Indexing the market can be configured with a number of different advanced features. Learning each of these settings might take a few minutes to understand, but once understood they unlock powerful ways to implement your indexing strategy. The following guide will walk you through important features for any cryptocurrency index fund. 

Weighting

There are three primary weighting options when constructing a dynamic index. These three options are weighting by market, square root, and equal. To better understand each of these options, let’s break down how these different options work. 

Market Cap

Market cap weighting is one which tracks the market caps of the assets which are held in the dynamic index. That means the assets with a larger market cap will consumer more of the portfolio than those which have a smaller market cap. This allows your portfolio to closely match the current state in the market, resulting in a performance which will be as close as possible to the market performance of all cryptocurrencies. 

For example, if you have an index of two assets and the first asset is BTC and the second asset is ETH. 

  • BTC Market Cap: $137,008,021,275
  • ETH Market Cap: $26,081,172,184

Calculating the weightings in the portfolio.

  • BTC weighting: 137,008,021,275 / (137,008,021,275 + 26,081,172,184) = 84%
  • ETH weighting: 26,081,172,184 / (137,008,021,275 + 26,081,172,184) = 16%

Therefore, the allocations in this example portfolio would be 84% BTC and 16% ETH.

Square Root Market Cap

A square root market cap distribution will take the square root of each of the market caps to dampen the affect an individual single asset has on the portfolio. As we saw in the last example, Bitcoin held 84% of the value in the portfolio. Since this may be drastically more than desired since it places a lot of value in a single asset, we can use the square root market cap in order to dampen the holdings of a single asset in the portfolio.

Let’s examine how this will change the resulting allocations.

  • BTC weighting: 137,008,021,275^(1/2) / (137,008,021,275^(1/2) + 26,081,172,184^(1/2)) = 69.62%
  • ETH weighting: 26,081,172,184^(1/2) / (137,008,021,275^(1/2) + 26,081,172,184^(1/2)) = 30.38%

Equal Weights

An equally weighted index is one which allocates an even percent across all assets. If there are 5 assets in the portfolio, that means each will receive 20% of the value for the portfolio. If there are 10 assets, each will receive 10% of the total value of the portfolio. 

Asset Selection Range

Select assets based on the customizable range which you desire for your dynamic index. Whether you want to index the top ten assets by market cap, index 20 mid cap assets, or 30 low cap assets, this selection range allows you to do so. 

A couple examples of ranges you can select would be rank 1 - 10. This will include the top 10 assets into the portfolio by market cap and maintain them as they swap in and out of that range. Another option would be to select assets from position 50 to 70. This means the index will take the assets which market cap range from 50-70 and add them to the index. As assets move in and out of this range, they will be swap to maintain the desired allocation range.

Minimum Asset Allocation

The minimum asset allocation sets a minimum limit to the percent of a portfolio that can be allocated to a single asset. This prevents conditions where using a market cap weighted index results in a significant number of low weighted assets. For example, allocating the top ten assets on Bittrex by market cap at the time this article was being written would result in the following distribution:

  • BTC - 66.76%
  • ETH - 12.69%
  • XRP - 8.2%
  • BCH - 3.42%
  • LTC - 3.09%
  • BSV - 1.86%
  • XLM - 1.14%
  • TRX - 1.1%
  • ADA - 1.04%
  • XMR - 0.7%

We can see that the majority of the assets in the index are allocated less than 5% of the total value for the portfolio. This might be undesirable, so we can set a minimum percent. For example, if we set the 5% which we just discussed, the resulting portfolio would look like the following: 

  • BTC - 49.51%
  • ETH - 9.41%
  • XRP - 6.08%
  • BCH - 5%
  • LTC - 5%
  • BSV - 5%
  • XLM - 5%
  • TRX - 5%
  • ADA - 5%
  • XMR - 5%

We can see the weightings from the larger assets are decreased in order to increase the weightings for each of the assets that are below the 5% threshold. The outcome is no asset holds less than 5% of the total value of the portfolio.

Maximum Asset Allocation

The maximum asset allocation is similar to that of the minimum asset allocation. This prevents conditions where using a market cap weighted index results in a single asset holding too much of the weighting in the portfolio. Continuing from the last example, we can see that BTC is still holding almost 50% of the value in the portfolio. If we wanted to reduce this amount to 20% for example, the resulting portfolio would look as follows:

  • BTC - 20%
  • ETH - 20%
  • XRP - 19.51%
  • BCH - 8.14%
  • LTC - 7.35%
  • BSV - 5%
  • XLM - 5%
  • TRX - 5%
  • ADA - 5%
  • XMR - 5%

We see that placing a maximum asset allocation on our index has reduced our BTC weighting to 20%. In doing so, we redistributed some of the weighting to other assets in the index. ETH for example increased in weighting enough to also exceed the maximum asset allocation, resulting it capping at 20%. The remaining amounts left over are distributed to the remaining assets based on market cap.

Asset Swap Buffer

The asset swap buffer is the allowable buffer before assets are swapped in or out of the portfolio. Since constantly adding and removing assets from a diverse portfolio can lead to excessive trading fees, the buffer places limits on when these swaps can occur. 

As an example, when a buffer of 5% is set for an index, this means an incoming asset must acquire enough market cap to become 5% more than the next largest asset in the index. 

Say we have an index of 2, using the example above with BTC and ETH.

  • BTC Market Cap: $137,008,021,275
  • ETH Market Cap: $26,081,172,184

Since ETH currently has a market cap of $26,081,172,184, that means the only way for ETH to be removed from this index is for an asset to reach a market cap of 27,385,230,794 or greater. Notice although the market cap of ETH is only $26,081,172,184, an incoming asset would need to acquire an extra 5% in order to be able to cause the swap. This prevents constant swapping of assets in and out of the index. 

Exclude Assets

Excluding assets ensures the asset which has been excluded will not become allocated in the index. If the excluded asset falls within the index range such that it would have been allocated if it had not been excluded, the asset will be replaced with the asset of the next highest ranking.

Imagine we have an index of the top 10 assets. The current portfolio would look as follows:

  • Rank 1
  • Rank 2
  • Rank 3
  • Rank 4
  • Rank 5
  • Rank 6
  • Rank 7
  • Rank 8
  • Rank 9
  • Rank 10

Now, let’s say we want to exclude the asset which is currently rank 5. The resulting index for our portfolio would be the following:

  • Rank 1
  • Rank 2
  • Rank 3
  • Rank 4
  • Rank 6
  • Rank 7
  • Rank 8
  • Rank 9
  • Rank 10
  • Rank 11 

Notice how Rank 5 is no longer in the index, however “Rank 11” has now been included. This allows us to keep 10 assets in our portfolio, even when an asset has been excluded.

Include Assets

In contrast to excluding assets, there are times when you will want to include an asset. This allows for the selection of a range of assets, but also include assets in the index which may be of specific interest to you. They may be inside or outside the range of the index. Including an asset means no matter where this asset’s ranking lies, whether it drifts inside or outside the index range, and regardless of price changes, it will be included in the index.

An example of this feature in action would be if you wanted to create an index of the top 5, but you also wanted to include DOGE because it holds a special place in your heart. The index would look like the following: 

  • Rank 1
  • Rank 2
  • Rank 3
  • Rank 4
  • Rank 5
  • DOGE

Notice: Rank 1 - 5 are included in the portfolio as well as DOGE. That means there are 6 total assets which will be added to the portfolio during portfolio allocation. 

Now that we have explored the core features which are required to construct a powerful cryptocurrency portfolio index fund, it’s time to implement this strategy for your portfolio. Implement your dynamic cryptocurrency index fund strategy with Shrimpy by signing up today! It’s free, so what are you waiting for - sign up here.

Additional Good Reads

How to Rebalance your Cryptocurrency Portfolio

Threshold Rebalancing - The Evolution of Cryptocurrency Portfolio Management

Crypto Users who Diversify Perform Better

Developing Trading Applications with Shrimpy’s Crypto Exchange API

Did this answer your question?