowledge truly is power when it comes to investing. However, far too many cryptocurrencies are available for any trader to research them all in a time-efficient manner. Cryptocurrency index tokens allow investors to give their portfolio broader exposure to the digital asset market without diving into the intricacies of which projects they want to back, and with how much money.

Indices also allow investors to instantly diversify their holdings while reducing exchange fees and other hidden costs that come with manually managing a diversified portfolio. This simplifies the investment process, especially for newcomers.

Since it’s possible to redeem the index’s underlying assets using its token, new traders have an excellent starting point to understanding the projects in the index.

Invest in All of Blockchain With One Token

Blockchain is changing how the world thinks about money, and while Bitcoin may have started it all, it’s the other projects building on blockchain developing the most cutting-edge innovations.

The market capitalization of all cryptocurrencies stood above $1 trillion at the start of last year, growing to a colossal $3 trillion by November 2021. At the time, Bitcoin was responsible for only around 40% of the total market capitalization — parking some capital in the rest of the market could prove fruitful in the long term.

The Total Crypto Market Cap (TCAP) is an index token that allows investors to profit from speculating on the growth of the cryptocurrency market capitalization as a whole. As an ERC-20 token, TCAP is available on a variety of Ethereum-based DEXs, as well as some centralized exchanges like Gemini.

Additionally, TCAP also allows holders to earn fees by providing liquidity on DEXs, and the token is pegged to the total digital asset market capitalization using Chainlink’s oracles, enabling it to aggregate a large number of data points from top data providers in the space.

Of course, not every token is worth investing in.

For those who prefer a more concentrated pool to invest in, the CRYPTO20 index tracks the performance of the cryptocurrencies in the top 20 ranks by market capitalization. While this cuts off a considerable chunk of the total number of tokens, the top 20 cryptocurrencies account for more than 90% of the total market capitalization and include assets like ETH, ADA, BNB, SOL, DOGE, SHIB and more.

Decentralize Your Finances

Decentralized finance (DeFi) is the culmination of years of attempts to bring the vast array of financial services into the domain of digital assets. For some, learning the basics of DeFi can prove too much, and understandably so. With so many concepts, protocols and terminology, it’s very easy to become overwhelmed or run into a wall trying to figure out where best to invest.
The DeFi Pulse Index (DPI) gives traders, especially newer ones, a safe and reliable route into the world of decentralized finance. Created by DeFi Pulse, a well-known data aggregator within the DeFi space, the DPI token tracks the performance of a variety of DeFi tokens weighted against their circulating supply.

DPI is built on Set Protocol’s v2 infrastructure and aims to include projects that have not only a significant following, but also those investing resources into blockchain and DeFi R&D. Currently, DPI consists of ten DeFi tokens, including COMP, MKR, YFI, SNX and BAL, among others.

Leverage Your Positions With Low Risk

One of the most significant innovations within the DeFi space has been the ability to lend and borrow cryptocurrencies without a centralized custodian. Using smart contracts, DeFi products facilitate disparate users to borrow assets against their holdings. While most loans in the crypto arena are overcollateralized, they are quite handy for increasing exposure to a specific market.

For example, Alice can put down 1 BTC as collateral against a 0.8 BTC loan, increasing her exposure to 1.8 BTC, essentially giving her 1.8x leverage on her investment. However, this requires some understanding of how different DeFi platforms function, and can be rather risky due to the high volatility in crypto markets.

With Index Coop’s Flexible Leverage Index, traders can obtain a 2x leverage in markets like Bitcoin and Ethereum, making it effortless to leverage BTC and ETH positions at much lower risk. Investing in the BTC2X-FLI, for example, gives traders the ability to invest in Bitcoin with 2x leverage without having to monitor their position, manage liquidations,or worry about price slippage.
The fund automatically dials the leverage up or down (within limits) based on market conditions to minimize the possibility of liquidation, and even allows for emergency deleveraging during potential black swan events to further reduce risk.

Invest in Sectors like the Metaverse

The metaverse has existed in concept for nearly three decades now. First described in a science fiction novel from 1992, the metaverse represents the future of online social interactions — an evolution of social media technology.

With NFTs giving people proof of ownership over digital commodities, blockchain is at the center of this shift towards a more digital society. Like with DeFi, newcomers can find the sheer number of projects to invest in pretty overwhelming, and with different projects building on various blockchain networks, keeping track of them all can be relatively cumbersome.

Similar to how the DPI tracks the top DeFi protocols, the Non-Fungible Token Index (NFTI) follows the performance of some of the most popular digital assets in the NFT space. Each token is weighted based on its supply and liquidity, and the index focuses primarily on projects that contribute back to the space. The index is maintained using a governance token called GNFT, and comprises projects like MANA, MATIC, SAND, AXS, YGG and ENJ.

Understand the Risks

Index fund tokens have a lot going for them and offer traders a quick and convenient way to invest in a diverse basket of crypto assets within a specific market sector.

However, these tokens are far from risk-free, and the pitfalls of these investments aren’t always obvious, particularly to newer investors.
The primary disadvantage of index fund tokens is their lack of flexibility — traders can’t change the composition of underlying assets to react to market changes, limiting their ability to fight back against losses.
Another point to note with these tokens is that they often do not outperform portfolios that invest directly into the underlying tokens. At best, most index funds provide equal returns, except in the case of leveraged index funds.
Additionally, many of these indices weigh each component based on market capitalization. While this allows the large-cap tokens to shine, they can also end up having an outsized influence on the index’s price. For example, a sudden drop in BTC or ETH value, which together account for nearly 60% of the total cryptocurrency market capitalization, would cause the CRYPTO20 index token to plummet significantly.
With blockchain bringing in a tectonic shift to the foundations of financial services, it was only a matter of time before index funds found their way to cryptocurrency investors as well. From groups like Index Coop and Indexed Finance to decentralized autonomous organizations (DAOs) like PieDAO and BasketDAO, digital asset markets are slowly seeing the value in indexed investments.
While the demand for these tokens today is still tiny compared to spot and derivatives markets, more index funds should arise as the blockchain industry approaches maturity in the years to come.
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