Passive Index Funds account for about 50% of every new dollar that flows into the stock market. You could say they’re kind of a big deal.
But not so in digital finance. Up until recently, you were the equivalent of a stock picker. You’d need to get to know a project, understand the founding team, learn about the product, where it sits in the market, etc, and then make the hard decision of which ones and how much you should invest, if any.
The problem is that we have decades of data that show humans are notoriously bad at picking the winners in financial markets. Over the last decade only 15% of fund managers have managed to beat the S&P 500 average.
Sometimes it’s better to bet on a rising tide than pick an individual boat.
Before a few weeks ago this really wasn’t possible in digital finance. You’d need to scan Coingecko for the most valuable coins in a given vertical, head on over to Uniswap to purchase those tokens, and wait…and hope your research was sound.
But hark! For we are saved!
A slew of new projects have launched bringing the promise of passive index investing to DeFi.
Do you believe digital finance is going to be bigger in a few years than it is today?
If so, these funds offer a great way to get exposure to an increasingly broad set of tokens that should appreciate if that thesis is correct. This is digital finance after all, nothing is certain.
So today I’m going to explain what this new flavor of Index Fund means in digital finance, and explore some recent projects you might be interested in investigating.
What are DeFi Index Funds?
Broadly speaking, they’re very similar to the index funds you might know from the traditional world of investing. When you buy one of these funds, what you’re really getting is exposure to a collection of tokens that represents the digital finance (or DeFi, for decentralized finance) category.
In traditional finance you’ll find thousands of these baskets, tracking everything from large technology companies to water production. There isn’t as much definition in the world of digital finance yet, the best you’ll get is tokens with large or small market capitalizations at this point – but more will come.
What are the benefits of index funds in digital finance?
Oh, let me count the ways.
When you buy a single token, you get exposure to a single project. When you buy an index, you get a much broader exposure to multiple tokens, so your performance is more likely to represent the performance of the overall space. Unless you have very strong convictions about a given project, data shows this is more likely to improve your performance over the long term.
One difference to note is that while traditional index funds often have hundreds or thousands of individual tokens in their index, currently the options in digital finance usually have only single digit or low double digit sample sizes. This is still far more diversified than holding only one or two tokens.
Set it and Forget it
If you wanted to achieve this kind of broad exposure the old fashioned way, it would involve spreadsheets to calculate the amount of each token you’d want to buy, gas to go and purchase all those tokens on the open market, and constant monitoring to make sure you kept up with changes in the market as various projects rise and fall in value.
This is perhaps the greatest benefits of index funds – it’s all done for you.
You automatically get exposure to tokens in the right proportion, usually according to the market cap of each underlying project. They are also updated on a regular basis so that exposure continues to evolve with the market.
As the market changes, so does the makeup of the index. As projects rise and fall in prominence, new ones are added, old ones dropped – so you always capture the best performing parts of the market. Every month.
Especially in a space that moves as fast as cryptocurrency, the time savings this provides – in both time spent researching and executing changes – is immense.
Fees on passive index funds in digital finance are still relatively elevated when compared to the most popular index funds in traditional finance (~1% vs 0.25%, let’s say).
But the value you receive for that fee is even greater than in traditional finance. There are plenty of commission free brokers in traditional finance. If you really wanted to save on the fees associated with index funds you could go and buy each underlying asset in the right amount. Sure it would cost you a ton of time, but you could do it.
In digital finance, every transaction costs gas. And just like rocket fuel – gas ain’t cheap. And it’s likely only to get more expensive as more people start to discover DeFi.
So to build the equivalent portfolio yourself in digital finance would cost you so much in gas and slippage fees as to wreck your performance for some time to come.
This is an underrated feature of index funds in digital finance. Whereas you can be reasonably sure a publicly traded company isn’t a scam (well, maybe not, hello Nikola), the same can’t be said of digital finance, yet.
Anyone can create a token, a website, and some snazzy social media marketing. Sometimes, particularly as a newcomer, it can be difficult to tell a star from a black hole.
And this is why index funds are great. As of now they are all still human curated. Meaning that experts in the field, in addition to using data based criteria, look at the community reputation and community involvement of a token to make sure it’s on the up and up.
While you can never guarantee the success of any individual project, it’s much more likely you won’t have an out and out scam on your books by using this filter.
The Risks of Using Passive Index Funds in DeFi
Smart Contract Risk
These index funds are, themselves, smart contracts. As with any software they are subject to bugs, sometimes very bad ones that could cause the loss of funds (hasn’t happened yet to any of the funds I looked at).
The tokens they in turn hold might also have bugs in their smart contracts. One of the selection criteria for most funds is that those contracts have been audited by a third party, so there is some degree of safety, but you can’t ever be 100% sure.
If you were invested in the stock market during the crash in March 2020, you probably think you’re used to volatility. Think again.
Unlike stablecoins, Index Funds invest in tradable assets who’s dollar denominated price goes up and down just like any stock, sometimes wildly.
To give you an example, $DPI, an index fund I hold in our model portfolio, experienced a 45% decline in just three weeks. You want to track the overall digital finance market? You got it. But it’s not for the faint of heart.
Most of the indexes I’m going to mention have a set of published criteria they use to select the tokens they include in the index. I’ve read them and they all seem quite reasonable. But digital finance, just like the traditional stock market sometimes isn’t reasonable. They might be wrongly excluding some projects that are going to explode in value, or vice versa.
The good news is rules can be updated and adjusted over time as we learn how digital finance is either similar or different from traditional markets.
The Speculative Nature of Digital Finance
All of these indexes hold tokens whose value is determined by the market, rather than being pegged to another currency or stablecoin. For the most part all the tokens included are for projects that have heavy usage, distribute funds to token holders and have good cash flows – but that isn’t universally the case, and those fortunes can change quickly in digital finance.
Today’s superstar may be tomorrow’s dud. This also isn’t all that dissimilar from traditional finance, but I wanted to include it anyway.
Phew OK – let’s get to the meat and potatoes – let’s talk DeFi Passive Index Funds!
Top 4 DeFi Index Funds
We’re going to look at four index options today. Normally when comparing index funds you’d want to look at their performance, but most of these options are still so new we can’t really evaluate that yet. Instead I look at which tokens they track, as well as the ease of access and liquidity currently available.
What’s stood out to me was the variety we see across the four funds. Some of that is by design (small cap versus large cap), but I would have expected more overlap. To get exposure to the most tokens, you’d need to hold all four indexes. Additionally the weighting of tokens between funds varied quite widely as well.
DeFi Pulse Index
Currently DeFi Pulse takes the cake for my favorite index fund for a few reasons.
- It’s the easiest to enter of the four funds. You can either buy directly on their website or via Uniswap.
- It has the best liquidity available – more than 10x any other option. This means you can buy more of it with less price slippage. Given how new all these funds are I expect this to be a short lived issue.
- It has a regular rebalancing schedule. Other options need proposals to be made and ratified by their governing bodies. This takes time and results in less frequent updates to the index. It is possible $DPI takes this route in the future as well now that they’ve launched their own governing body.
- The rules for adding and balancing tokens in the index are easy to understand and clear.
DeFi Pulse Index does charge a 0.95% annual fee – the highest of the four options compared today. While still low compared with traditional mutual funds, it’s significantly higher than you would see on an index tracking ETF.
The current tokens included in the DeFi Pulse Index are:
Liquidity test: A $10,000 USDC purchase of $DPI on Uniswap would result in a price impact of 0.09%. This was the clear winner of the four tests I ran.
Best For: Medium sized investors who want exposure to more projects and are looking to build a five figure position.
Disclosure: Finance Astronaut holds this index in our Model Portfolio.
The “S” stands for small cap. If you want exposure to smaller DeFi projects – that of course have the potential to become big, this “Pie” from PieDAO could be for you. It only contains 6 tokens at the moment, but the list can be updated and adjusted by the community over time.
It’s also worth noting there are absolutely no fees (that I could detect) attached to DEFI+S. You will will incur a fee to swap into this token, as with all the others, but there was no ongoing cost to own this Pie.
Buying DEFI+S can be done on Balancer. A $1,000 purchase results in very small slippage, while $10,000 had much larger slippage, so liquidity is an issue currently. Liquidity is improving daily however as it’s being heavily incentivized by the governing body, PieDAO.
The current tokens in DEFI+S are:
- $UMA – 33% weight
- $REN – 31.5% weight
- $LRC – 20% weight
- $BAL – 11% weight
- $PNT – 3% weight
- $MLN – 2% weight
Liquidity test: A $10,000 USDC purchase of $DEFI+S on Balancer would result in a price impact of 1.61%.
Best For: Small investors looking for small cap exposure. Or any investor needing small camp exposure who can wait to build their position over time.
The counterpart to DEFI+S, this time with “L” standing for large cap, this fund tracks some of Defi’s biggest projects.
Surprisingly, this was the only index to include $LINK – a project with an incredibly strong following and recently some great price performance to boot. Beyond this, it’s largely similar to $DPI with exposure to fewer tokens, though of course this can be updated in the future by the community.
There are currently no ongoing fees for owning DEFI+L. There is a 0.1% fee when you first swap into it from another digital asset, but that is a one time fee. This helps DEFI+L compare favorably against the DeFi Pulse Index.
Similar to DEFI+S, a $1,000 USDC purchase on Balancer results in very manageable slippage, while $10,000 was much larger. DEFI+L is rapidly scaling is liquidity at the moment, again with heavy incentivisation from PieDAO, so hopefully this will be a temporary problem.
The current tokens in the DeFi+L Index are:
- $LINK – 18.8% weight
- $YFI – 18.3% weight
- $AAVE – 16.1% weight
- $UNI – 13% weight
- $SNX – 12.75% weight
- $COMP – 10.8% weight
- $MKR – 10% weight
Liquidity test: A $10,000 USDC purchase of $DEFI+L on Balancer would result in a price impact of 1.17%.
Best For: Small investors looking for DeFi exposure. Larger investors will need to be patient and build up their position over time.
It’s a shame that sDEFI is only tradeable on the Synthetix exchange, because it has the widest basket of tokens of any of the index’s I looked at. Though the rebalancing frequency of sDEFI is unclear, it’s done by community vote.
To buy sDEFI you first need to convert any other digital asset to their own stablecoin, sUSD, via Curve.fi. Once that’s done you can sell your sUSD for sDEFI here. This extra hurdle is a hassle, as there aren’t a lot of uses for sUSD outside of interacting with Synthetix. It would be good to see this requirement dropped in the future and I’d wager would see an uptick in adoption of sDEFI.
The current tokens in the sDEFI Index are:
- $COMP – 20.5% weight
- $MKR – 15% weight
- $KNC – 11.8% weight
- $SNX – 10.2% weight
- $ZRX – 9.7% weight
- $REP – 7.2% weight
- $AAVE – 6.7% weight
- $REN – 5% weight
- $UMA – 4.2% weight
- $LRC – 3.8% weight
- $BNT – 3.4% weight
- $BAL – 2.5% weight
There are no ongoing fees to owning $sDEFI which makes it very attractive if you want to take the additional step of converting to sUSD.
Liquidity test: I was unable to find a way to purchase $10,000 worth of sDEFI outside of Synthetix exchange. While once you’ve converted any of your assets to sUSD, the fees and slippage (there isn’t any beyond gas) are lower than any other option, this additional step alone made me consider whether to include it as an option.
Best For: Large investors looking for the broadest tracking available. This would make the extra steps necessary to get into sDEFI worth it.
DeFi Dad put together a great tutorial on how to purchase sDEFI if you’d like further information.
What’s Next for DeFi Funds?
A common trait of traditional index funds that’s missing from digital finance right now – dividend yield. Many, but not all, of the tokens held in these funds reward the holders of said tokens with fees earned by the protocol. Those funds would be distributed to these index funds, which in turn could either be distributed to the holders of the funds or reinvested to buy additional tokens. This is definitely coming soon – but isn’t there just yet.
There are only a handful of options for you to pick from at the moment. Partly because the number quality projects are still limited. But more are launching every day. As the market expands, I’m sure we’ll see additional slices of the market carved into their own index funds, just like in traditional markets.
So what do you think – do you like the idea of passive index investing coming to digital finance?